(Illustration by Ben Wiseman)

There has been an increasing realization that, along with philanthropy and government aid, private enterprise can contribute to solving social and environmental problems. At the same time, a growing number of investors are expressing a desire to “do good while doing well.” These are impact investors, who seek opportunities for financial investments that produce social or environmental benefits. However, the rapid growth of the field of impact investing has been accompanied by questions about how to assess impact, and concerns about potentially unrealistic expectations of simultaneously achieving social impact and market-rate returns.

This article is addressed to impact investors who wish to know whether their investments will actually contribute to achieving their social or environmental (hereafter, simply “social”) objectives. We introduce three basic parameters of impact: enterprise impact, investment impact, and nonmonetary impact. Enterprise impact is the social value of the goods, services, or other benefits provided by the investee enterprise. Investment impact is a particular investor’s financial contribution to the social value created by an enterprise. Nonmonetary impact reflects the various contributions, besides dollars, that investors, fund managers, and others may make to the enterprise’s social value.

The most novel and intriguing question we consider is whether and when investors can expect both to receive risk-adjusted market-rate returns on their investments and to have real social impact: that is, can investors both make money and make a difference? That is the claim made by many impact investment funds. One recent study asserts that most of what it estimates to be a $4 billion impact investing market involves investments producing market rate returns.1

We posit that a particular investment has impact only if it increases the quantity or quality of the enterprise’s social outcomes beyond what would otherwise have occurred. Under this definition, it is readily apparent that grants or concessionary investments (investments that sacrifice some financial gain to achieve a social benefit) can have impact: By hypothesis, an ordinary market investor, who seeks market-rate returns, would not provide the capital on as favorable terms, if at all.

But if an impact investor is not willing to make a financial sacrifice, what can he contribute that the market wouldn’t do anyway? We believe that in publicly traded large cap markets, the answer is nothing: Even quite large individual investments will not affect the equilibrium of these essentially perfect markets. The frictions or imperfections inherent in some smaller, private markets, however, may offer the possibility of achieving both market returns and social impact. For example, someone with distinctive knowledge about the risk and potential returns of a particular opportunity may make an investment that others would pass up.

The question of investment impact is of obvious importance to investors who want to make a difference. Although we do not reject the possibility of earning market-rate financial returns while achieving social impact, we are skeptical about how much of the impact investing market actually fits this description.

Impact Investing Defined

An impact investor seeks to produce beneficial social outcomes that would not occur but for his investment in a social enterprise. In international development and carbon markets, this is called additionality. With this core concept in mind, we define the practice of impact investing capaciously, as actively placing capital in enterprises that generate social or environmental goods, services, or ancillary benefits such as creating good jobs, with expected financial returns ranging from the highly concessionary to above market.2

The adverb “actively” excludes negative investment screens. This is not a judgment about their value, but rather reflects the general understanding that impact investing encompasses only affirmative investments. Within the field of impact investing, we include concessionary investments, which sacrifice some financial returns to achieve social benefits, and non-concessionary investments, which expect risk-adjusted market returns or better.

Like philanthropists, impact investors invariably intend to achieve social goals. They are, by definition, socially motivated. Their goals may be as specific as providing anti-malaria bed nets to residents of a region in Africa or as general as doing environmental good. In contrast, socially neutral investors are indifferent to the social consequences of their investments. Many endowments invest in a socially neutral manner, as do individuals who invest through money managers or funds whose only mandate is to maximize financial returns.

Whatever an investor’s intention, the fundamental question is whether an investment actually has social impact. For example, socially neutral investors, motivated only by profit, have contributed to the social impact of telecommunications companies in both the developed and developing world. Yet while social impact can be achieved unintentionally, this does not mean that intention is unimportant. In business, as in philanthropy and all other spheres of life, people are more likely to achieve results that they intentionally seek.

Having impact implies causation, and therefore depends on the idea of the counterfactual—on what would have happened if a particular investment or activity had not occurred. The enterprise itself has impact only if it produces social outcomes that would not otherwise have occurred. And for an investment or nonmonetary activity to have impact, it must increase the quantity or quality of the enterprise’s social outcomes beyond what would otherwise have occurred.

Enterprise Impact

In this article, we explore the three parameters of impact: the impact of the enterprise, investors’ contribution to the enterprise’s impact, and the contribution of nonmonetary activities to an enterprise’s impact. Without successful outcomes from the social enterprise, no investment can have social impact. Therefore, the social impact of investors and other actors ultimately depends on that of the enterprises they support.

An enterprise can have impact in several ways, two of which are fundamental: product impact is the impact of the goods and services produced by the enterprise (such as providing anti-malaria bed nets or clean water); operational impact is the impact of the enterprise’s management practices on its employees’ health and economic security, its effect on jobs or other aspects of the well-being of the community in which it operates, or the environmental effects of its supply chain and operations.

