Conducting Impact Due Diligence

    This article is part of NordSIP Insights – NordSIP Insights – SDGs 2020: 17 Shades Faster. Read or Download the entire publication here.

    By Irene Mastelli, Independent Advisor, Maloja Advisory

    Irene Mastelli, Maloja Advisory

    As we meet impact managers and conduct due diligence on their funds, we ask: what is different when looking at impact investing compared to mainstream investments. In this article, we argue, the two tasks and processes are similar in most aspects. At the core, investors want to know if the proposition is credible, if the team can execute on the strategy, and, in the process, gain knowledge of and become comfortable with key risks. Impact, however, requires at least three additional layers of expertise.

    Responsible investing with intent

    When conducting an impact due diligence, just as for traditional investments, investors should look at whether the target company or the investment manager is stable and well-resourced, if the team has experience, and if there is a convincing basis to generate economic returns. Beyond that, the first hurdle for the investment manager and investment team is to qualify as responsible investors. For example, they should have a strategy to tackle and mitigate environmental, social and governance (ESG) risks, and an overarching principle of “doing no harm”. Impact investing is sometimes defined as an evolution of responsible investing (responsible investing with intent), and it should always incorporate its basic elements. In this respect, investigating how the investment company and team approach ESG is key.

    The three dimensions of impact

    Impact investing adds another dimension to the process – asset owners should also investigate the three key differentiators of the proposition: intent, contribution (also known as additionality, or the difference capital is making relative to someone else’s), and finally reporting. In fact, impact is not an asset class, rather it is an approach that can be applied to many different types of investments, from single assets to comingled vehicles. Without all three elements of intent, contribution, and reporting, a fund can represent a ‘sustainable’ or ‘thematic’ strategy, but it does not constitute an impact investment.

    The hunt for contribution

    Of all three, contribution is probably the hardest to assess. Investment managers bear the burden of demonstrating that, should their capital not have been deployed in the project, the positive impact would not have been achieved. Very few managers can show true additionality. The use of techniques such as randomised control trials is, in many cases, either impossible, not viable, or plain unethical.

    The necessary theory of change

    For a strategy to qualify as impact, a credible “theory of change” is also necessary – a model, based on certain assumptions, that explains how the manager plans to go from action to outcome to more systemic impact.

    Consider a fund providing capital to small medium-size enterprises delivering an essential service in an emerging market, with the intent to improve access to such service, and targeting underserved populations. The greater access to financing, for example, represents the additionality. Another contribution may be brought about by the investors’ expertise in helping the target company to market its services more effectively. The theory of change explains how the company’s action tackles the initial problem (the poor access to the essential service, in this case), leading to improvements for the target population, ultimately leading to overall societal gains. In this case, the model would have to highlight the assumptions and causal links to show how capital leads to better outcomes and systemic change.

    The issues with reporting

    Where available, the impact report can truly shed light on both contribution and theory of change. Reporting, therefore, is an essential piece of the proposition. However, many of these reports present the reader with a colourful “SDG patchwork” alongside wind turbines and happy children, but how many narrate a convincing story, with a coherent and logical model? They often miss a clear narrative linking the societal or environmental issue; how the capital makes a difference, which key performance indicators (KPIs) are targeted, which were achieved, and if the investments are leading to more systemic change. In addition, first-time funds will, of course, have a tough time presenting any reporting at all, given that they will have had nothing to report on.

    The notion of impact investing does generate emotional value and impact reports give investment managers a chance to capitalise on that value, while being more creative. Ultimately, however, for impact investments to be taken seriously, reporting has to clearly showcase achievements and link them to the investment and impact thesis.

    An additional hurdle is that a vast majority of the commercial, large, institutional impact funds are generalists. They invest in a number of unrelated sectors and impact themes, whether societal or environmental. As a result, reporting on unrelated KPIs is problematic. For example, reduced greenhouse gas emissions are unrelated to the number of adults in job training and these metrics cannot be presented coherently in one chart. Ultimately each manager should find ways to tell its own story in a compelling way.

