Piecing together the impact investing puzzle

Ben Thornley, co-founder at Tideline, looks at how value creation practices bring a manager’s impact credentials into sharper focus, the strong positive correlation between impact and financial performance, and the role of allocators in incentivizing and enabling managers to deliver impact value.

As the impact investing market matures, with over $1 trillion in capital, many of its distinguishing characteristics are becoming more widely understood.

Specifically, the two pillars of impact “intentionality” and “measurement” are relatively self-evident and form the backbone of asset owner diligence practices and emerging regulations. In the words of the UK’s Financial Conduct Authority, “the key attributes of the impact category are theory of change and measurability”.

By contrast, the third and final pillar of impact investing has remained more obscured: “contribution”.

This is understandable. Contribution as a concept can feel esoteric, with impact defined as a change that would not have occurred, but for the actions (i.e., contributions) of an investor. As a result, the industry has created frameworks that run the risk of over-engineering efforts to calculate investor “additionality” – a term often used interchangeably with contribution.

Yet it’s also a missed opportunity. Contribution can and should be described in simpler terms – as an investor’s active and differentiated role to create the impact they seek to deliver. And in the same way a raison d’etre of traditional diligence is isolating a manager’s differentiated financial value proposition, contribution is uniquely revealing of the skills and capabilities of impact investors.

That’s why, one year ago, Tideline and Impact Capital Managers (ICM) set about investigating a cornerstone of contribution: the investment holding period in private capital markets, when all investors put their expertise, resources, and networks on the line to create value and optimize an asset’s performance.

With that goal in mind, we believed that by zeroing in on the distinct ways in which impact investors are creating value, we could deepen our understanding of a few key questions that help provide more clarity on the contribution pillar:

• First, what are impact investors doing differently?
• Second, what are the skills and capabilities needed for impact value creation?
• And third, how are efforts to optimize for impact projected to directly enhance financial performance? In other words, how is impact financially material?

Here are a few of our biggest takeaways.

Impact value creation

When talking about impact, it’s important to first clarify the three overlapping ways in which positive social or environmental outcomes are generated through investment, since value creation strategies will differ depending on the modality in question.

Most impact investors focus on “growth” as the pathway to impact, by scaling inherently impactful products, solutions, and business models (83 per cent of the 12 managers we studied in detail).

Many investors (50 per cent) also create impact through a “systems” pathway, focused on systematic interventions affecting a company’s operations, workforce, or value chains, often with a broader objective of shifting industry norms.

Finally, we have the “transformation” pathway (16 per cent). Transformation is about pivoting an impact-agnostic business to be impact-aligned, often with the goal of catalyzing or accelerating such transition in the market.

The report that resulted from our research, New Frontiers in Value Creation, includes numerous examples of each pathway.

With the goal, then, of either growing, systematizing, or transforming their assets, impact investors are taking active steps during the holding period to create impact value, using their role as owners or lenders to enhance the social or environmental performance of an investment.

But how?

We discovered seven key impact value creation levers that repeated over and over, through the 12 case studies, dialogue at ICM’s annual conference, interviews with market experts, and the results from a survey of over 30 of ICM’s members.

> Impact positioning to strengthen the market presence of an asset

> Product/service development to enhance user/consumer experience

> Market building to expand the addressable market

> Workforce initiatives to support employee productivity and commitment

> Impact incentives to integrate impact goals into performance

> Access to aligned capital, with mission-driven investors complementing commercial sources of capital

> Impact risk management to avoid unintended consequences

Importantly, the levers to create impact value were almost always deployed with the goal of driving a commensurate improvement in the financial return of an investment – a linkage we detailed in our research.

ESG vs impact

While some of the seven levers build on traditional and ESG-driven value creation approaches and capabilities, they constitute an especially hands-on investment approach and, in theory, create an additional layer of competitive advantage unique to impact investors.

Traditional value creation strategies like cost transformation and buy-and-build optimize for cash flow and valuation multiples, while ESG-driven val­ue creation strategies like managing regulatory risk and improving an asset’s resource efficiency address broad stakeholder risks and opportunities. Distinctly, impact-led value creation is infused in an asset’s business and operating model and di­rectly influences the core drivers of financial value, in­cluding revenue growth, operating margin, long-term productivity, and valuation.

 Asset owner implications

Although it would be a stretch to claim we have definitive proof of the financial materiality of impact, the research convinced Tideline and ICM of the strong, positive correlation between impact and financial performance. As a result, we believe it would be unwise for allocators to risk not digging deeper into the unique capabilities that make impact value creation possible. These include the extent to which impact is part of a manager’s DNA and investment process, their heightened awareness of diverse stakeholder perspectives, and their access to unique networks, data, and expertise.

Unsurprisingly, asset managers are strongly influenced by the ex­pectations and preferences of their investors, particularly as they are expressed throughout the diligence process. As contribution is increasingly recognized as a differen­tiating factor in driving impact and financial performance, investor demand for fund managers who demonstrate these capabilities will continue to grow.

Impact investing as a harbinger

This year marks the 10-year anniversary of the publication of The Impact Investor: Lessons in Leadership and Strategy for Collaborative Capitalism, co-authored by this writer, together with Cathy Clark and Jed Emerson.

Our book concludes that impact investors have perhaps the most privileged window into larger economic mega-trends, where financial, social, and environmental performance intertwine, and therefore have much to teach all investors.

With some of the most difficult-to-access insights into impact investing coming into sharper focus – in this case, the pillar of contribution – allocators are being armed with information that will be critical to ensuring sustainable financial performance for decades to come.

What remains, however, is for allocators to turn the spotlight on their own role enhancing the returns of underlying investments, asking what they can do to incentivize, better enable, or even directly support managers to deliver impact value.

Ben Thornley is managing partner and co-founder at Tideline, a specialist consulting firm advising institutional allocators and managers in impact investing. Since its founding more than a decade ago, Tideline has supported investors deploying over $200 billion of impact capital.