Investing for Impact

INVESTING FOR IMPACT

Investors of all types are aligning values for social outcomes with needs for financial returns and recycling of capital. The result is driving a transformational shift in how we invest and address social challenges in our communities.

By investing new forms of capital into innovative initiatives that seek to leverage business practices to achieve a social purpose, impact investing attempts to achieve a more sustainable and scalable solution to environmental and social challenges. This blending of proven commercial practices with social aspirations is attracting greater amounts of capital from a growing number of investor types, such as large national foundations, institutional investors, endowments, municipalities, venture funds and angel networks. At the same time, philanthropists of all kinds are utilizing both their base of invested assets and grant capital to drive impact through impact investing. The combined effect is producing a new age of innovation among entrepreneurs, business models and capital structures that seek a dual purpose (a “double bottom line”).

A GLOBAL MOVEMENT WITH LOCAL IMPACT

According to the Global Impact Investing Network impact investments are defined as investments made with the intention of generating measurable social and environmental impact alongside financial return. Such investments can provide capital to a range of businesses and funds that generate sustainable and scalable solutions to problems that cannot be realized by negative screen investments or philanthropy alone.

Started in 2015 by the G8, the Global Social Impact Investment Steering Group (GSG) was established to catalyze the global social impact investment market. Below is their introductory video on impact investing.

The Case Foundation, created by digital pioneers Jean and Steve Case, “create programs and invest in people and organizations that harness the best impulses of entrepreneurship, innovation, technology and collaboration to drive exponential impact.” Their efforts to drive social change are focused on three key pillars: revolutionizing philanthropy, unleashing entrepreneurs and igniting civic engagement. To learn more about their current work, click here.

There is a range of investor mindsets. The mindset of the impact investor is focused on intentionally setting out to deliver positive social or environmental impact and financial return. However, many social impact investors are likely to start out with either a traditional financial capital or philanthropic mindset.

Traditional investments are usually made without consideration of social or environmental impact, and philanthropic contributions are generally made without regard to financial returns. Impact investing incorporates “both/and” thinking.

Impact investing lives on a continuum of investing opportunities. Understanding the primary driver and the underlying business model will help you better gauge your place on the continuum. It is not uncommon for investors to fluctuate across the spectrum based on specific or unique opportunities to achieve revenue and social impact goals.

UNDERSTANDING SOCIAL IMPACT INVESTING

Social impact investing aspires to generate a meaningful social or environmental impact alongside a financial return

Though “Impact investing” has existed in various forms for many years, the concept has gained substantial momentum in the past decade. Investors of all types – private and public sector, philanthropic and for-profit – are seeking solutions that achieve both a social impact and a positive return by investing in initiatives that are more sustainable and efficient. Many of these solutions are leveraging proven business practices, such as growing an earned revenue stream, in order to enhance sustainability and scale in new ways.

Environmental, Social and Governance (ESG)/Socially Responsible Investing (SRI)

The term “impact investing” is broad and encompasses a wide range of investor types and asset classes. Among many endowments, institutional investors and investment funds, the concept of impact investing generally refers to “Socially Responsible Investing” (SRI), or the aligning of investment dollars with a given organization’s ideals around Environmental, Social and Governance (ESG) practices. SRI typically places the importance of financial returns above or equal to the desire for social or environmental impacts, which often are achieved by various forms of either selective investment strategies (i.e., a fund focused on energy efficiency) or negative screening (i.e., omitting investments in tobacco, firearms and mountaintop mining). SRI practices are also increasingly stretching across asset classes, to include private equity, venture capital and alternatives in addition to traditional equities and fixed-income investments.

Place-based, or Community-based, Impact Investing

In contrast to SRI and ESG, place-based impact investing prioritizes generating a measurable social impact over obtaining a market-rate financial return. Many private angel and venture investors, community foundations, private and family foundations and public sector officials are approaching local social challenges through investing debt or equity capital, along with traditional forms such as grants. Many of these investments are subsidized, or below-market, and also range across all asset classes. The result is influencing a transformational shift in how local social challenges are addressed at the community level.

Investors are actively investing in a range of business models that represent a continuum of strategies for achieving impact. The various models employed offer investors solutions to social issues that fit various levels of risk tolerance and return expectation.

DEFINING SOME TERMS

ESG & SRI

Environmental, Social and Governance (ESG) and Socially Responsible Investing (SRI) are tools to influence private companies by shareholders. ESG and SRI investors use several tools – such as negative screening to avoid industries harmful to society (e.g., non-renewables) and positive screening to seek industries net beneficial to society (e.g., renewables) – to influence their investment portfolio. ESG and SRI are not place-based impact investment tools, but they have deeply influenced the philosophy behind impact investing. According to a recent Vanguard report, global ESG and SRI assets under management total $22.9 trillion and are growing.

Credit-based Forms of Impact Investing

Loans: According to the Global Impact Investing Network (GIIN), “private debt or fixed income is the largest asset class in impact investing, accounting for 34% of impact investors reported” assets under management (GIIN, 2018). Impact investments are generally subordinated and unsecured, providing borrowers with significant flexibility. Some impact investors will seek more preferential terms, like senior loans, which have the first call on any payment or assets in case a borrower is unable to pay on its obligations.

Nonprofits and social enterprises can use debt capital for the acquisition of facilities, for the construction of new facilities or for equipment. It can be long-term debt. It can be short-term debt, bridge loans, meant to close the gap between a project’s financing needs and the receipt of revenue or grants. It can also come in the form of working capital or lines of credit. When properly managed, debt capital can be a powerful tool to drive social impact.

