The Building Blocks of Impact Investing

There are many buzzes around impact investment nowadays. Everyone is trying to do impact, from mainstream seed investors like 500Startups launching ImpactAim to global private equity firms like TPG with their RISE fund. Not only investment firms are interested in impact, unicorns like Grab and Tokopedia have recently published their impact reports as well. Danone Aqua is now a B Corporation, and so do two other smaller Indonesian companies. McKinsey & Company estimates that impact investment industry is now a USD 228 billion on an AUM (Assets Under Management) basis. There are different estimations of the size of Impact Investment industry by different organizations. As an example, GIIN (Global Impact Investing Network) estimates the size of the industry is even bigger at USD 502 billion AUM.

These are commendable initiatives that are worthy of the full support of everyone in the startup ecosystem. If the unicorns and the biggest and the most active investors are thinking about social impact, then there will be conscious effort of the other players to also explicitly declare their intention to influence the society on top of making the financial returns.

However, the term “impact” can also be at risk of being overused. Borrowing an old business adage “if everything is impact, then nothing is”. Defining impact is delicate, as most businesses can bring net positive impact to the community simply by doing business as usual. A 5-stars hotel company can be called an impact enterprise as they provide thousands of construction jobs and then later probably provide hundreds of jobs to local communities, but they might be using ground water excessively for their operations. Uber supports hundred of thousands of livelihoods in urban areas, but this might change soon as Uber CEO himself said self-driving vehicles are the future of the Company. In 2007, a group of foundations and investors convened by the Rockefeller Foundation originated the term “impact investing,” which was later defined as “investments intended to create positive impact beyond financial return.” Even with this definition, the boundaries of Impact Investment is still muddy.

To be able to qualify as impact investors or impact enterprises, the idea AND the execution of impact must happen thoughtfully and thoroughly, both at fund level and the enterprise level at all times, before the investment is made, when the investment is being made, and when the investment has already been made. From any aspiring impact investors, there are 9 “building blocks” of impact that are important, with seven of them essentials at the enterprise level, and two at the fund level.

First Part — The Enterprise Level

Phase I: Pre-Investment

1) Impact Statement

The Company must have strong objectives outside of its financial objectives. These can be social or environmental impact, employment impact, economic development impact, policy impact, or pilot/demonstration impact.

Grameen Bank has the mission of “providing comprehensive financial services, empowering the poor to realize their potential and break out of the vicious cycle of poverty”. Note that it aims to provide comprehensive financial services, not only microcredits, and the aim is to empower the poor. Impact building blocks such as metrics, governance, and policies can be derived from such a strong mission statement.

Another good example is d.light, a provider of solar powered equipment for household use. Their mission statement says that it “is dedicated to providing the most reliable, affordable and accessible solar lighting and power systems for the developing world and reaching 100 million people by 2020”. The specific language and numbers provide a strong sense of direction to the whole company.

Another benefit of having an Impact Statement is to protect the company from “excessive impact reporting requirement”. Imagine an impact enterprise with 3 different impact investors on board with each impact investors having a set of 5 impact-minded LPs. Each organization have their impact reporting mandate, that are slightly different from each other, and the current norm is to have these reporting requirement cascading down to the investee company, who now has to manage 5x3+3 = 18 different set of metrics to track! Impact Statement helps to bring clarity of which metrics are important, and which ones the company can push back to the investors or, if that is futile, play a role as an impact bureaucrat and treat it as necessary obligations.

Many companies do not have the impact mission written down, although they intuitively do have a fuzzy sense of social impact mission. If the missions are not explicit, it is then impossible to be communicated clearly, measured objectively, and achieved systematically. Some companies have it wrong the other way around: they have a good and explicit mission statement, but they don’t cascade it down to their daily activities. The other impact building blocks discussed here should play a key role in safeguarding the mission.

2) Impact Due Diligence

Due Diligence (DD) serves two main objectives. It validates that the Impact Statement is genuine, realistic, and aligned with aspiration of the stakeholders. Sometimes, the due diligence will be conducted with the future situation in mind (“What would be the impact when the factory is operational?”), so this need to be taken into consideration. There also has to be a hypothesis of the potential risks to the Impact Mission when the Company scales up as the inclination of the management might change (“Increase interest rate” — in the case of microfinance, or “Replace workers with robots”, or “It’s becoming harder to work with thousands of farmers, let’s start our own farm instead” and so on). Banco Compartamos, a microfinance organization in Mexico, is a well-known example of a “mission drift”.

DD is also important to develop guidance for management. A typical Impact DD should produce a list of potential negative externalities to be avoided, usually by referring to a common standard like the IFC Sustainability Framework guidelines. Impact DD reports also suggest impact metrics to be tracked initially, as these will change when the business evolve, to be monitored in Building Block 5 (“Impact Accounting”). Finally, Impact DD should also identify the gaps in the implementation of Impact Statement, to be rectified through Building Block 6 (“Policies & Procedures”)

Phase II: During Agreement — When Investment is Being Made

3) Walk-Out Provision

Impact Investors have to be very clear that the Company has to stay true to the Impact Mission. If the Company intentionally deviate from the mission, it should provide an exit to the Investor. To act as a deterrence to the deviation, the terms of the exit has to be very favorable to the Investor.

4) Impact Governance

Impact Investors and the Company have to agree on a rules and mechanisms to discuss impact at senior level, e.g., by having an Impact Committee in the board or mandatory discussion of impact at the board level. Agendas and decision-making authorities should be determined at this point to avoid future deadlocks.

