Risk, Return + Impact – The New Efficient Frontier

Investments are traditionally viewed along a spectrum of risk and return, where taking on higher risk usually results in achieving higher return.

This article serves two purposes – a) understanding what risk and return mean in the impact investing works and b) exploring the third dimension of impact in making investment decisions.

Risk

Beyond factoring in the traditional risks of an investment, impact investment analysis requires understanding the particular risks of the social entrepreneurship landscape. Some examples include impact risk – uncharted and hard-to-access markets, lack of credit history of clients and measurement risk – given the challenges in measuring social impact, investors seeking to maximize impact as opposed to financial return, may be exposed to inaccurate assessment of impact.

An overarching observation is that impact investments are typically considered riskier than traditional investments. This unfounded view is largely based on the fact that most mainstream investors are not familiar with the field of impact investing and with the history of various investment products within that field. This Wharton podcast interview with Durreen Shahnaz, founder of the Impact Investment Exchange, highlights this important challenge.

Fundamentally, impact investors should be aware of the spectrum of risks they are facing and determine what their appetite for these risks are before making any investment decisions.

Return

For decades people typically believed that we can either have an impact or make money and that social impact impaired financial return. From this view has come the theory of being “finance first” versus “impact first”. What we find is this just doesn’t map the practice of impact investing. For example, in the years following the financial crisis of 2008, commercial investments were seeing losses of 20-40% while many impact investments were consistently reporting returns of 4% or more. In the case of microfinance, for example, some investors achieved returns of 7% throughout the downturn. Each investment is unique, but it is clear, the belief that social impact impedes a financial return is out of date.

In fact, investors around the world have started to understand that impact investments do not only preserve capital, but that impact itself can be a driver of business success and hence, profit. This report from the Global Impact Investing Network provides evidence on the financial performance of impact investments over the last decade.

Increasingly, impact investors are ignoring market-defined levels of appropriate financial return. They are developing their own desirable financial return targets which integrates measurable social and environmental value creation. After all, impact investors are finding that they are indeed the market. Hence, how they operate determines how the market operates.

Looking beyond

As discussed above, impact investors are now thinking beyond the traditional trade-off between doing good (social impact) and doing well (financial return).

Today, investors evaluate various investments with regard to their performance across the three axes of blended value creation. It is then less a question of being “finance first” or “impact first”, than a strategic consideration of risk appetite and return expectation. These questions of risk and return are viewed with a commitment to maximizing the total, overall performance of a portfolio on both financial and social/environmental terms.

Can you think of any examples where impact can drive a business’ success and profit?