Loan Guarantees/Credit Enhancements: Without making grants or loans, investors can leverage their balance sheets and credit to facilitate social impact by acting as a guarantor on a social enterprise. With guarantors, social enterprises can find more favorable terms on debt. Investor backing may, on its own, be able to lower the overall cost of loans. Investors can also provide credit enhancements – “first-loss capital” – to encourage other private investors to invest in riskier than ordinary deals.

Fixed-income Securities: Several Community Development Financial Institutions (CDFIs), such as LIIF and the Reinvestment Fund, have begun offering S&P-rated “impact notes” that provide modest financial returns (generally 0.5-4.0%) over the course of 3 months to 10 years.

Flexible Capital: Significant investments, generally made by a foundation or other source of philanthropy as a grant, to transform an organization’s operations are meant to catalyze impact. It can be change capital used to re-align an organization’s strategic priorities. It can be growth capital used to expand the reach of a social enterprise. It is meant to be used for relatively short term realignments in strategy. These investments frequently, but not always, do not seek any financial return.

Kinds of Capital (Nonprofit Future Fund)

Equity

PFS & SIB

Pay for Success (PFS) and Social Impact Bonds (SIBs) provide an innovative means to contracting whereby payment for service delivery is tied to the achievement of measurable outcomes. Contracts generally provide for a quantity of outputs, but PFS aims to improve the quality of outcomes.

PFS contracts are difficult to structure because they require several actors: a service provider; a funder (such as an impact investor) who expects a financial return upon achievement of agreed upon outcomes; an independent evaluator who determines the effectiveness of a service in meeting its outcome objectives; and a payor (typically governments) who pays the funder, depending on outcome measures, the principal and return.

PFS is an attractive new tool because it holds service providers accountable to baseline outcome measures and rewards more effective programs with higher financials returns. The first PFS project, which launched in 2010, successfully decreased recidivism in the United Kingdom. Since then, more than 100 initiatives have been implemented globally.

Pay for Success (Nonprofit Finance Fund)
Social Impact Bond Database (Social Finance UK)

Tax Credits

New Markets Tax Credit (NMTC) Program is run through the U.S. Department of the Treasury’s Community Development Financial Institutions (CDFI) Fund. NMTCs credits are managed through Community Development Entities (CDEs) such as Invest Atlanta affiliate Atlanta Emerging Markets, Inc. (AEMI) and provide tax credits totaling 39% of the original investment amount over a period of 7 years. NMTC projects have to be located in a designated qualified low-income community. PolicyMap can be used to determine eligibility.

The New Markets Tax Credit: How It Works (Video, NMTC Coalition)
New Markets Tax Credit Fact Sheet (CDFI Fund)
New Markets Tax Credit Eligibility Map (PolicyMap)
New Markets Tax Credit (IRS)
New Markets Tax Credit: An Introduction (Congressional Research Service)

Low Income Housing Tax Credit (LIHTC) Program provides dollar-for-dollar tax incentives to private or nonprofit developers to create affordable housing. Tax credits are provided to states and distributed to developers by the state’s designated authority. In Georgia, the Department of Community Affairs manages its distribution. There are two types of LIHTC – 9% credits, which are typically used for new construction, and 4% credits, which are typically used for renovations – that last for 10 years.

How do Housing Tax Credits Work? (Video, Virginia Housing Development Authority)
Housing Tax Credit Program (LIHTC) (Georgia Department of Community Affairs)
An Introduction to the Low-Income Housing Tax Credit (Congressional Research Service)

Opportunity Zones (OZs) were created in the 2017 tax bill and the program is awaiting final regulations from the IRS. Proposed regulations were published for comment in mid-October 2018. The roughly 9,000 OZs encompassing 35 million Americans created through the program will attract investors, if implementation is successful, by [1] deferring capital gains taxes until 2026 or withdrawal from an opportunity fund, [2] reducing capital gains taxes by 15% after a 7-year OZ investments and [3] permanently excluding new gains derived from an opportunity fund if the investment is held for 10 years.

Tax Incentives for Opportunity Zones: In Brief (Congressional Research Service)
Federal Guidance on Opportunity Zones (U.S. Department of the Treasury)
Proposed Regulations (IRS)
Opportunity Zone Resources (CDFI Fund)

PRI & MRI

Program-Related Investments (PRIs) are codified in the 1969 U.S. Tax Reform Act and provide a means for private foundations to create blended value, financial and social returns. While private foundations are guided by the 95/5 rule, whereby they must donate 5% of their assets per year to enjoy their tax privileges, the law counts PRIs as a philanthropic endeavor, counting it as part of the 5% because their associated favorable terms for borrowers (e.g., subordinated, low-interest rate debt). PRIs provide for greater recycling of capital through social good projects, financing of larger, high-risk capital projects, and more flexible debt and equity positions available to social enterprises.

GSIC PRI Toolkit

Mission-Related Investments (MRIs), like PRIs, are investments seeking blended returns. Unlike PRIs, MRIs seek financial returns on par with market-rate returns. MRIs are not codified in law.

How Mission-Related Investments Work (Video, Ford Foundation)

CRA

The Community Reinvestment Act (CRA) is intended to encourage banks to help meet the credit needs of the communities in which they operate. It requires that each institution’s record in meeting the credit needs of its entire community be evaluated periodically. Qualifying activities include: investing in Community Development Entities (CDEs) and Community Development Financial Institutions (CDFIs), supporting minority- and women-owned financial institutions and low-income credit unions (MWLIs), serving as a joint lender for a loan originated by MWLIs, facilitating financial literacy education to low-income communities, operating branches in low-income communities, providing low-cost education loans to low-income borrowers and offering international remittance services in low-income communities. CRA is associated with a degree of controversy due to higher-priced loan products possibly receiving CRA credit, but it also facilitates significant small business lending and community development in MWLI communities.

The Effectiveness of the Community Reinvestment Act (Congressional Research Service)
Community Reinvestment Act (FFIEC)