MAY 2021

Arriving at Impact 4.0

While it's not a silver bullet, changing the way we deploy financial capital is integral to addressing systemic challenges

KATHRYN: Impact investing used to be the domain of fringe players. Now it’s big business–by some counts, $17 trillion in the US. I thought we could get into the weeds on some of the intriguing developments in this space that you and I keep coming back to.

We won’t start at the beginning, because this is a concept that goes all the way back to biblical times, but we’ll pick up when the term impact investing surfaces… about fifteen years ago.

CHRISTIAN: It was coined by the Rockefeller Foundation and reflects an evolving attitude towards impact. While it’s used across a range of investments, our primary focus will be on its application to investments in private and public companies. 

The early approach to impact investing was “do no harm” and can be traced to religious groups who preferred not to support or profit from sales of weapons, alcohol or tobacco. Catholic investors in particular used this philosophy to inform their individual portfolios; however, its principles were adopted and expanded on by activists who pushed for divesting from assets associated with apartheid. You still see this approach–think about the movement to divest from fossil fuel companies.

The next phase of impact investing examined how companies who received capital were being run. Environmental, Social, and Governance–ESG–became the generally accepted framework and is still used today. At its core, ESG takes into account how responsible a company is. It gives shareholders a better picture of the impact a company is having on its employees, partners and at times, its supply chain. One of the reasons it has caught on is because it does double duty by assessing risks to the health of a company.

I would say the limitations of ESG emerge when you try to take a deeper look at the impact of a company.

KATHRYN: -there must be hints of the externalities a company is creating?

CHRISTIAN: Yes. But it’s possible for a company to do well on an ESG audit and have significant externalities. Maybe an OEM down the supply chain from a problematic end process. Or a food manufacturer developing products high in sugar.

And it doesn’t answer bigger questions about the reason for a company’s existence.

KATHRYN: Okay, so we have our first two phases: “do no harm” and “act responsibly.”

CHRISTIAN: Then the logical leap to “actively create good.” Which marked a significant turning point and coincided with a shift in the entrepreneurial mindset. 

The Benefit Corporation designation is such a clear illustration of this phase. You have a new crop of startups that came of age built on lofty ambitions of purpose and profit.

KATHRYN: We launched one ourselves.

CHRISTIAN: Sometimes investors looked at the product (green tech) or sometimes people (women and minority founders), and sometimes both. This was a positive shift, though there was a significant range on the depth of impact. Anyone could slap an “impact” label on deals with catchy concepts. Often this was done in earnest, and the end result had just diverged from the mission. 

KATHRYN: Which gets us to the challenges that have driven this question of what’s next.

CHRISTIAN: I recently spoke with a friend who told me he’d stopped “impact investing.” It wasn’t that he stopped putting his money toward impact, but he’s been looking for places where it can go further. He said that he had stepped back to assess the deals he’d been a part of. And at the end of the day, he felt they were companies that he and his co-investors had thought would succeed in being highly profitable while doing less harm, but that the “impact” label had fallen short. 

A familiar example is TOMS. You have this shoe company that invents the buy-one-give-one model. The founder, Blake Mycoskie, wants to make a difference, and one-for-one is a creative way to attempt that. Critiques of TOMS focus on the ineffectiveness of the one-for-one model, but I think it’s noteworthy that TOMS paved the way in their crossover from scrappy do-gooders to big business.

KATHRYN: Also, interestingly, TOMS recently announced that it is moving away from the one-for-one model and will instead be giving away one-third of its profits.

CHRISTIAN: So in 2014, Blake sold half of his stake to Bain. The transaction valued TOMS at over $600 million, which meant Blake was in line for a $300 million payout from his mission-driven company. Critics have no end of material about the deal, but I think it points to a far bigger issue than Blake making millions. He may have looked at the company and the buyer and felt that he wanted to get as much cash as possible to put into his next round of ventures (philanthropy and impact funding included). Given his use of the proceeds and the fact that TOMS was recently taken over by its creditors, that might have been most impactful. The real takeaway for me is that there wasn’t a significant difference in the outcome of this social venture versus a profit-only tech startup. 

KATHRYN: “Actively creating good” at a company level isn’t always the same as making a meaningful dent in the inequity at the root of many of the problems that social entrepreneurs and their investors are trying to solve.

CHRISTIAN: Right. 

Taking a step back, in many ways these first three mindset shifts make up the core of stakeholder capitalism.

KATHRYN: Which is having a moment in the spotlight. 