Phase III: During Investment

5) Impact Accounting

It has become customary for investors (and some of the larger enterprises) to publish annual impact reports, highlighting the numbers of stakeholders that are supported by the investments they made. In general, these reports are rarely helpful to the readers. By its very nature, impact is super-hard to quantify: Is USD 1 million investment helping 1 million farmers better than USD 2 million investment helping 500,000 fishermen? Should it be 1 million fishermen instead of 500,000? Should it be 100,000 fishermen but the impact is deeper? What depth is sufficient? Even in a relatively mature and straightforward sector like microfinance, there’s still an ongoing debate about its impact, hence there’s no way we can even start a debate about impact in relatively new e-commerce or ride-hailing or agritech sectors.

And there’s a whole issue of adverse incentive in play: one can select metrics that are flattering to be displayed in reports and ignore the ones that are more meaningful, and numbers can be inflated by measuring things a bit differently.

Those points being said, Impact Accounting still has to be done as thorough as it can be, with the emphasis of doing so as the basis for discussions with management. Please note the phrase “as thorough as it can be” because it is also too easy to overdo it and spend valuable resources doing so. There are a lot of impact measurement tools and frameworks, e.g., PRISM, CSI, and III frameworks that can be used. These are fine tools hence no need to reinvent the wheel with a new framework for every Company.

6) Policies and Procedures

Policies and procedures are the bread and butter of impact. They guide how the company engages with the stakeholders and employees. They are verifiable, their execution can be audited, and most importantly, they become the DNA of the Company after a long period of implementation. If there are incoming investors or management team in the company that are less inclined with the mission, it is exceedingly difficult for them to modify the internalized ways of working within the Company.

One procedure that worth highlighting here is the “grievance mechanism”, basically a way for the stakeholders to log complaints to the company and get them resolved. No matter how well is the intention of the company, there will be issues in the field. Some issues will be bogus, as there will be people who want to take advantage of the company, but most will be real issues and more often than not, unpredictable. The context of the stakeholders is very different than the company and even more so with the investors. Impact investors has to demand full transparencies and reporting on this to be made available.

Policies and Procedures are inherently qualitative in nature; hence they are rarely discussed, compared to the highly quantitative impact metrics. Is thirty pages of detailed SOP better than one page of high-level principles? Would an impact investor have sufficient knowledge of the company’s sector and operations to evaluate the Policies and Procedures?

7) Impact Discussions at Board Level

The objective is to have an honest discussion on the [1] Impact Statement, supported by facts and figures from [5] Impact Accounting and assessment of [6] Policies and Procedures. This should happen on a regular basis, e.g., quarterly, and properly minuted with the minutes made accessible to relevant stakeholders.

Second Part — The Fund Level

Monitoring the Impact of the Companies alone is not sufficient to ensure impact is happening. The incentives for the Fund Managers also need to be aligned. When Fund Managers are likely to be expected to deliver on the financial returns in form or IRR numbers (a very objective target), they also have to make sure that impact is achieved. When the pressure to deliver commercial results is looming, it is very easy for the Fund Managers to pay less attention to impact, treating it as a mechanical reporting checkbox to be ticked-off.

8) Fund Impact Governance

Who monitors the Fund Managers if they really take impact seriously? In a typical private equity fund structured as PE/VC, the LPs (Limited Partners) assume this role. But many LPs sit thousands of miles away in their offices, mostly in major cities in developed countries. There need to be an independent body or committee, appointed by the relevant stakeholders, that keep the Fund Managers honest by having periodic review of the Impact at Portfolio Company level and at the Fund level.

The independent body or committee should also tasked to make the judgment calls on how much or how little impact assessment is required with the portfolio companies. It does not make sense to inundate smaller portfolio companies with impact reporting obligations, but their responsibilities must grow as they are scaling up.

Not many existing funds have this level of governance in place, but it will be a critical role in the future, when the interest in Impact Investing have become mainstream and the public are keeping a critical eye on the sector.

9) Structure for Impact

Regardless of how heavy or light the Impact Investor decides to implement the building blocks 1 to 8, it needs additional resources above and beyond the regular costs of running the Fund’s investment activities. Additional expenses are not avoidable, and they usually come through either having a bigger team, one or more dedicated impact specialists, consultants/advisors to perform monitoring and evaluation, and to operationalize the impact committees. The actual costs vary from one fund to another, depending on the scope of sectors, geographical, and depth of impact to be achieved. If a fund claims they are an impact fund but having no additional costs than a mainstream fund, then it raises doubts on whether what they are doing is meaningful.

Like when a simple house does not need all kind of building materials, investment in a small business does not have to incorporate all the above building blocks. If the investor believes that the [1] Impact Statement is very robust and the Founders sincerely bought into it, then [4] Walk-Out Provision might not be required. If time and cost is a constraint, Impact DD can be performed in a “quick-and-dirty” way first, to be conducted properly in a few years.

It is not too late today to give “Impact” the robust structure that it deserves, while it is still a relatively small and nascent industry. Together, we must develop the impact ecosystem by giving credibility to the word so that it is something the general public can trust. Labeling ourselves as “Impact” and publishing impact reports with pretty pictures and context-less numbers would not cut it anymore.

Venture Builder. In Medium to share perspectives on how industries are being transformed by digital technologies.

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