An initiative has designed an approach that integrates impact investing methods into financial decision-making, stretching beyond traditional positive and negative screening.
Mike McCreless, executive director of Impact Frontiers and head of investor collaboration at the Impact Management Project, tells Expert Investor: “Once prospective investments have passed both [positive and negative] impact screens, asset managers typically make investment decisions and construct portfolios based purely on financial considerations.
“However, few investors or lenders actively optimise both impact and financial performance simultaneously.”
The Impact Frontiers Collaboration is an initiative of the Impact Management Project, facilitated by UK non-profit organisation Bridges Insights, and seeks to build a global consensus on how to measure, manage and report impacts.
Among the collaboration’s partners are Bridges Fund Management, Calvert Impact Capital, IDB Invest, Nuveen and Nesst.
It has worked over two years to design an integrated approach, which it published recently in a handbook.
Investors had difficulties achieving both impact and financial return at the same time due to siloed methods.
“But for investors to play an even greater role in solving social problems, impact management must leave its silo and integrate with financial management,” Collaboration’s authors wrote in a 2020 article.
The model is leading, as it is systematic, McCreless believes. It also allows investors to adapt it to their own strategy and context.
“The approach doesn’t tell them what their goals should be, either impact or financial; rather, it helps them to build tools to achieve their goals,” he says, adding that it also allows these goals to be communicated internally and to external stakeholders.
Based on four foundation questions, the collaboration developed four steps to integrate impact with finance (see chart below):
- Create an impact rating
- Select a financial valuation metric
- Determine implications for future investments
- Measure, manage and communicate integrated impact and financial performance of portfolios/investments
Step 1: Impact ratings
As a first step, investors create an impact rating.
According to the authors, an impact rating is a “weighted sum of indicators that collectively cover multiple dimensions of impact”, such as the number of people reached.
It can also identify the highest-impact investments.
“[Ratings] can increase the clarity of organisations’ impact goals and the quality and consistency of decision-making,” the article says.
The rating is created using the organisation’s strategy and preferences in regard to the impact it wants to achieve and also includes, for example, a literature review and consultation with other stakeholders (see chart below).
Caitlin Rosser, senior officer, impact and communications at Calvert Impact Capital, commented in an online webinar: “After determining all of the factors we wanted to include in the impact rating, thinking about weights and priorities and levels of importance for each of those factors was one of the biggest challenges.”
She said that, as the highest priorities carrying the most weight, the organisation identified those factors that “Calvert Impact Capital values the most in terms of expected impact and assessing impact”.
Meanwhile, she highlighted that this process includes constantly iterating with internal stakeholders and modifying the rating according to continuous learnings.
Step 2: Select a financial valuation metric
In a second step, investors chose a metric, which should quantify the expected financial value of a prospective investment.
For instance, Nesst and other lenders estimate net present value; Nuveen and WaterEquity use internal rate of return (IRR); and IDB Invest calculates the risk-adjusted return on capital, the article explains.
Step 3: Determine implications for future investments
In the following step, previously calculated data is visualised by using portfolio scatterplots.
McCreless explains how impact and financial value of all transactions in a portfolio can be plotted on an x-axis, using the impact scores, and a y-axis, using the expected financial values of investments.
The relationship between expected impact and expected financial performance can vary depending on how an investor measures and rates impact, resulting in both positive and negative correlations, McCreless says (see charts below).
As an example of how to apply the integrated method, a portfolio manager coloured its investments to differentiate between those to pursue and those to abandon.
Lower-performing investments in red bubbles were phased out; higher-performing investments in blue were continued; and new and highest-performing in grey were identified (see chart below).
Another example by IDB Invest sets a hurdle rate to be able to exclude those investments that don’t fit its minimum requirements (see chart below).
Calvert plotted borrower performance across several impact dimensions, such as additionality, impact risk and environmental, social and governance (ESG) policies, to benchmark numerous investments in its portfolio.
Calvert’s Rosser commented: “We can use this kind of analysis to compare a loan that is being presented and how it performs on impact against the other loans that are in this strategy bucket.” (see charts below)
Step 4: Measure, manage and communicate performance
As a next step, the portfolio scatterplots allow investors to measure and manage their investments.
The chart below shows how Root Capital’s portfolio increased its impact and financial performance from 2015 to 2018.
However, investments by the participating organisations will not mature for several years, so demonstrating improved impact and financial performance will take time, the Collaboration authors wrote.
The outcome of the tool also depends on the availability and quality of data.
“Investors should monitor and evaluate the investments that the ratings help select to verify whether the expected impact occurs,” the authors recommend.
The blueprint is an open-source tool and enables investors to further develop and improve it.
In the next project phase, it is planned that investors will work on developing customised versions for specific asset classes or investor types.
“Its ultimate goal is widespread adoption and continuous improvement of these methods, so that the financial sector can fulfil its potential and serve society by allocating capital most effectively over the long term,” McCreless says.