The theoretical framework that underlies the assessment of enterprise impact makes a distinction between outputs and outcomes. An output is the product or service produced by an enterprise; the (ultimate) outcome is the effect of the output in improving people’s lives. So the impact investor must answer two questions: First, to what extent will the intended output occur? Second, to what extent will the output contribute to the intended outcome (where the counterfactual is that the outcome would have occurred in any event)?

Consider an investor supporting an organization that manufactures and distributes bed nets with the goal of reducing morbidity and mortality from malaria. The focus of the first question is whether the bed nets were manufactured and distributed. It is answered by looking at the quantity and quality of the organization’s outputs.

The second question is concerned with whether the bed nets actually reduced malaria in the target population. For example, even if bed nets are often effective, and even if the ultimate outcome occurred in the target population, can the reduction in malaria be attributed to the enterprise? Perhaps the reduction was due to a simultaneous vaccination or mosquito eradication program. The question of outcomes, or social impact, is typically answered by using the same social science methods used in assessing outcomes in public policy and philanthropy—for example, randomized controlled studies or econometric analysis.

The Impact Reporting and Investment Standards (IRIS) and Global Impact Investment Rating System (GIIRS) provide standardized metrics for assessing some common output criteria. But these focus more on an enterprise’s operations than on its products. With rare exceptions—most notably, the field of microfinance—there have been few efforts to evaluate the actual outcomes of marketbased social enterprises. The absence of data and analysis makes it difficult for impact investors to assess the social impact of the enterprises they invest in.

Investment Impact

As we noted above, to have investment impact requires that an investment increase the quantity or quality of the enterprise’s social output beyond what would otherwise have occurred. Assuming that, at the time of an investment, the enterprise can productively absorb more capital, then an investment has impact if it provides more capital, or capital at lower cost, than the enterprise would otherwise get.

Debra Schwartz, director of program-related investments at the MacArthur Foundation, has alliteratively summarized the kinds of capital benefits that impact investors can provide in terms of five P’s, to which we add a sixth, perspicacity:

Price. Below-market investments

Pledge. Loan guarantees

Position. Subordinated debt or equity positions

Patience. Longer terms before exit

Purpose. Flexibility in adapting capital investments to the enterprise’s needs

Perspicacity. Discerning opportunities that ordinary investors don’t see

These capital benefits enable the enterprise to experiment, scale up, or pursue social objectives to an extent that it otherwise could not. The first five are particularly relevant to investments that expect below-market returns. The sixth, perspicacity, may hold the key to achieving both market returns and social impact.

Socially motivated investors fall into two categories: concessionary investors who are willing to make some financial sacrifice—by taking greater risks or accepting lower returns—to achieve their social goals; and non-concessionary investors who are not willing to make any financial sacrifice to achieve their social goals. Most so-called “double-bottom-line” impact investors are nonconcessionary. In the context of philanthropy, non-concessionary socially motivated investments are often called mission-related investments, and are distinguished from program-related investments, which are generally concessionary.

Concessionary Investments | The return sacrificed by a concessionary investment is, in effect, a charitable donation or grant. Assuming that the enterprise can productively deploy additional capital, a concessionary investment has investment impact virtually by definition, because it makes available capital to which an enterprise would not otherwise have access. Consider three general situations in which impact investors have made concessionary investments.

Supporting nascent enterprises. The early stages of many social enterprises that aspire to become financially sustainable depend on philanthropy and highly concessionary investments that involve higher risks than ordinary market investors would take. This was true of microfinance and of other social enterprises that serve base-of-pyramid (BOP) populations, which often depend on innovations in technology and marketing and require significant investments before yielding any financial returns.

Subsidizing ongoing enterprises. Some mature social enterprises require the ongoing support of investors who are willing to forgo a degree of financial return for social benefits. For example, in 1994 the US Department of the Treasury created Community Development Financial Institutions (CDFIs) to “provide economically depressed communities access to credit, equity, capital, and basic banking products.” Subsequently, the Calvert Foundation began offering below-market Calvert Community Notes, which in turn are invested in CDFI-accredited community organizations that provide below-market loans to nonprofit organizations and small businesses in underserved communities.

Simultaneous layering of concessionary and non-concessionary investments,. with the former intended to encourage the latter. For example, the New York City Acquisition Fund is designed to promote the development of affordable housing by providing flexible capital for developers. The city was joined by the MacArthur, Rockefeller, F. B. Heron, Robin Hood, Starr, and Ford foundations in providing subordinate debt and loan guarantees. More or less non-concessionary investors include Bank of America, JP Morgan Chase, and HSBC.

