Investors routinely examine the risk of achieving their financial objectives, and screen investments for ESG risk, but how do impact investors consider the risks to achieving their intended environmental and social impact?
The Operating Principles for Impact Management requires signatories to “assess the likelihood of achieving the investment’s expected impact. In assessing the likelihood, the Manager shall identify the significant risk factors that could result in the impact varying from ex ante expectations.”
According to Bluemark, about 50% of signatories currently have a methodology in place to do this, most often by applying a discount factor to the expected impact score (or other impact metric). I recently asked a cross-section of impact investors and DFIs about their practices. We found that most investors make some kind of impact risk assessment, but it is mostly qualitative (is this high or low risk?) and relies on the judgement of the impact specialist on the team. I think impact investors can – and should – do better than this.
The practice of risk-discounting the impact score to give a single number hides more than it reveals. Just as a financial portfolio is assessed on its overall risk-return profile, with some low-risk, low return assets balancing high-risk, high return assets, and with diversification to reduce correlated risks across assets, so impact investment portfolios can be balanced in a similar way. Impact investments are rarely low risk – the drive for impact leads to an increased appetite to take risks in serving new markets, deploying new business models and technologies, backing new businesses.
These risks can be attenuated by careful portfolio construction so that even if some risky bets fail, the overall portfolio achieves a satisfactory positive impact. The appetite for risk will be different for different investors – some will actively seek new technologies, underinvested countries and first-time entrepreneurs for at least part of their portfolio, in pursuit of outsized impact. Presenting impact risk as a separate dimension of the investment decision makes such choices explicit.
To do so requires considering impact risk as a separate dimension of the impact assessment, alongside the investment’s potential impact under the base case. Simply discounting the impact score does not provide decision-makers with the two dimensions of information (risk and reward) required to build a balanced portfolio. Of course, variations in outcomes can be on both the upside and the downside – explicit consideration of potential variance around the expected base case can encourage a more balanced assessment of potential impact, as it makes visible the potential to outperform expectations as well as the risk of falling short of them.
How to assess impact risk in a way that goes beyond informed judgement, important though that is?
First, draw insights from other types of risk analysis already being done as part of investment due diligence. Credit risk analysis and ESG risk analysis generate important insights for risks to impact. Start by analyzing the expected impact outcomes under the high and low financial cases, and look at the key drivers of financial performance identified in the credit analysis.
Of course, any adverse credit outcome which puts the future of the business in doubt also puts in doubt the sustainability of impact. But the credit analysis can also provide a useful check on the realism of the impact assessment – if the expected impacts can only be achieved in optimistic scenarios for firm performance, then the assessment is too optimistic. Likewise, the ESG risk analysis can also identify scenarios where impact may not be sustained due to environmental or social problems, or may be offset by negative impacts. Without directly linking credit ratings, ESG ratings and impact ratings, these three types of ratings should be consistent with each other. Surprisingly, even large DFIs with formal ESG and credit risk ratings do not yet join the dots in this way.
Second, learn from prior investment experience. This is easier to do in large institutions with a long track record to analyze. They can exploit existing portfolio parameters such as country type, sector, instrument, credit risk rating and ESG risk rating. For example, Blue Orchard draws on learnings from previous investments on when impact was achieved. Multivariate analysis can establish the past variance between ex ante and ex post impact scores based on attributes of this type. This will allow the assignment of risk categories to new projects based on prior project experience. We recognize that past experience will not be entirely reliable as a predictor of future performance, but it is a robust starting point for assessing risk. It will make the risk assessment transparent and more credible.
Smaller funds and institutions can draw on industry level data and research to understand the risks to impact from various investment parameters. For example, it is widely known that the risk of business failure (and hence failure to sustain impact) is higher in the first years of a firm’s operations, is higher for first-time entrepreneurs, is higher for untested technologies etc. This kind of empirical knowledge can form the foundation for an impact risk assessment that goes beyond judgement. Some industries are riskier than others, some countries are riskier than others – in lower income countries, macro risks tend to swamp other factors in driving adverse outcomes.
Thirdly, consider how closely the investee’s business objectives are aligned with the impact that the investment is expected to achieve. For example, a company seeking to reach many low-income customers with a new pay-as-you-go service has a business model that is directly linked to its impact. If, however, the impact emerges instead through employment schemes or community activities that are not integral to its business success, or through expanding to an underserved and potentially less lucrative market, there will be a greater risk of the impact not being sustained. Leapfrog Investments, for example, considers the ability of investee firms to implement a viable business model as part of its impact assessment.
To be credible and useful to investors, impact assessment needs to be clear-eyed about the risks to impact. The best way to do this is to consider impact risk as a separate parameter in asset selection, and to build a more robust, empirical basis for assessing impact risk, drawing on all relevant information generated by the due diligence process, as well as on past experience.
Neil Gregory is a lecturer at Johns Hopkins University School of Advanced International Studies and the former chief thought leadership officer at the International Finance Corp.