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How does impact investing fare in balancing financial returns with social or environmental goals, and what are its implications on investment risk profiles and strategies?

Image courtesy of interviewee. December 12, 2024

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This video discusses the financial aspects and risk profiles of impact investing, particularly in private markets, which have been less studied compared to public markets. It emphasizes the need to understand the risk properties of impact investments, as private markets offer unique opportunities where investors can influence deal sourcing and actively support portfolio companies.

This video highlights that data on private impact investing funds is scarce, but the Impact Finance Research Consortium has been working to gather relevant data. The authors present an approach to analyze performance and risk exposure of impact funds, using cash flow data to derive a measure of market risk exposure (beta).

Key findings include that impact funds typically exhibit lower market risk exposure compared to other private market strategies. When adjusting for market risk, there is no statistically significant difference in performance between impact funds and comparable strategies. The results suggest that for investors focused on market risk-adjusted returns, impact funds may not be as concessionary as previously thought, while those prioritizing total returns may find impact funds less appealing.

The study also indicates that different investors will perceive the financial merit of impact investing variably, depending on their specific portfolios.

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Here are five key points from the video regarding the analysis of impact investing in private markets:

1. **Need for Understanding Risk Properties**: Impact investing in private markets requires a deeper understanding of its risk properties, which has been discussed extensively in public markets but is lacking in private market conversations. This understanding is essential to grasp the financial merits and overall implications of impact investing.

2. **Data Challenges in Private Markets**: There's a significant challenge in obtaining data for private market funds, as they are often small and not covered by established databases. The Impact Finance Research Consortium has made strides in gathering relevant data, though it remains difficult due to the secrecy and variability of private market operations.

3. **Methodology and Cash Flow Analysis**: The analysis of private market fund performance can be approached through discounted cash flow analysis, relying on contributions and distributions to measure net present value (NPV). The importance of selecting the appropriate discount rate, especially in high beta strategies, is highlighted to accurately assess performance.

4. **Findings on Market Risk Exposure**: The study finds that impact funds exhibit lower exposure to market risks (lower beta) compared to comparable private market strategies. This insight is crucial for investors concerned about market risk-adjusted returns, indicating that impact funds may not be less advantageous than other private market funds when considering alpha.

5. **Performance Assessment for Investors**: For investors whose portfolios are aligned with the U.S. public market (e.g., the S&P 500), impact funds may not yield worse risk-adjusted performance (alpha) compared to other private funds, even though total returns may appear lower. This nuance suggests that impact investments can hold their ground financially when assessed appropriately.

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Here are some key quotes extracted from the video regarding impact investing and its risk properties in private markets:

1. **Understanding Risk**:
- "As much as we debate the financial merits of impact investing, we can't make progress understanding this without understanding the risk properties of impact investing."

2. **Importance of Private Markets**:
- "I would argue that private markets are maybe the most interesting place to think about impact in finance."

3. **Role of Investors**:
- "In private markets, there's a long history of hands-on accompaniment of portfolio companies."

4. **Data Challenges**:
- "It's always difficult to get data for private market funds; many of them are small, not necessarily covered by the existing databases."

5. **Collaboration for Data**:
- "We owe a lot to the work of the Impact Finance Research Consortium, which has been working for years to collect data on private market impact investing funds."

6. **Methodology for Performance Measurement**:
- "Our key insight is to exploit a systematic bias of performance in private markets, which then allows us to back out the beta or market risk exposure."

7. **Comparative Analysis**:
- "We find that impact funds have lower exposure to market risks, lower beta than otherwise comparable private market strategies."

8. **Performance Metrics**:
- "If you look at measures of total return, like multiples or IRR, impact funds underperform relative to comparable private market strategies."

9. **Understanding Alpha vs. Beta**:
- "For these investors, if they care about market risk adjusted returns, impact funds are not necessarily concessionary relative to other private market funds."

10. **Conclusion on Financial Returns**:
- "Maybe you care about total financial returns, in which case impact funds don't look as good, but maybe you care about alpha, in which case you're not actually giving up as much as you might think."

These quotes encapsulate essential insights on the discussion surrounding impact investing, particularly in the convideo of private markets, risk profiles, and the performance metrics applied to assess these investments.

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As much as we debate the financial merits

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of impact investing,

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we can't make progress understanding this without

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understanding the risk properties of impact investing.

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And that's been an essential part

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of the conversation in public markets,

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but it's completely missing from the

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conversation in private markets.

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And yet I would argue

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that private markets are maybe the most interesting place

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to think about impact in finance.

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Um, and that's because this is where the new generation

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of firms is being financed.

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Uh, investors have a lot more influence on deal sourcing.

