Making Safe: Seven Strategies for Managing Risk in Impact Investing
By Marta Maretich
Risk is the spice of life and a necessary factor in most investing. Investors are compensated for putting their capital in peril (to a degree) with higher levels of risk attracting higher returns. Without risk there would be little reward.
This makes the art of risk management one of the most important skills in modern finance. Delivering financial products that provide the right level of risk for different investors is key to the success of advisors, fund managers and investment firms. This is as true for impact investing as it is for mainstream finance, especially now that the sector is starting to diversify and attract more corporate, institutional and other large investors.
Yet impact investing faces special challenges when it comes to managing risk, as a recent report by Bridges Ventures highlights; and this unique risk profile calls for special handling when it comes to putting together impact investing products.
To start with, impact has more risks than other kinds of investing. Not only does it have all the risks usually associated with mainstream capital placement; capital risk, transactional cost risk, exit risk and others; it also has what is known as impact risk: the risk that the intended impact will fail to materialize, or that what benefits one set of stakeholders will have negative consequences for another.
In this way, impact risk can be directly related to another risk for investors: reputational risk. It can also pose a problem for institutional and philanthropic bodies who might otherwise use grants or subsidies to bring about intended outcomes in a more predictable way. While these forms of support may have their own drawbacks, impact risk can be a deterrent for this sector of the market, the study shows.
There are other ways risk is different in impact, too: Transactional cost risk can be higher in impact investing where deals are often smaller; exit risk is exacerbated when the need for liquidity conflicts with a commitment to impact outcomes, for example.
All this leaves little doubt that managing risk is a tricky business for impact investors, a fact the sector has known for some time; Jed Emerson has written on the subject of risk management in two reports for ImpactAssets. However, this research brings more detail to the picture through a close examination of 20 real-world impact investment products along with in-depth interviews with fund managers and investors. Crucially, it identifies seven strategies for managing risk in impact investing products:
1. Downside Protection
Provides a safety net if the investment doesn’t work out. A common strategy is to establish a “capital stack” with junior equity providing the first layer of downside protection, preferred equity or mezzanine debt the second and senior debt the third. Collateralisation is one version of this; an alternate version uses third-party guarantees.
Traditional fund structures are “bundles” of investments rolled into one product, spreading risk. More broadly, “bundling” is the aggregation of products that are dissimilar enough to provide diversification. “For example,” the report says, “an intermediary could construct a multi-asset portfolio with property-backed debt balancing higher-risk equity investments, or with liquid product balancing illiquid”.
3. Track Record
Track record is still an issue in the impact space where few fund managers have had time to develop solid reputations for success. Yet the researchers found evidence that established mainstream fund managers are starting to partner with impact investment experts; an echo of Emerson’s multilingual teams. There are also cases where impact investors with a track records of delivering one kind of impact investment product are adding new products to their existing platform. “First-time fund managers (or first-time products) can build credibility with investors by bolting on to an existing platform (benefiting from the experience, networks and back-end), rather than starting from scratch.”
This report defines a liquid impact investment as any product that is “tradeable on a platform, where the platform may be a widely used exchange or a smaller listing that matches buyers with sellers by providing detailed product information (including financial and impact track record, as well as associated risks)”. Some products in this study used platforms like Ethex to achieve liquidity, others traded on open markets such as Capita’s online share portal and the Euro MTF Market in Luxembourg. Factors such as the quality and type of legal documentation, the number of trading platforms and market-makers, transaction costs and overall market transparency all influence liquidity.
5. Technical Assistance
Already a common strategy for organizations like Root Capital and Village Capital who blend market-building with impact finance, technical assistance strengthens businesses through interventions such as improving financial controls, upgrading management staff, improving corporate governance and providing impact assessment training. The research also highlighted a variation of technical assistance: impact investment products that form part of a larger investment management platform. In these cases, a new product benefits from an experienced investment team providing standardized best practice support across the platform.
6. Placement and Distribution
According the report, impact products are de-risked through the involvement of advisors who can “demystify and explain” them to investors, as well as those who have a wide distribution network. With mainstream markets, de-risking requires a bigger network in the form of “a number of advisors or underwriters” working together to sell the investment and potentially take responsibility for managing its liquidity needs.
7. Impact Evidence
Impact strategy, impact measurement, aggregating and analyzing social and environmental impact data; all these have long been the center of debate in the sector. The report offers more evidence of the centrality of impact with products incorporating impact measurement and reporting systems as a way of mitigating risk. Interestingly, products in the study used a number of methods including IRIS, ESG frameworks and nonspecific methods developed privately. Impact that could show a focus on wider stakeholder groups was seen to be most valuable when it came to managing risk.
Managing risk will continue to be a challenge for impact investors, yet this study represents an important step forward in sharing learning across the sector. More than just an academic exercise, it offers a rare opportunity to see inside the workings of a range of impact investment products. Its message is practical (it includes a “toolkit” for risk mitigation) and directed at asset managers, product developers and intermediaries. But we can all learn something about risk management and the practice of impact from its findings.
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