What your board needs to know about the rise of impact investing

With opportunities to invest for positive social or environmental impact on the rise, directors should be aware of the risks involved, writes Ben Power.

Stephen Fitzgerald, an independent non-executive director of insurance company QBE, says he has had a fairly conventional investment management career. However, the former head of Goldman Sachs Asset Management International has also been involved in the environmental movement for many years. This commitment has included sitting on the board of the Great Barrier Reef Foundation.

Thinking about how finance and purpose intersected, Fitzgerald realised if the world was to address environmental challenges, philanthropy wasn’t enough. “You have to mobilise mainstream capital,” he says.

He became involved with a new movement — impact investing — and is now managing partner of Affirmative Investment Management, which handles US$650m in fixed income investments that generate a strong financial return, but also have a positive social and environmental impact.

“Rather than just trying to reduce the negative impact of investments you have made, [impact investing] is proactively looking to have a net positive impact, or net positive externality, as well as delivering mainstream returns,” says Fitzgerald.

Impact investing is specifically designed to achieve social or environmental outcomes, as distinct from traditional investments that may incidentally deliver positive societal impacts. It now operates across asset classes including real assets, private equity, fixed income and hybrids, such as social impact bonds. Investment avenues range from financing social housing and renewable energy to delivering positive outcomes in health and education.

Before the COVID-19 pandemic struck, impact investing was creating a major shift in global finance. But when the pandemic took hold, it seemed environmental and social concerns would become a luxury that investors and companies could no longer afford. Yet as the world faces major health and economic challenges, COVID-19 has actually shone a brighter light on the role that businesses and organisations play in broader society.

Richard Brandweiner, CEO of the Australian arm of Pendal Group, which has $101.4b in funds under management, says investors are bringing a more stringent lens to investment decisions that factors in the externalities. He describes impact investing within the context of three investment categories — ESG (environment, social and governance) which is about factoring in non-financial externalities into investing decisions, sustainable investing where investors screen to avoid sectors and securities not deemed sustainable. “Impact investing is that step further where you are deliberately investing to achieve certain environment and social outcomes,” says Brandweiner. “It’s the fastest-growing part of the investment management landscape, albeit off a smaller base.”

In December, Pendal (formerly BT Investment Management) recruited a London-based impact investment team. It recently launched its first impact investing fund, the Regnan Credit Impact Fund, which invests in bonds that go to improving environmental and social impacts, including the likes of Woolworths and NSW Treasury Corporation green bonds. It is soon to launch a global listed equities impact fund.

Superannuation funds have helped to drive the increased appetite for impact investments. Industry fund HESTA was an early adopter, saying its impact investing strategy is consistent with its fiduciary responsibility to members for the long term. It has partnered with Social Ventures Australia on a trust that invests in social and affordable housing, aged care facilities and programs that restore children to the care of their families.

“The only thing [COVID-19] can do is enhance impact investing, not undermine it,” says Louise Sylvan AM FAICD, chair of Energy Consumers Australia and also on the board of Impact Investing Australia. “The board table discussion is going to be a lot more about society, not just the business and its bottom line.”

“Directors’ responsibility is absolutely to drive shareholder value,” says Fitzgerald. “But it’s much broader. It’s about the impact you’re having environmentally and your place in society. It’s an absolutely critical part of the responsibility of a director.”

Brandweiner says investor awareness has transitioned over the decades — investors were concerned about returns, then, with the coming of modern portfolio theory, there was a focus on risk and return. “The reality is there is a third axis in most investment decisions — what impact does that decision have on society? Now we are starting to measure it. Impact investing is making it explicit, ensuring you are making investment decisions that target a positive outcome alongside the financial outcome.”

Impact investing has evolved from socially responsible investing (SRI) which escalated in the 1960s when anti-Vietnam War activists lobbied for universities to screen out defence contractors from endowment funds. SRI seeks to exclude unethical or harmful investments, such as tobacco and fossil fuels. From the mid-2000s, investors began to incorporate environmental, social and governance (ESG) factors in their investment decision-making process alongside conventional financial factors. But impact investing advances SRI and ESG by having a clear goal — the investment must generate a financial return, but also create measurable positive and social impacts.

Sylvan, a former Australian Competition and Consumer Commission deputy chair, says impact investing is changing how investors judge companies. “They don’t want to simply see negative screens,” she says. “They’re looking to see a positive outcome and real work as to how you handle any damage you might do as a company.”

The emergence of impact investing has been created by a “confluence of factors”, says Rosemary Addis AM GAICD, an impact investment pioneer and founder of Impact Investing Australia. These include the recognition that risks such as climate change are a threat to long-term performance of investments. Millennials also want investments aligned with their values. There is also a growing interest in using business models and market tools to solve social and environmental problems.