These are examples of the beneficial effects of subsidies. But the fact that an investment is concessionary is no guarantee that it will create net positive social impact. Subsidies can also mask an enterprise’s inefficiencies and crowd out healthy competition. Subsidizing microfinance and community development institutions has been both positive and harmful in different circumstances.

In any event, the ideal outcome for most enterprises that initially rely on concessionary capital is that they eventually yield market returns and attract socially neutral investors. Here, impact investors have played their part in bringing the enterprise to market, the impact investing story is over, and the enterprise is now supported by customers and ordinary market investors.

The modern history of microfinance provides examples of this. The story begins with grants to the Grameen Bank and other microfinance institutions (MFIs) to develop and prove the concept, followed by concessionary loans and equity investments to begin implementing it. Although even today many MFIs depend on subsidized investments, an increasing number now attract market investors. For example, in 2007 the initial public offering of the highly profitable Compartamos Banco was vastly oversubscribed, and some mainstream banks, such as Citigroup, now have a microfinance business. This generally positive story has a dark side, however. As MFIs become more financially attractive, they may adopt practices that compromise their social missions.

Non-Concessionary Investments | It’s easy to see how belowmarket investors can provide capital benefits to an enterprise, but it is less clear how and when investors expecting market returns (or better) have investment impact. Yet much of the impact investment space is occupied by funds that promise their investors both socially valuable outputs and at least market returns. For example, Elevar Equity generates “outstanding investment returns by delivering essential services to disconnected communities underserved by global networks.”

We don’t question these fund managers’ assertions that their investments have strong financial returns. The immediate question is how their investments might have investment impact. Under our criterion of additionality, the investment must increase the quantity or quality of the social or environmental outcome beyond what would otherwise have occurred. The counterfactual is that ordinary, socially neutral investors would have provided the same capital in any event. Under the additionality criterion, how can an impact investor expect market returns and still provide capital benefits to the enterprise? After all, if it’s a good investment, one would expect socially neutral investors to be in it as well.

Most economists agree that it is virtually impossible for a socially motivated investor to increase the beneficial outputs of a publicly traded corporation by purchasing its stock. Especially if—as is generally the case—stock is purchased from existing shareholders, any benefit to the company is highly attenuated if it exists at all. Impact investing typically does not take place in large cap public markets, however, but rather in domains subject to market frictions. While some of these frictions impose barriers to socially neutral investors, socially motivated impact investors may exploit them to reap both social benefits and market-rate financial returns. These frictions include:

Imperfect information. Investors at large may not know about particular opportunities—especially enterprises in developing nations or in low-income areas in developed nations—let alone have reliable information about their risks and expected returns.

Skepticism about achieving both financial returns and social impact. Investors at large may be unjustifiably skeptical that enterprises that are promoted as producing social or environmental value are likely to yield market-rate returns.

Inflexible institutional practices. Institutional investors may use heuristics that simplify decision making but that exclude potential impact investments, which, for example, may require more flexibility than the fund’s practices permit.

Small deal size. The typical impact investment is often smaller than similar private equity or venture capital investments, but the minimum threshold of due diligence and other transaction costs can render the investment financially unattractive regardless of its social merits.

Limited exit strategies. In many developing economies, markets are insufficiently developed to provide reliable options for investors to exit their investment in a reasonable time.

Governance problems. Developing nations may have inadequate governance and legal regimes, creating uncertainties about property rights, contract enforcement, and bribery. Navigating such regimes may require on-the-ground expertise or personal connections that are not readily available to investors at large.

We believe that non-concessionary impact investors are especially likely to have investment impact in conditions of imperfect information—for example, in social or environmental niche markets where impact investment fund managers or other intermediaries have special expertise or intelligence on the ground.

Perfect markets are functionally omniscient, but the impact fund manager says (in the words of David Chen of Equilibrium Capital), “I see something that you don’t see.” Socially motivated investors may be particularly interested in identifying these opportunities and thus may be able to have impact even at nonconcessionary rates. This is the most likely explanation for the asserted double-bottom-line success of firms like Elevar Equity. Even here, one might ask whether investments that seem nonconcessionary on their face incorporate hidden concessions in the form of risk or extra and costly due diligence that ordinary investors would not undertake.

Nonmonetary Impact

Beyond just providing capital, fund managers as well as other actors can improve an enterprise’s social outputs by providing a range of nonmonetary benefits:

Improving the enabling environment for social enterprises and investors. Governments and foundations can provide funding to improve the social, political, and regulatory environments in which social enterprises and their investors operate. For example, the Boulder Institute has developed scoring and rating models for MFIs, established benchmarking, introduced an open source management information system, and trained thousands of MFI practitioners. In addition to providing public goods of these sorts, a well-designed set of investments in a sector has the potential to catalyze markets to a greater extent than the sum of random investments in the individual investee enterprises.

