Impact investment is a rapidly growing phenomenon that has sparked enthusiasm across a wide range of actors, including investors, policy-makers, entrepreneurs and citizens. Impact investments are an important element towards building a more inclusive capitalism that serves society better. Such investments also can enhance effectiveness and efficiency to tackle the ongoing global economic, social and ecological crises of our time.
Rather than run the risk of distorting market mechanisms through unsustainable charitable gifts, the unique and differentiating mission of impact investors is to build better, more competitive markets by investing in businesses with potentially large social benefits, such as better livelihoods and perspectives for underprivileged people or a reduced ecological footprint on our planet. Those socially beneficial goods and services—be they improved value chains, solar panels, seeds, or medicines—are, after all, the “purpose” of businesses. Impact investors also understand that profit is a condition—and result of—achieving purpose. Understanding this is critical to impact investors’ ability to leverage their scarce capital with that of traditional market-rate investors.
What characterizes “impact investing?
Coined in 2007 by the Rockefeller Foundation, the term “impact investing” was first used during an event to discuss the creation of a new global investment industry. This industry connects financial markets with the real economy by supporting organizations that create positive social and environmental benefits in addition to financial returns.
Despite ongoing discussion among practitioners and academics, two key elements are widely agreed upon: It must include intentional pre-determined social impact, combined with an analytical approach for impact measurement.
Another key aspect of impact investing is the concept of “additionality”. Two influential academics in the impact investing field – Brest and Born (2013) – argue that impact investing must improve a social or environmental outcome more than what would have otherwise occurred – a concept known as “additionality”.
The additionality principle encourages investors with scarce capital to concentrate their investments where it makes a difference.
The motivations of impact investors are varied: Philanthropic investors put impact first and may deliberately accept no or below-market financial returns, whereas for-profit impact investors seek to prioritize financial returns with a targeted social impact threshold.
What is philanthropic impact investment?
Philanthropic impact investment aims to create impact by supporting social enterprises building viable organizations and unlocking sustainable social innovations. Efforts to help new ventures navigate from a stage of proven start-up to early growth involves serious (i.e. multi-year) professional and personal commitments of key individuals and substantial resources (in the hundreds rather than the tens of thousands of USD often provided by traditional philanthropic gifts). Due to the many uncertainties combined with a lack of experience and resources at this early stage of enterprise development these commitments carry a high-risk profile.
Despite promises of an innovative business model to result in both financial success and social impact over the long term, a systematic expectation of positive financial return at this stage is simply not realistic: strategic and organizational viability is too uncertain, scale is too limited, and risk of failure is too high.
Importantly, philanthropic impact investment is distinct from charity since it provides resources with the goal of generating a cash-on-cash return, therefore “investment.” However, as it does not systematically lead to positive financial net returns within a reasonable time frame, this patient form of impact investment can be considered “philanthropic.”
A typical philanthropic impact investment size in terms of financial capital is between $USD 300,000-500,000. The risk of either complete failure or of middling performance without really taking off is substantial at this phase of enterprise development as the business is still volatile.
A philanthropic impact investment approach differs from what venture capitalists do since a clear, explicit and measurable impact goal is pursued, and capital follows more patient, longer term financial return expectations. It is also different from traditional philanthropic giving since a clear financial return expectation increases the focus on market solutions and hence a higher likelihood of longer-term sustainability.
What are the keys to successful impact investment?
- The business model should be sufficiently visible and allow for a ballpark estimation of the targeted social impact.
- There should be an element of bringing a non-traditional solution to market that unlocks social innovation.
- A medium term (3-5 years) path to economic sustainability must be plausibly articulated. This should capture the market potential and how future competitors affect growing revenue and gross margin projections. It also requires an analysis of both one-time investments and regular running cost that provide a plausible path to break-even within 3-5 years.
- Good ideas ultimately only become realized if combined with entrepreneurial energy and relevant skills: Therefore, the most critical criteria are the existence of either an individual entrepreneur or an entrepreneurial team that has the essential intrinsic entrepreneurial qualities and skills mix that are necessary to succeed.
Research Fellow Patrick Reichert is a researcher at the elea Center for Social Innovation at IMD.
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