SII: A New Landscape for Equity Pledges

SII: A New Landscape for Equity Pledges

The corporate and financial worlds have evolved towards achieving new ways to maximize their benefits and minimize their costs. Along these lines, new financial instruments and regulations have come up and, for the financial sector in particular, they reflect better the different interests and realities of investors, investees, markets, and regulators.

Investors’ main goal will still be to achieve higher profits, however this is balanced with a sum of factors, such as level of risk, exposure to certain industries and timelines. Nowadays, higher share value and long-term profits are increasingly certain when factors such as environmental, governance, and social factors are involved in the investment analysis. In fact several studies, like the one performed by University of Reading’s Henley Business School, have found that when such elements are included in the portfolio analysis, the share value of those investments in the long-term, is higher than that of investments where those elements of analysis were not considered.

For the above reason, Environmental, Social and Governance (ESG) aware investments, Socially Responsible Investments (SRI), Social Impact Investments (SII), Equity Pledges, and the latest trend: Impact and green bonds; are some of the financial tools that are becoming more widely used by portfolio managers. Through these types of investments, shareholders are able not only to behave in a socially and environmentally responsible way but also to increase their share value and financial profits, while investees tackle social and environmental issues.

As these tools become more widely used by stock markets, private equity firms and mainstream private banks, it’s important to understand the main difference among them. Where ESG investments - and to a lower degree SRI - mean shareholders filter their potential investments using social and environmental data related to the investment, SII also embeds, measures and reports both the financial and non-financial returns it aims for. SII goes a step further than ESG and SRI, and praises a potential investment for the specific impact it will generate along with its financial returns.

 

What Are Social Impact Investments?

Investments that intentionally target specific social objectives and financial returns, and measure and report on both are generally known as Social Impact Investments (SII). Although no official definition is always used, the most important element is that the investment’s success is measured by both its financial return and by specific social outcomes achieved. These investments span across multiple asset classes and instruments, such as publicly traded equities, fixed income instruments and private investments.

Financial and non-financial returns do not necessarily work as a trade off and one can see high profits from a high impact investment. Depending on the type of investment, level of risk, time frame and impact desired, portfolio managers can balance the investment to favor one type of return over another.  As a general mandate, as long as the investment is targeting industries and sectors that help mitigate social problems, the portfolios can be as vast as one would wish. 

The degree to which investors value financial, non-financial, short and long-term factors depends on the motivations and strategy they follow for their investments. For example, investors in an alternative energy strategy use capital to create a positive impact on the environment.

In addition to having the potential for lowering carbon emissions, investors are expecting a higher return because alternative energy companies are working in a high growth oriented space. However, investments in strategies such as microfinance and community development offer a greater potential for social impact, but often yield lower and slower returns than traditional strategies.

Likewise, the pursuit of a specific impact strategy usually responds to one of these motivations:

1. Base of Pyramid:

An interest in developing the base of the economic pyramid (BOP) by allowing communities to increase their purchasing power might allow for investors to cope with long-term investments in developing countries in exchange for having a leading position in such markets in the future.

2. Shareholders Mandate:

Some portfolio managers find themselves constrained by their shareholders or even by some national Stock Exchanges (New York, Mexico City, Egypt, among others belonging to the Sustainable Stock Exchanges Initiative) to increase their pipeline of impact or to include ESG analysis in their investments.

3. Public Partnerships:

Governments can commission private entities to tackle specific markets and social issues, develop public-private partnerships or support by giving political and/or fiscal incentives or reliefs to these ventures.

 

Opportunities and Risks in Impact Investments

The amount of available funds to be invested represent a considerable opportunity for small or large businesses, entrepreneurs and foundations to be recipients of these funds. These opportunities also allow investors to choose from a wide range of projects to meet their investments criteria. For example, only in the United States and the United Kingdom, Germany and Canada, Asset managers, pension funds, and Foundations represent available funds for $150 billion, £100 billion, €100 billion and $44 billion respectively.

Furthermore, according to a report by Global Impact Investment Network (GIIN) and JP Morgan, the amount invested by the 125 leading impact investors was forecasted to have grown by nearly 20% in 2015.

