It is almost easier to list the private equity managers who are not getting into impact than it is to list those who are. After raising $2 billion for its first-ever impact fund, private equity manager TPG Growth is looking to raise a second Rise Fund, this time at $3 billion. We have come a long way.
And yet impact investing must do more if we are to tackle the vast environmental and social challenges with the scale and urgency required. There is not enough money flowing to where it is needed. There is not enough good product. Crucially, few managers have been able to put forward a track record of sufficient out-performance to rebut the naysayers and encourage the fence sitters.
There is a serious danger that the impact investing industry’s momentum will be lost and this moment will pass. The promise of impact investing — capital to create a more sustainable and equitable future for the planet — is too big to let it fail. And the solutions are within our grasp.
For impact investing to thrive, and, crucially to tap into institutional capital, it needs to focus equally on impact and investing. That will require building investment management firms with the right incentives, including “skin in the game” for management; long-term, performance-driven compensation; enough runway and capital to produce results and build first-class investment teams; and a focus on risk management and outperformance.
Impact must be fully integrated into the investment process – something that many investment firms which are entering the impact space still fail to do. That impact, ideally, would be a source of both risk mitigation and returns. And the product must be scalable.
For all the talk of impact investment the actual number of at-or-above-market rate, investible opportunities remains small. Especially when compared, for example, to the cryptocurrency gold rush currently under way.
Over the last few months we have been discussing among practitioners and market observers what it will take to take to move capital at scale into impact investing. It is our belief that by collaborating with the broader capital markets, we can propel impact investing forward to the point where trillions of dollars are being used to finance projects with positive environmental and social outcomes.
Our research has focused on the institutional asset owners, large sovereign wealth funds, pension plans, foundations and endowments, as well as development banks and other government entities which control the world’s largest capital pools. Engaging with these institutional investors and asking what it would take to allocate capital to specific impact investments, we have identified several critical barriers:
- Returns. Many institutional investors still believe that impact investments mean sacrificing returns.
- Costs. Impact investments cost more to structure than conventional products due to fees, ongoing expenses, and time-to-market.
- Track Record. Capital managers and users have limited track record generating financial returns with impact; less experienced fund managers fail to meet investment governance requirements from institutional capital allocators.
- Expectations. Impact investing suffers from unrealistic return expectations: either the bar is too high—impact must outperform; or the bar is too low—impact is expected to sacrifice returns for outcomes. For institutional investors to move capital at scale into impact opportunities the investors, as fiduciaries, must believe that the risk-adjusted returns they can expect to receive will meet benchmarks.
- Growth Capital. Impact firms lack capital to develop and incubate products and talent. Most impact firms lack growth capital to develop their track record and build up a business.
There are already some successful impact investment businesses. The $18.5 billion Generation Investment Management is the clearest example of a successful boutique sustainable investment management firm. But, a decade after Generation launched, few managers have been able to replicate their success.
More recent efforts such as the institutional investor and foundation-led Aligned Intermediary – an initiative aimed at driving more institutional capital into clean and renewable energy infrastructure – have shown promise, but few results.
The move by major investment managers, particular private equity firms including KKR, Bain Capital, and TPG Growth, to offer impact investment funds is an indicator of just how big the market demand for impact investment strategies are.
But most of these established names also have a history of investing in businesses and sectors which can be deemed to have had a negative social and, or environmental impact. And while having been an investor in, say, high-carbon energy infrastructure should not automatically exclude a manager from being an impact investor (such a background and expertise arguably is useful), these firms have yet to demonstrate that they can separate their drive for profit from the kind of winner-takes-all capitalism which has made Wall Street so successful (and so destructive).
To date, impact investments have struggled to connect consistently with institutional capital because they often generate lower financial returns, present more limited track record, and cost more to undertake than conventional investments. This contributes to sub-scale, inconsistent impact investment deal flow, which has limited the capacity for investment firms to develop products for clients seeking impact and commercial returns. Starved of market trades, incremental capital allocation and capacity building grows only marginally.
To overcome this slow-growth dynamic, institutional investors need access to intermediary capacity to source, structure, and asset manage impact investments on competitive terms to existing investments, while reducing risks to develop this emerging area. Partnering with mission-driven intermediary capacity or building that capacity in-house can overcome barriers for institutional investors to allocate greater capital to impact.
If institutional investors and fund managers seeking commitments can address these issues, they can unlock greater flows of institutional capital to investments that deliver robust, measurable social and environmental impacts and financial returns.
Marc Diaz is a finance leaders fellow at the Aspen Institute. He previously launched and led NatureVest, The Nature Conservancy’s impact investing platform.
Imogen Rose-Smith is an investment fellow with the University of California and a regular on ImpactAlpha’s Returns on Investment podcast. Previously she was a staff writer with Institutional Investor magazine.