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Impact Investing Needs Better Returns to be Sustainable

In 2020, global extreme poverty increased for the first time in over 20 years, with an additional 100 million people living in poverty. Inequality is reaching concerning levels almost everywhere. Pollution is threatening our planet. All these worrying developments are disproportionately affecting the poorest regions of the world, with effects expected to linger or even worsen post-covid. What should investors do to help? Many people agree that capital should not only generate returns for investors, but ultimately feed into a flywheel that makes the world a better place for everyone. Impact investing has enormous potential to do just that. To reach its full potential in emerging markets, however, the impact investing industry needs to significantly increase equity returns. Without higher returns, it misses an important opportunity to attract capital to where it is most urgently needed.

There is a key difference between investing in developed markets and emerging markets (such as India, Vietnam, Ghana, and Colombia). Developed economies are flush with capital so impact investing there can “afford” to focus on various priorities. Emerging markets, however, have a much more fundamental issue: they have significantly less access to capital. About 90% of the world’s population under age 30 lives in emerging markets, yet less than 25% of private equity capital raised over the last decade has been focused on these regions (according to Preqin).

Woman making chartMost businesses in emerging markets do not have sufficient access to bank financing and lack the capital to scale. Hospitals must build more bed capacity and hire more doctors, education providers need to expand their course offerings and hire teachers, labs require new machinery, and so on. Capital scarcity also starves innovation. Some of these businesses have the potential to become catalysts for broad regional prosperity, or “market-creating innovators”, a term popularized by Clayton Christensen and Efosa Ojomo of the Christensen Institute. Ojomo’s research indicates that the best way to reduce poverty is to support innovative businesses that grow into large commercial ecosystems. This process creates an exponential pull-effect that draws entire societies to pursue education, infrastructure construction, and other prosperity-generating outcomes.

Therefore, bringing capital to these companies is the most positive impact that investors can deliver to emerging markets. And the best way to attract capital flows and sustainable investor demand is, unequivocally, the outlook of strong returns.

Herein lies the biggest problem facing emerging markets: observed private equity investment returns in emerging markets trail developed markets significantly. Long-term net annual returns for developed markets private equity are ~13-15%, compared to ~10-12% in emerging markets. On average, impact- focused funds are even further behind (~6% in emerging markets) (Data from Cambridge Associates) . While there might be multiple reasons for underperformance, the key issue is that lower returns decrease the attractiveness of the impact investing industry. Over time, commercial interest in it will wane, reducing the available capital, and thus creating a vicious cycle that makes it harder for local entrepreneurs to build businesses and create prosperity. Therefore, the highest priority for emerging markets impact investors must be to improve returns.

Herein lies the biggest problem facing emerging markets: observed private equity investment returns in emerging markets trail developed markets significantly.

While this empirical shortfall in returns might lead some to conclude that impact is a distraction from achieving high returns, research actually points in the opposite direction. The risk-mitigating benefits of paying close attention to ESG are increasingly appreciated even outside of the impact investing industry. For example, prudent mainstream investors may encourage a company to limit its environmental impact for risk management purposes. However, research has recently taken it a step further. Studies led by Harvard Business School Professor George Serafeim indicate that the right focus on ESG issues and impact not only mitigates risk but actually enhances investor returns. For example, intentionally building diverse management or a happy employee base can be a meaningful competitive advantage leading to higher success in the long run.

Business presentation

So if impact enhances returns, isn’t it ironic that empirical returns are lower? The industry is currently clearly missing something. Even worse, some investors have surrendered to the simplistic notion that impact investing will always generate lower returns. This assumption discounts the attractiveness of investing with positive impact and damages the whole impact investing industry meaningfully.

So if impact enhances returns, isn’t it ironic that empirical returns are lower? The industry is currently clearly missing something.

Admittedly, adequately assessing and measuring impact is complex. For example, impact investors might shy away from investing in pesticides because of the negative perception of potentially harmful chemicals. However, in India, where up to 30% of annual harvests are destroyed by pests, pesticides are vital for crop protection and, hence, food security – yet utilization of pesticides is far behind other emerging markets countries, such as China. In this case, avoidance of such sectors presents a significant opportunity cost for creating impact, and constructive engagement with such companies to improve their ESG capacity and performance could create significantly greater net positive impact.

Impact assessments should thus focus on solving broader, practical problems, rather than let narrow or overly theoretical definitions dismiss a potentially attractive opportunity. This balance is clearly complex, but thankfully the industry has made considerable strides in better defining, measuring, and tracking impact. The important point is that, regardless of these considerations, investors should never trade off impact against returns.

Woman giving thumbs up signThere is no shortage of examples of companies that created significant positive, and sustainable, impact for entire communities while also generating strong financial returns for their investors. Just to name a few examples, over the last 10 years India’s BYJU’s has brought quality education content to millions of students. It recently became the world’s largest ed-tech company valued at $18 billion. M-Pesa, a Kenyan mobile phone-based financial-services company has brought financial services to millions of previously unbanked people across Africa. Over 8 years, 2% of Kenyans escaped extreme poverty as a consequence. It also reduced crime in otherwise largely cash-based societies and created tens of thousands of jobs.

What can be done to bring the impact investing industry to its full potential? The most important thing is that investors understand that their returns must be better. To start, they should not intentionally target and underwrite lower returns, since research shows that no trade-off between impact and returns is necessary. Additionally, financial analysis and due diligence on investment opportunities have to meet high standards because achieving impact is not a valid excuse for poor returns.

What can be done to bring the impact investing industry to its full potential? The most important thing is that investors understand that their returns must be better.

High returns eventually create the most significant and sustainable impact: they attract more capital flows that are desperately needed to support businesses, encourage entrepreneurs, foster innovation, and eventually create strong, local ecosystems. Once investors take this to heart, it would be a breakthrough in emerging markets investing with profound, large-scale, and sustainable, impact.

Clemens Feil is a growth equity investment professional at the largest global development finance institution focused on the private sector in developing countries. Clemens has a decade of private equity investing experience, including at Bain Capital, Clayton, Dubilier & Rice (CD&R), and Neuberger Berman. Clemens has a BSc from the ... Read more

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