Jan
12
2017

What I'd like to see from impact measurement in 2017

1 While these two proverbs are typically linked to Sir Winston Churchill and Peter Drucker, respectively, there
are other websites that claim both are misattributed.

 

Over the past few weeks, I have read plenty of investor prognostications about what will occur this year. Since I don’t have a crystal ball, I thought I’d take a slightly different take and proffer a list of five developments I would like to see occur within the impact investment ecosystem. As our industry continues to “inch from niche to mainstream,” my fundamental assumption is that there will be an inexorable demand from the marketplace for impact measurement rigor. If you accept this as true, then any of the following outcomes would arguably advance the growth of impact investing. Let’s get to work!

1) Standardization of impact classification and measurement
First, there currently exists no commonly accepted impact classification system. This is a problem because heuristic tools (e.g. Morningstar style boxes, GICS codes, and Russell Indexes) facilitate communication, streamline comprehension, and in the financial services, accelerate investment. Second, while the IRIS metrics catalog is becoming the go-to impact measurement standard, adoption has been relatively lackluster amongst fund managers. And even those who do use IRIS frequently tell us that it is rather unwieldy. Thus, the industry needs a holistic solution to these two issues, one that cogently classifies every impact metric within the same taxonomy that managers use to market their fund’s impact intention(s). My hope is that, in combination with more intuitive metric definitions, this standardization process will augment awareness – and discernment – of impact performance.

2) Quantification of impact expectations
Currently, there is only a limited number of asset owners who base capital deployment decisions on the anticipated impact performance of prospective funds, companies, and nonprofits. But for a growing number of investors, the simple “sniff test” is insufficient: as more capital recipients report their social and environmental benefits, these investors rightfully want to know whether the reported numbers are good or bad. In the absence of explicit manager targets or industry benchmarks, this is an indiscernible inquiry – one that should make advisors squirm. Consequently, we have started asking managers to share some thoughts on their portfolio’s numeric impact expectations. I suspect we are not alone in this regard.

3) Continued application of impact-based compensation
Many impact investors focused on private investments have two straightforward expectations: to generate a financial return, and to catalyze social and/or environmental benefit. A large subset of those private fund managers earn an incentive fee (i.e. higher monetary compensation) if they surpass a designated financial hurdle. A seemingly obvious question follows: why wouldn’t their payment also be tied to their impact performance? Shouldn’t at least a portion of impact managers’ earnings also be tied to an impact incentive fee, if they exceed pre-established impact thresholds? Media Development Investment Fund (MDIF) is the only private investment manager that I had ever seen link their “carry” to their mission success. So I was quite surprised to see the following headline in December 2016 in the Wall Street Journal: “Social Funds Tie Pay to Impact.” Unfortunately, that article cites only one other fund (Shelton Green Alpha) who employs the practice – and it is a mutual fund whose compensation is focused more on impact ratings than metrics. Nevertheless, impact-based fees are an encouraging development that I hope will soon become a trend throughout our space.

4) Creation of an impact metrics repository
If I need to check the Sharpe or Sortino ratios for a fixed income fund, I may look it up in Morningstar. Similarly, if I want to look at historical performance data for a specific sector of the stock market, I can go to Factset. Or if I want to analyze the financial returns of several different private equity or venture capital funds, I might turn to Preqin. Why doesn’t our industry have this sort of database, which aggregates the impact returns generated by its various asset managers? B Analytics has started this process in earnest. But like the IRIS catalog, I believe B Lab’s product is lacking, partly due to inadequate coverage, and partly because the database is focused more on individual private companies. But the point here is not to criticize the work of the GIIN or B Lab, the impact investment industry’s standard bearers. Instead, I’d simply like to see widespread uptake of their solutions – or, perhaps alternatively, the formation of offerings that better meet the needs of the marketplace.

5) Establishment of an impact auditing firm
Auditability will be a lynchpin to each of the aforementioned hopes. Indeed, I have already had clients ask me whether their portfolio’s impact data has been verified by a third party. It’s a fair question, the response to which is a sheepish shake of the head. Investors typically expect external audits to be prepared for their existing asset managers and investees. Indeed, the lack of such oversight would be considered a significant flaw in governance. Why don’t we hold the reporting of impact data to the same standard that we do financial information? It doesn’t take a crystal ball to see that as impact performance influences more investment decisions, managers will want their offerings to stand out from the crowd. For how long should we trust that their figures will be free from unintentional error, as well as purposeful misrepresentations? Indeed, how would we know if it hasn’t happened already? Consequently, I would like to see a start-up that can provide a reputable audit of these impact reports. There may not be sufficient market demand…yet. But our experience suggests that this isn’t as far off as some might think, particularly if the industry continues to attract such significant volumes of capital.

 

Written by Nick Flores




 

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