Paul Brest: Are impact investors settling for too little impact?

ImpactAlpha, July 17 – Many impact investors are concerned about whether their capital will generate financial returns. Stanford’s Paul Brest cautions that such investors might better ask whether it’s having any impact.

“Impact investors—encouraged by fund managers—can readily delude themselves into thinking they’re actually having impact on these issues when their investments are not moving the needle at all,” says Brest, the former dean of Stanford Law School and former president of the Hewlett Foundation.

Brest, along with Hal Harvey, are out with a second edition of “Money Well Spent,” their 2008 guide to what they call “strategic philanthropy.” The two worked together at the Hewlett Foundation; Harvey now leads Energy Innovation, a San Francisco policy and strategy consultancy.

Impact investing is the single biggest change in philanthropy since the first edition, Brest told ImpactAlpha, and the new edition devotes an entire chapter to it. “We are neither cheerleaders nor antagonists, but critical friends,” Brest said in an email exchange.

Brest has challenged impact investors to think not only of the impact of an enterprise’s outputs or production processes in improving lives or the planet. In addition, he proposes, investors must ask whether their investment enables that enterprise to produce more of such valuable outcomes. Might that enterprise have achieved the same results with a socially-neutral investor? If so, what impact did that impact investor really have?

“The impact investing industry has at best ignored and at worst resisted the question of additionality,” he says.

There are a number of reasons. Many investors are satisfied with aligning their investors with their values: making “investments in companies that produce good things (e.g., health products in the developing world) in good ways (creating jobs), and not in companies that produce bad things (cigarettes) or in bad ways (polluting),” whether or not their own investment made any difference.

And of course, counterfactual reasoning – what would have happened otherwise – is difficult, “and the question calls for such reasoning on a meta-level,” he acknowledges.

Still, Brest challenges impact investors to specify ways in which they add impact, for example by providing capital at lower costs or on more flexible terms than the enterprise could otherwise get. It is difficult, he says, ‘to achieve social impact and simultaneously expect risk-adjusted market returns.”

The reluctance to engage the A-word may not be surprising. “Much of the growth of the impact investing industry is fueled by commercial institutions seeking to get more wealth under management,” Brest says, “and assessment of the additionality of their investments does not promote this mission.”

The impact investing chapter in the new edition of Money Well Spent concludes with a number of cautions for impact investors that are worth quoting at length:

Non-concessionary investors’ claims to have private information should be taken with a grain of salt. These investors are in tight competition with myriad private-equity investors whose success depends on developing value-relevant private information.

Though not impossible, it is difficult to create social value (as distinguished from achieving value alignment) while also delivering market-rate financial returns or better. Funds that promise both deserve special scrutiny.

Seemingly non-concessionary investments may have hidden concessions, including accepting more risk, than might be apparent to a fund’s limited partners.

The socially screened mutual fund industry should be under- stood as offering investors a value alignment strategy, not an impact investment strategy. Investors in such funds should take care to understand the premium expense ratios charged by the sponsors of such funds, as well as the sacrifice in diversification they are likely to offer.

The appropriate benchmark against which to evaluate private investments is other private investments, including their significant illiquidity premium.

If the fund is serious about impact, it should report on impact as well as financial returns, including an estimate of an investment’s social value created. Suppose that a fund’s general partner promises its limited partners both social impact and market-rate returns. If there are many opportunities that present this overlap in the fund’s particular domain, everyone is happy. But if such opportunities are scarce, the general partner will have to compromise one or the other goal. Especially because she and her limited partners will find it much easier to measure financial success than social impact, the latter is likely to be sacrificed, intentionally or not. A strong signal that the general partner is committed to social impact as well as financial returns would be that her compensation is based on (a more or less) objective measure of social impact as well as financial returns.

The presence of any public equities in a self-styled impact fund should be treated as the thirteenth strike of the clock, which calls the others into question. This is not to say that an individual philanthropist or foundation should not have a portfolio that includes socially neutral and socially motivated investments. But their investments in an impact fund should have, well, impact.

One final and somewhat different point. Thus far, we have focused on an investment’s putative impact in achieving positive social goals. However, impact investments in large-scale development projects have the potential to cause unintended harms to individuals, communities, and the environment, and may call for self-scrutiny as well as accountability mechanisms similar to those developed by development finance institutions.

We believe that the field of impact investing holds real promise. Our overarching concern is that it will appear to “grow” by ignoring impact and that this will cast a shadow of doubt over truly impactful impact investments. That’s the same dampening effect that snake oil salesmen had on the emergence of genuine pharmaceuticals in the nineteenth century.

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