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They can exert greater price pressure potentially.

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And in private markets, there's a long history of

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hands-on accompaniment of portfolio companies.

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So for example, investors taking seats on the board

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or helping with hiring

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or general guidance in running the business.

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Uh, so for that reason, we thought it was essential

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to understand the risk profile

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of impact investing in private markets.

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It's always difficult to get data for private market funds,

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but especially for impact investing funds in the space.

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Um, many of them are small, not necessarily covered

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by the existing databases like frequent for those

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who are familiar with this space.

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So we owe a lot to the work

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of the Impact Finance Research Consortium,

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which has been working for years

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to collect data on private market impact investing funds.

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Um, some of the data we use in the project comes directly

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from audited cash flows, that we get from impact funds

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that they shared with the consortium

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and that we converted into a database format,

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and then we were able to augment that with,

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additional data from preq, which also provides cashflow data

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for private equity and VC funds.

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Um, what's useful about combining the two data sets

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by the way, is that then, you know,

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not only does it give us the biggest data set possible,

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but then we have, different types

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of funds represented in our data in terms of methodology.

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Our key insight is to exploit a systematic bias

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in a commonly used measure

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of performance in private markets, which then allows us

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to back out the beta

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or market risk exposure,

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using only the cash flow of the funds.

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So our approach builds on, two important papers,

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one by Steve Kaplan and Antoinette Sauer from 2005,

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and another one by, Arthur Cord Wagon

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and Stephan Nagel from 2016.

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And the intuition is this.

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So you can think of measuring the performance

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of private market funds the same way

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that you measure the performance

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of many projects in corporate finance, which is

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to do essentially a discounted cash flow analysis.

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Um, so you take all of the cash flows,

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the contributions into the fund, the distributions out

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of the fund, and you discount these back to the

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time of initial investment into the fund.

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And that gives you a sort of NPV

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or performance measure, for the fund.

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Now the question is what do you use as a discount rate?

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Um, so you can use the total return on public markets,

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which is simple and straightforward,

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and this is the way that Kaplan insurer initially did it.

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Um, but one drawback of that is that if you think

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of a high beta strategy

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that amplifies the movements of a market.

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And so if your strategy has a beta two roughly speaking,

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that means that when the market goes up,

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your strategy goes up twice as much.

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And when the market goes down, your

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strategy goes down twice as much.

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So if you're looking at returns in a time when equity

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markets have been hot, even if you discount

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with a market rate, a high beta strategy will mechanically

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look better than a low beta strategy.

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And then that was a point made by Corda Wagon Nagel

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and they propose a way to correct

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for this using a different discount rate.

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It's the realized stochastic discount factor.

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Our insight is simply that if you look at the difference

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between these two measures, one that corrects for beta

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and one that doesn't, then the difference, the wedge

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as we call it in the paper between the two, is going

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to grow with beta.

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And so that's what we do.

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We calculate this difference, this wedge

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between the two measures,

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and we use that to back out the market risk exposure.

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We find that impact funds have lower exposure

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to market risks lower beta than

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otherwise comparable private market strategies.

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And we find that this matters

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for assessing financial performance.

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So if you look at measure measures of total return, like

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multiples or IRR impact funds underperform relative

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to comparable private market strategies.

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But if you adjust for market risk exposure for the beta,

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or in other words if you care about alpha,

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then there actually isn't a statistically significant

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difference in performance.

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And then we also show

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that there are distinct risk profiles in other dimensions.

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Uh, for example, if you add a public sustainability factor

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that helps explain returns

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for impact funds, but not for other funds.

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Our baseline results, we think

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of investors whose wealth portfolio is best represented

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by the US public market and specifically the s and p 500.

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That's a good place to start

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because it represents investors

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with a well diversified portfolio

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broadly represented by the market.

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So for these investors, if they care about market risk

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adjusted returns,

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impact funds are not necessarily concessionary relative

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to other private market funds.

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Um, and we also show this, by the way,

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using long, short portfolios.

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Um, so

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for these investors, if they care about market risk adjusted

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returns,

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what we typically call alpha impact funds are not

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necessarily concessionary relative

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to other private market funds.

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And that's essentially because for

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Other funds, more

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of their performance is explained by beta.

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Now maybe you care about total financial returns,

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in which case impact funds don't look as good,

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but maybe you care about alpha,

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in which case you're not actually giving up

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as much as you might think.

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We also consider alternatives to the public market

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as the best representation of the wealth portfolio.

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Uh, specifically we consider a public sustainability index

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and an emerging markets index,

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for investors whose wealth portfolio is best represented

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by these alternatives.

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Um, so whose wealth portfolio looks different,

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then the returns

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to impact investing are actually more concessionary.