Impact investing is in its relative infancy, and the lines with sustainable and value-aligned investing are somewhat blurred. But the impact lens can be applied to all asset classes across bonds, equities, venture capital and real estate. One of the purest forms is investing in social impact bonds, which pay a return to investors when they generate a positive social outcome such as reductions in homelessness and long-term unemployment. The Global Impact Investing Network, in its Sizing the Impact Investing Market report, estimates 1340 organisations currently manage US$502b in impact investment assets worldwide.

However, the appetite is enormous. According to Creating Impact: The Promise of Impact Investing, a report by the International Finance Corporation, investor demand for impact investing is as high as US$26 trillion — including US$21 trillion in publicly traded stocks and bonds, and US$5 trillion in private markets involving private equity, non-sovereign private debt and venture capital.

In Australia, a report by the Responsible Investment Association Australasia (RIAA) in partnership with Deakin Business School at Deakin University — Australian Impact Investor Insights, Activity and Performance Report 2020 — found the market for impact investing has surged 249 per cent to $19.9b in the two years to 31 December 2019.

There is also a burgeoning appetite from investors. The report found that Australian investors, including super funds and family offices, wished to increase their proportional allocation to impact investments more than fivefold to $100b during the next five years — or from 0.7 per cent of assets under management to four per cent. That would include investing in clean energy, housing, health and wellbeing, education and conservation.

Reflecting the growing importance of impact investing, the federal government has established a Social Impact Investing Taskforce chaired by Michael Traill AM, the co-founder and executive director of Macquarie Group’s private equity arm, Macquarie Direct Investment. The taskforce, supported by a team within the Department of the Prime Minister and Cabinet, is developing a strategy for the Commonwealth’s role in the social impacting investment market.

In a forward to the RIAA report, Traill says the challenge for impact investing is to “mobilise the forces that will convert what still has the characteristics of a cottage industry into the kind of well-structured and sophisticated market that will liberate exponential pools of funding that generates both reasonable financial returns and clear social impact”.

Sylvan also notes the World Bank estimates that by 2030, US$30 trillion will be invested in impact investing.

“That’s one-third of institutional funding globally,” she says. “As a director, one of your particular tasks is to look at the horizon and how it will affect your business. Impact investing is one of the key things to be looked at. Although embryonic, it’s moving enormously fast.” The primary message is that investors are increasingly shifting their focus from ESG to impact investing, which will have a significant impact on the role of directors.

“It changes the nature of what boards must do substantially,” says Sylvan. “It’s slowly moving the whole set of equations for how companies are viewed as investment prospects. That’s critical to a director. You need to know how people are going to be recommending you as something to be bought. You need to be able to measure social and environmental impacts because investors are increasingly going to be assessing companies on those metrics.”

However, there is a long way to go when it comes to companies measuring their impact on the environment and society. Addis, who is also a trustee of the Global Steering Group for Impact Investment and senior adviser to the United Nations Development Programme’s SDG Impact, notes that PwC’s SDG Reporting Challenge 2019 report found that 72 per cent of companies reference SDGs in their annual corporate or sustainability report. However, just 14 per cent mention specific targets, and only one per cent are reporting quantitative measures to show their progress towards their targets.

Sylvan says COVID-19 only reinforces the social role of business and organisations. A lot of normal market behaviour became unacceptable very quickly — energy companies couldn’t disconnect consumers and banks couldn’t sell up mortgage holders. There was also a spotlight on companies that were behaving badly. “It’s forcing us to think about those business responsibilities,” she says.

Investment consultant Mercer says COVID-19 “elevates the value of responsible investing” and particularly highlights the “S” in ESG — including labour forces.

Addis says businesses will respond to COVID-19 in different ways, with some going into scarcity, survival mode, “but we’re also seeing some major asset owners doubling down.” So with COVID-19 set to reinforce the trend of impact investing, how should directors prepare? Fitzgerald suggests starting with an audit of what your organisation is already doing, then setting ambitious goals.

“This is for the external world, for your shareholders and, most critically, it’s for your employees,” he says. “Employees want to know the companies they’re working for are leaders in how they interact with the environment and the community around them. Impact investing is one part of that.”

With rapid growth and the industry wrestling with definitions, Brandweiner warns investors and directors to be on the alert for green or impact “washing” and to ensure they carefully scrutinise claims of impact.

“The implication for people with governance roles is that as a community we are becoming increasingly aware of our impacts,” says Brandweiner. “Society is becoming less tolerant of negative externalities. It doesn’t just matter what the product or service you create is, it is also the impact. It’s a big issue for company directors — at the end of the day, your decisions and activities leave a wake and how that capital is invested will shape the world that we are going to retire into.”