As a long-time philanthropist, I have years of experience trying to draw direct causal relationships between monetary support of an organization and the change I’d like to see in the world. But as a recent impact investor and graduate student focused on the discipline, I’m puzzled as to why the same level of scrutiny isn’t part of a rather similar process. 

When investing for financial returns, asset owners will scrutinize the value chain to identify where gains are generated. Why then does it seem that double or triple bottom line investors don’t take the same critical lens to an impact strategy as they do a business strategy? When impact is one of the objectives, the early stages of vetting a prospect should include an analysis of where the points of impact lie along the social and environmental continuum. Who is impacted? Is it the social entrepreneur or consumer of their goods and services further down the chain, or both? What is the expected order of impact magnitude, will its reach be targeted and deep or broad and diffused? Is impact delivery an intrinsic element of the enterprise model or ancillary to its core strategy? These questions should be given due consideration during the due diligence process.

SHIFTING PERSPECTIVES: From ‘what’ to ‘how’ in due diligence

When it comes to impact investing, the process itself and not merely the outcome holds valuable lessons about whether a strategy worked as effectively as it could have, whether it is scalable, and whether the approach can be replicated. As many in the field move from a focus on individual solutions to systems change, such insights become crucial. Attaining this knowledge, though, requires open channels of communication and trust, the foundations of which are laid during the due diligence process. Due diligence provides investors with a unique opportunity to examine not only what area of impact an investee purports to operate in but also how they propose to achieve social or sustainability aims within it. This is where the importance of a theory of change enters the picture. Understanding a business model is one thing, understanding an impact causal chain is another. The more an investor questions the assumptions underlying an impact hypothesis and tests the strength of the connections between a proposed business model and its impact logic model, the more likely it is that funds and enterprises with the highest potential for realizing both sets of returns will receive funding.

DIRECT INVESTMENTS: Charting a clearer course to impact

Direct investments into social enterprises offer the best chance to understand cause and effect. They afford clearer views of capital flows, more direct communication, and better opportunities for identifying which impact strategies work and how. Whether it’s equity or debt, venture or growth, an MRI or a PRI, eliminating the layers between an asset owner and an investee reduces the number of filters through which information must pass through. When asked what questions are important for assessing impact potential, founding partner of the impact-focused Candide Group, Aner Ben Ami said, “take every investment… and allow them to inform the conversation in terms of what is their theory of change. What are they trying to achieve versus coming in with a very rigid, ‘here are the metrics we need you to report on.’”

Direct investing allows asset owners to understand whether social returns will grow in lockstep with the business, and whether impact is at the core of an enterprise or merely an appendage. “We ask, ‘are these practitioners that really have the experience or desire? Do they go down deep, to the ground floor, and really understand what are the messy challenges they need to deal with? Who is informing this impact approach over time?” explains Ben Ami. By teasing apart entrepreneurs’ theories of change and analyzing their impact track record with the same scrutinous lens they do past financial performance, investors can train their mental muscle memory to identify the hallmarks of effective impact strategies.

Meaningful outcomes will only manifest if investors employ a more rigorous evaluation process for impact opportunities than: “I’ll know it when I see it.”

Direct investments also support trust building and knowledge sharing, including insight into when a strategy may not be working as planned. The challenge inherent in measuring impact outcomes begs the question of whether asset owners should be content to wait until the end of an investment lifecycle to begin to understand what worked. There is a great deal that can be learned throughout the process and not paying attention is a missed opportunity, especially if a course correction is needed. As all entrepreneurs can attest, understanding the causes of a setback are essential for ultimately achieving success. Asset owners of all sizes who build genuine relationships with their investees and welcome reports on pitfalls as well as progress can glean valuable information and learn from the experience.

FUND INVESTMENTS: More layers require more critical analysis

Making a slew of direct investments may not be feasible for large asset owners looking to deploy capital at scale and funds provide the opportunity to lessen time costs as well as reduce risk exposures. However, the additional layers of mediation that come with a fund structure increase the need for scrutiny. Public market funds can’t provide the strategic specificity, linearity, and transparency needed to substantiate impact claims. Even private market funds often don’t scratch the impact surface beyond superficial identifiers of social or sustainability interests. Fund investing thus requires a heightened level of expertise and critical analysis from the asset owner and its investment advisor. It also requires a greater level of intentionality and clarity regarding the impact causal chain from fund managers.

The Surdna Foundation presents a strong model for making fund investments that are the fullest expression of its organizational mission. Adam Connaker, Surdna’s Director of Impact Investing, engages program staff to identify PRIs, establish close connections with investees and track progress. The collaborative approach not only provides program staffers with an opportunity to learn more about the investment decision making process, it also employs their expertise in vetting impact strategies by tapping a wellspring of knowledge about programs, initiatives, and solutions that have proven effective in areas of impact interest. “Our PRIs have the deepest alignment with our social justice mission because they’re scaffolded by an ecosystem that includes philanthropic and investing expertise,” said Connaker. “This hands-on approach works to identify and support innovative GPs with high impact potential and commensurate opportunity for scale. What we learn from each investment is shared across the impact investing and program teams.”

Funds that are more intentional about impact can embody this commitment in the level of clarity with which they express their theory of change and in the degree of connectivity between their investing approach and impact thesis. Take as an example Chicago TREND, a real estate fund that invests in commercial retail centers in minority neighborhoods and offers coinvesting opportunities to community members. The fund stabilizes and strengthens the asset, attracts retail that will serve the community and returns profit to local investors. “It’s more than just a retail strategy,” said Emma Gonzales Roberts, COO of TREND’s nonprofit arm. “This is community development. It’s about strengthening and transforming neighborhoods and about building wealth. We have several centers of impact.”

Not only does TREND’s approach have the potential for impact across a range of dimensions — urban revitalization, job creation, financial inclusion — it’s easy to understand how its capital functions to achieve these goals with a strategy that is both scalable and replicable. It also bears noting though, that funds need not embrace the impact label to create it. Just look at the increase in private equity firms’ interest in ESOPs and the growing trend of including broad-based employee ownership programs and payouts in their models (see KKR).

CONCLUSION

None of anything I’ve written will read as a revelation to longtime practitioners, some of whom have been in this industry for over 30 years now. What it may be is a helpful reminder to raise the bar on what should be considered an impact investment by elevating the importance of its theory of change, drawing a stronger distinction between capital that is simply aligned with investor values and authentic, solutions-oriented investing. All impact investors share a greater purpose and while those intentions are necessary, they’re nowhere near sufficient. Meaningful outcomes will only manifest if investors employ a more rigorous evaluation process for impact opportunities than: “I’ll know it when I see it.” This dated judicial aphorism shouldn’t be an acceptable due diligence approach. Investors should deeply question not only what they’re investing in but how the model is going to work. Don’t we owe it to humanity to subject the promise of progress to greater scrutiny than the standard applied to pornography?