Finding and promoting impact investment opportunities. Impact investment intermediaries are critically important in discovering investment opportunities and bringing them to the attention of investors, thus helping to overcome the information failures previously noted. For example, Agora Partnerships identifies early-stage impact investment opportunities in Central American communities, focusing on small and growing businesses that are too large for microcredit and too small for traditional financing. Its clients, such as the Draper Richards Kaplan Foundation, engage Agora to pursue impact investment opportunities in the region.

Aggregating capital and providing other investment services. Fund managers and other intermediaries reduce transaction costs by creating economies of scale, and they may also provide technical assistance to impact investors. For example, Imprint Capital Advisors helps foundations and family offices identify domestic and global opportunities for impact investment. Imprint guided several foundations to invest in Southern Bancorp, a US development bank that provides banking and nonprofit services aimed at reducing poverty and unemployment in distressed rural communities.

Providing technical and governance assistance to enterprises, and helping them build strategic relationships. Fund managers and other third parties provide nonmonetary benefits, ranging from technical assistance for nascent enterprises to helping more mature enterprises develop relationships with customers, suppliers, and other partners. For example, Root Capital’s Financial Advisory Services are designed to strengthen the business processes of social enterprises with high growth potential in Africa and Latin America. Training modules focus on business and administrative management, financial planning, risk management, accounting, and loan applications.

Gaining socially neutral investors. One of the unfortunate characteristics of imperfect impact investing markets is their inability to attract the large majority of socially neutral investors who demand market returns. Where such returns seem plausible, a respected institution can signal to other investors that a particular investment or an entire sector that others may have thought dubious is actually worthy of consideration. For example, the David & Lucile Packard Foundation made an initial $1 million equity investment, followed by a low-interest $10 million loan, in EcoTrust, a sustainable forest management firm. The foundation’s general counsel noted: “Our main reason for investing in EcoTrust Forest in this way is to demonstrate that sustainable forest practices can generate a profit so that mainstream investors will become more interested in it.”3

Securing and protecting the enterprise’s social mission. Over time an enterprise’s management and directors may discover opportunities to increase financial returns at the expense of social impact. For example, the manufacturer of products or services designed for BoP clientele may find it more profitable to market to wealthier Securing and protecting the enterprise’s social mission. Over time an enterprise’s management and directors may discover opportunities to increase financial returns at the expense of social impact. For example, the manufacturer of products or services designed for BoP clientele may find it more profitable to market to wealthier customers. The dangers are especially acute as the enterprise scales up and takes on new, socially neutral investors. There are a number of possible protections against such mission drift, including contractual arrangements; B Corps, and other corporate forms that require, or at least welcome, producing social benefits that may compromise market returns; and the continual influence of socially motivated investors.

The Demand for Information About Impact

Having addressed this article to impact investors who wish to know whether their investments will actually contribute to social or environmental impact, we conclude with a reality check on investors’ making this inquiry and learning from it.

A 2010 survey of philanthropists and impact investors suggests that the vast majority are not willing to make any effort to gain information about the actual social or environmental impact of their investments.4 Social impact is notoriously difficult to measure, and it could well be that many investors are satisfied with the good public relations and warm glow of doing a beneficent act. But we are optimistic that there are impact investors with significant resources who actually care whether their investments are making a difference.

For those who do care, efforts to assess impact come at a cost—greater or lesser depending on the degree of evaluative rigor. Estimating the expected financial return from an investment is a difficult but familiar exercise. Estimating social return is intrinsically much harder because of the complexities of placing values on social and environmental outcomes and predicting what outcomes an organization is likely to achieve. Estimating the value of nonmonetary contributions that directly benefit an enterprise is a commonplace task that an organization engages in whenever it hires consultants. Estimating the value of nonmonetary contributions to an entire sector is a far more speculative task.

In contrast to enterprise and nonmonetary impact, assessing a particular investment’s additionality in order to determine its investment impact is a novel task that, so far as we know, has not previously been undertaken. In this article, we propose the questions that underlie this analysis. An investor who expects market returns must ask whether his non-concessionary investment is likely to have investment impact, and if so, how much. An investor who is prepared to sacrifice market returns should ask how much concession it’s worth making for the social value produced by the organization. Although we have no a priori commitment to any particular depth of analysis, we believe that realizing the promise of impact investing depends on all three measures becoming central to the marketplace.

Read a longer version of this article, “Unpacking the Impact in Impact Investing.”