CHRISTIAN: Yes. McKinsey wrote about this last month, and I’m paraphrasing here, but it’s essentially a company defining its mission as creating long-term value for internal and external stakeholders. It broadens the understanding of “value,” fosters resilience and encourages accountability.

KATHRYN: So it’s a model of corporate governance that expands the focus on shareholders to stakeholders.

CHRISTIAN: Yeah. I think the challenge, which the TOMS story illustrated, is that these values have generally been applied within the existing corporate and investment structures.  However, the tools–and often the people as well–that have contributed to our current social and environmental problems are ill-suited to address them. While tackling these challenges is only possible with responsible governance and a “do good for all” mentality, there’s a pressing need to embrace a more comprehensive approach to deploying capital. This “Impact 4.0” is anchored in the recognition that how a deal or investment firm is structured must be aligned with the overall impact goals. 

KATHRYN: There’s a lag between what we’re investing in and how we’re setting up those investments. 

CHRISTIAN: Right.

There are a number of approaches that can be dialed in depending on the goal. Many of them aren’t new but haven’t been utilized to their full potential and are getting a deeper look from forward-thinking investors and entrepreneurs. 

One has to do with ownership, control and the distribution of profits. There's a catchall term "alternative ownership" that refers to a spectrum of legal structures that adjust who is involved in making decisions in a company and who gets to share in the financial outcomes of those decisions. This can range from employee stock ownership plans and profit sharing to the slightly less understood cooperatives and foundation/steward ownership. You’ll also sometimes see concrete environmental or social performance goals tied to financial incentives. 

KATHRYN: Putting legal guiderails in place to prevent mission drift.

CHRISTIAN: Yep. 

Then you have flexible timelines. I think you’re also going to see a lot more on the long-term or evergreen investment structures. Right now, whether it’s the stock market or most venture and private equity funds, you’re seeing short-term vehicles. For those funds in particular, they often need to deploy their capital into investments and get it back to investors in a ten-year timeline.

KATHRYN: Which doesn’t leave time for a company to grow healthily. 

CHRISTIAN: A lot of companies struggle to keep up their mission when they agree to that timeline. 

I’m seeing more holding companies and evergreen funds that are either on very long timelines–like 25 years–or taking a permanent capital approach where there’s no structured timeline for an exit. It doesn’t mean that there can’t be an exit, but it’s not going to be forced by the structure.

I’d identify another as flexible risk and return expectations. I think more investors are getting excited about the range of instruments that fall between profit-first investing and traditional philanthropy (which still has a significant role). 

These investors recognize that decoupling the traditional high risk/high financial reward or low risk/low financial reward pairing and adding a third “impact” lens can make a big difference in the results they can drive. They may decide to make investments that have a lower (or even negative) expected financial return in order to spur needed economic activity in an under-resourced community. 

KATHRYN: For example?

CHRISTIAN: Maybe investors choose to take on risk with no financial upside by guaranteeing loans or mortgages that allow entrepreneurs and home-buyers to tap into otherwise unavailable pools of capital.

KATHRYN: Interesting.

CHRISTIAN: You also have new mechanisms to return capital to investors.  Across the board, you need to have ways for investors to create liquidity without forcing the sale of the company or a public offering. I think you’re going to see more deals that are based on revenue and profit–as opposed to traditional stock or equity–or that have clear pathways for selling shares on the private market.

Okay, the last one I’ll mention is expanded access to capital–and profits. 

KATHRYN:  Which would be the need to drive capital to underrepresented–maybe undersupported is a better word–companies and individuals.

CHRISTIAN: The percentage of women and minorities working for and receiving capital from venture capital and private equity funds is extremely low. We’re starting to see some movement here; in the past couple of years there has been a notable uptick in funds raised by and/or looking to invest in women-led companies and minority-led companies.

At the same time, it's important to democratize access to profits alongside investment. Right now, many investment opportunities with the highest upside are limited to high net worth individuals, both because you must be an accredited investor and because the minimum investment is so large.

Crowdfunding is one tool that can address both sides of this "equity of access" to capital and profits. While rewards-based crowdfunding has gained traction, debt and equity crowdfunding are rapidly growing in their use and sophistication.

I would say in summary, given that impact investing is entering the mainstream and that we are at a pivotal moment for climate change, it’s vital that we understand the implications of how huge sums of money are going to be deployed. Once money is invested, it’s much harder to go back and adjust the vehicle that was used. 

This conversation has been lightly edited for clarity and length. The opinions expressed are for general informational purposes only and are not intended to provide specific investment advice.