    In this respect, whilst the Sustainable Development Goals (SDGs) themselves represent an epochal shift, their use in impact reporting can be, at times, almost confusing. It seems that any economic activity can be classified under at least one of the goals, whether it is sustainable or not. The underlying targets, however, are more compelling than the 17 SGDs. For example, SDG 7 “Ensure access to affordable, reliable, sustainable and modern energy for all” is difficult to measure without looking at the underlying targets, for example target 7.3: “By 2030, double the global rate of improvement in energy efficiency”. Ideally the report should explain how the fund plans to affect that specific area. Alternatively, managers may define goals on their terms, which might very well differ from the sub-targets, in a perfectly acceptable manner. As long as the aim is coherent with the goal and the effect consequent and measurable.

    Tricky alignment

    Beyond the design of an impact strategy and its deployment, investors should get comfort that the managers put their money where their mouth is. Compensation should be strongly tied to responsible behaviour and to achieving a positive impact. “Impact hurdles”, i.e. variable compensation tied to the achievement of certain outcomes as per the fund’s strategy are still relatively rare, however. Some teams donate part of the carried interest to worthwhile causes and, in some cases, that is presented as a part of the impact proposition. Mechanisms for full alignment of interests seem more important. Investors are interested in obtaining a financial return and contributing to societal and environmental impact. It may be optimistic to think that managers will be motivated as much by their contribution to charity as by the size of their personal bonus and carry.

    The assessment of other qualitative and organisational aspects shouldn’t be neglected. Investors should view positively the firm’s engagement in industry initiatives (for example the Global Impact Investing Network (GINN), the UN Principles for Responsible Investing (PRI), or the IFC’s Operating Principles), as well as the presence of a responsible investment function with real investment decision-making power. Similarly, investors should investigate the team’s ability to generate a sufficient pipeline. Information about positive impact is not as widespread as financial information, and therefore, to screen investments from an impact perspective requires different skills. In this respect, particularly new impact managers benefit from the collaboration with philanthropic entities that bring knowledge and experience in delivering impact on the ground.

    The gist of it

    In summary, impact investment funds present three specific challenges, in addition to the risks of traditional funds. The first is a potential lack of responsibility in investing – for example, the absence of processes in place to ensure that investments are carried out responsibly, and that ESG risks are considered and integrated in the investment analysis. Failure to properly take these factors into account will ultimately result in either financial underperformance or reputational damage (or both).

    Responsibility goes beyond the investment process. The culture and ethos of the people behind the strategy should be carefully evaluated. Recent news of irresponsible, or unethical, and in some case unlawful behaviour come to mind. The allegations that Bill McGlashan, founder of TPG’s Rise Fund (one of the largest, most visible and earliest impact funds), was involved in an illegal college admission scheme provide the perfect example. McGlashan allegedly paid bribes to improve the chances of his children’s admission to elite US colleges, charges which he denies. This kind of charges would hurt the reputation of any fund, but they may put the entire ecosystem in danger when they are associated with a supposed leader in the impact industry.

    The second is “impact washing” – labelling an investment as impact hoping for a greater commercial appeal rather than a genuine intent to generate systemic change. This issue can be tackled by investigating a manager’s impact proposition, and only consider as impact those with intent, contribution, and reporting, and a credible and substantiated theory of change.

    The third is fraud, which is not specific to impact investing, but the risk may be higher when looking at investments that are designed to generate an emotional response from the investor. In its Operating Principles for Impact Management, which are considered an industry standard, the International Finance Corporation (IFC), the development finance institution of the World Bank Group – a large and sophisticated impact investor, calls for independent verification of impact by a third party or an independent committee within the firm. Whilst this is considered costly and can be perceived as bureaucratic, it is as essential as an independent financial verification, an indispensable line of defence against fraudulent schemes.


    To conclude, analysing an impact proposition requires some of the same well-tested methods developed in the due diligence of traditional investment managers, as well as the analysis of additional elements that are the essence of what constitutes impact, and namely intent, contribution, and reporting, held up together by a theory of change. Asking questions and employing the same intuition that always served investors well, particularly when something does not smell right, remain of course indispensable.


    Image by bluebudgie from Pixabay

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