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So our findings really suggest that the financial merit

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of impact investing will be different for different types

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of impact investors.

Understanding Impact Investing in Private Markets

00:00:00 - As much as we debate the financial merits of impact investing, we can't make progress understanding this without understanding the risk properties of impact investing. And that's been an essential part of the conversation in public markets, but it's completely missing from the conversation in private markets. And yet I would argue that private markets are maybe the most interesting place to think about impact in finance. and that's because this is where the new generation of firms is being financed.

00:00:33 - They can exert greater price pressure potentially. And in private markets, there's a long history of hands-on accompaniment of portfolio companies. So for example, investors taking seats on the board or helping with hiring or general guidance in running the business. so for that reason, we thought it was essential to understand the risk profile of impact investing in private markets. It's always difficult to get data for private market funds,

00:01:08 - many of them are small, not necessarily covered by the existing databases like frequent for those who are familiar with this space. So we owe a lot to the work of the Impact Finance Research Consortium, which has been working for years to collect data on private market impact investing funds. some of the data we use in the project comes directly from audited cash flows, that we get from impact funds that they shared with the consortium

Analyzing Data Integration for Private Market Fund Performance

00:01:37 - and then we were able to augment that with, additional data from preq, which also provides cashflow data for private equity and VC funds. what's useful about combining the two data sets by the way, is that then, you know, not only does it give us the biggest data set possible, but then we have, different types of funds represented in our data in terms of methodology. Our key insight is to exploit a systematic bias

00:02:05 - of performance in private markets, which then allows us to back out the beta or market risk exposure, using only the cash flow of the funds. So our approach builds on, two important papers, one by Steve Kaplan and Antoinette Sauer from 2005, and another one by, Arthur Cord Wagon and Stephan Nagel from 2016. And the intuition is this. So you can think of measuring the performance of private market funds the same way

00:02:36 - of many projects in corporate finance, which is to do essentially a discounted cash flow analysis. so you take all of the cash flows, the contributions into the fund, the distributions out of the fund, and you discount these back to the time of initial investment into the fund. And that gives you a sort of NPV or performance measure, for the fund. Now the question is what do you use as a discount rate?

Understanding Beta and Market Risk in Impact Investing

00:03:07 - which is simple and straightforward, and this is the way that Kaplan insurer initially did it. but one drawback of that is that if you think of a high beta strategy that amplifies the movements of a market. And so if your strategy has a beta two roughly speaking, that means that when the market goes up, your strategy goes up twice as much. And when the market goes down, your strategy goes down twice as much. So if you're looking at returns in a time when equity markets have been hot, even if you discount

00:03:42 - look better than a low beta strategy. And then that was a point made by Corda Wagon Nagel and they propose a way to correct for this using a different discount rate. It's the realized stochastic discount factor. Our insight is simply that if you look at the difference between these two measures, one that corrects for beta and one that doesn't, then the difference, the wedge as we call it in the paper between the two, is going

00:04:14 - And so that's what we do. We calculate this difference, this wedge between the two measures, and we use that to back out the market risk exposure. We find that impact funds have lower exposure to market risks lower beta than otherwise comparable private market strategies. And we find that this matters for assessing financial performance. So if you look at measure measures of total return, like multiples or IRR impact funds underperform relative to comparable private market strategies.

Evaluating Alpha and Risk Profiles in Impact Investing

00:04:47 - or in other words if you care about alpha, then there actually isn't a statistically significant difference in performance. And then we also show that there are distinct risk profiles in other dimensions. for example, if you add a public sustainability factor that helps explain returns for impact funds, but not for other funds. Our baseline results, we think of investors whose wealth portfolio is best represented by the US public market and specifically the s and p 500.

00:05:17 - because it represents investors with a well diversified portfolio broadly represented by the market. So for these investors, if they care about market risk adjusted returns, impact funds are not necessarily concessionary relative to other private market funds. and we also show this, by the way, using long, short portfolios. so for these investors, if they care about market risk adjusted

00:05:48 - what we typically call alpha impact funds are not necessarily concessionary relative to other private market funds. And that's essentially because for Other funds, more of their performance is explained by beta. Now maybe you care about total financial returns, in which case impact funds don't look as good, but maybe you care about alpha, in which case you're not actually giving up as much as you might think. We also consider alternatives to the public market

Impact Investing: Varied Financial Merits by Investor Type

00:06:43 - specifically we consider a public sustainability index and an emerging markets index, for investors whose wealth portfolio is best represented by these alternatives. so whose wealth portfolio looks different, then the returns to impact investing are actually more concessionary. So our findings really suggest that the financial merit of impact investing will be different for different types of impact investors.

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