Traditional financial activities operate on the basis of two dimensions: risk and return, with both dimensions being measurable. Any investment strategy must have clearly defined measurements for the desired risk level and the expected return. Impact investment involves a third dimension: expected social return on investment.
Most investment brings significant benefits to society, in the form of jobs, economic growth and, ideally, products and services that meet society’s needs. However, most investments and economic activities also involve significant and more or less indirect costs to society. As a rule, these costs are not borne by the investor; instead, they are defined as externalities and not included in the calculations. Socially responsible investments seek to take into account both societal costs and benefits. In impact investment, the project’s social benefit is the primary criterion for decision-making. Financial return can be on a par with that from traditional financial investments, and has proven to be so in many instances. However, this need not be the case, as decisions are made on the basis of an overall assessment of social and financial return. We might say that impact investors “internalise the externalities”.
Sometimes, impact investors invest in the expectation of negative financial return. This is the case if the social return is so important to the investor and/or to society that it outweighs any financial loss.
The figure below shows the European Venture Philanthropy Association’s definition of different investment criteria. As we can see, the different criteria have fuzzy borders. To some extent and across much of the spectrum, venture philanthropy and impact investing overlap. A venture philanthropist employs both pure donations and investments, but it is always the social impact that is the focus. Impact investors on the other hand do not give pure donations, but choose those investments that hold a certain likelihood of bringing a return. Although any social return will be key to their decisions, they may also elect to have a “finance first” focus. When we say “finance first”, we mean that the primary criterion for selection is an expectation of a certain financial return, beyond which certain social criteria must be met. “Social first” means that it is the social impact that is the decisive selection criteria; financial return comes in second place.
The dividing line between venture philanthropy and impact investment is not always clear-cut, and investors often operate in more than one arena. Unlike traditional charity, impact investing and venture philanthropy offer several clear advantages to recipients:
1) Greater incentive to secure success through thorough prior analysis (due diligence),
2) Investors follow their projects over time,
3) Investors bring their knowledge, capabilities and network to their projects so as to secure their success.
There are also clear advantages for the donor or investor:
- Donors/investors have greater opportunity to contribute to the desired outcome,
- The recipient has a greater incentive to complete the project successfully,
- There is a potential for accumulated learning.
Investing in projects that will generate social benefits with a certain financial return is highly advantageous for society at large:
- After more than half a century of experience, we know that pure donations often do more harm than good,
- This form of investment significantly increases access to capital,
- Access to expertise in the field of business development and innovation is important to investments in socially beneficial projects.