Within Impact Investments, a combination of impact, risk, time frames, and return factors can be managed through different financial vehicles, and, Merryl Lynch Bank of America’s highlights in the following table show the most common types of vehicles and their associated risk and profits:

As the table shows and as it is widely known, Impact Investments and Equity Pledges come with their own associated risks, the most common being:

 

Identifying Failure

Venture Capitalists know only some of their investments will pay off, and they know when to exit a failing one. However, impact investors must be very clear on their Key Indicators (KPI) to know when they are making a good social impact or not. To mitigate this, benchmarks, timeframes and key indicators must be set clear and kept constantly in check. If these are not being met, the exit plan should be considered on time.

Due to the nature of some countries where investments are done investing in developing new companies and technologies in an uncertain political and economic climate is certainly a risk for any investor.

Two main ways to mitigate this are to include this investment within a diversified portfolio, or to deploy all the energy and resources to understand the country and be able to act within its particularities.

Economically unstable countries tend to have volatile currencies which represent large financial risks for investors. In this case, doing the investment in a stable foreign currency such as United States Dollar or Euro, usually solves this problem.

The amounts being invested by these investors are not shy and, even if many of them dedicate only a fraction of their net funds to these investments, the sums add up to significant investments and returns. The pioneers and followers of Impact Investment know this and increasingly a number of private and public banking managers are now including more impact investments into their strategies.

Such is the case of Omidyar network in the United States, who, for the last 10 years, has been investing in entrepreneurs who develop innovations that are improving the lives of millions of people around the globe. Equally, in September of last year, insurance company Zurich pledged 10% of its equity allocation to impact investments. Through $100m USD, the bank and its portfolio managers expect to: “mitigate environmental risks by supporting a low-carbon economy and encouraging environmentally friendly technologies (…) and to increase community resilience by helping to build community capital and address the needs of populations that lack traditional means to achieve such goals.”

 

Opportunities Through Governmental Support

The importance of impact investors and equity pledges is being acknowledged for being a way to have healthier, long-term portfolios, increased share value and innovative ways to develop new markets among others. For that reason national governments are offering full support in different ways. The biggest effort so far has been by the United Kingdom’s initiative during the G8 meeting in 2013.

The G8 countries who met in London explored how impact investing can accelerate economic growth to solve the most pressing social challenges across borders. For this purpose, the Social Impact Task Force  has now recommended policies to accelerate impact investing, establish a common global approach for measuring social outcomes, and encourage greater engagement across foundations, institutions and private investors with input from the G8 countries. These recommendations have evolved towards a steering group composed of 14 countries: (Australia, Canada, France, Japan, Italy, USA, Germany, United Kingdom, Mexico, Brazil, India, Israel and Portugal) who have committed to commission social services, allow fiscal relieves and incentives, and follow policies to develop the ecosystem of social entrepreneurs and investors.

 

Social Impact Investment Taskforce

The Social Impact Investment Taskforce was announced by Prime Minister David Cameron at the G8 Social Impact Investment Forum in June 2013. It aimed to catalyze the development of the social impact investment market.

Led by Sir Ronald Cohen, the taskforce brought together government officials and senior figures from the worlds of finance, business and philanthropy from across the G8 countries. The Taskforce membership includes one government official and one non-government expert with experience in finance, business or philanthropy, from each participating country. Most G8 nations, as well as the European Union, are represented. Australia has observer status.

Taskforce meetings are intended to focus on the state of the social impact investment market in the host region, and on the infrastructure required to build a global market.

Working groups were set up in the following areas:

 

Impact measurement

This group sought to develop a set of general guidelines for impact measurement practice for use by social impact investors globally to ensure that impact measurement is widely recognized and employed as a fundamental part of the practice of social impact investing.

 

Asset allocation

This working group focused on how capital can be attracted to social impact investment from specific investor communities such as foundations, endowments, pension funds, commercial banking institutions, investment banks and individuals.

International development and impact investing

This group explored the role of impact investment in international development.

 

Mission alignment

This group examined issues such as corporate forms, governance and legal protection as they relate to social ventures and mission-driven businesses.

The Taskforce was superseded by the Global Social Impact Investment Steering Group (GSG) in August 2015. The GSG will continue the work of the Taskforce with a wider membership, comprising 13 countries plus the EU, and active observers from government and from leading network organisations supportive of impact investment.

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