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Impact Investing Returns as Good as S&P 500: Wharton

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Must impact fund managers sacrifice their funds’ missions to satisfy investors’ demands for returns? That’s the question a new paper from the Wharton School seeks to answer.

The results are promising. On a gross basis, funds that sought market-rate returns kept pace with the S&P 500, the paper found.

The Social Impact Initiative at Wharton, the University of Pennsylvania’s business school, surveyed 53 global impact investing private equity funds to determine how much permission and control was granted to managers in making investment and exit decisions, and how those decisions affected performance.

Those 53 funds represent 557 individual investments with a median $22.5 million in committed capital. Over three-quarters had less than $50 million in committed capital, and just 8% had more than $100 million.

Acknowledging the small size of the sample, the Wharton Social Impact Initiative used data from ImpactBase, the Global Impact Investing Network and Thomson One to compare the sample to the overall industry and assess potential biases. It found the number of funds under management and the number of portfolio companies are a good proxy for size and success of the industry, while the level of committed capital was a proxy for size and maturity.

In the report, general partners are the fund managers who provide capital for portfolio companies, and limited partners are the investors who provide capital for the general partner to invest.

The report examined impact investments based on four components of liquidity and mission preservation: Did the fund managers have legal permission to pursue investments based on their impact mission? Assuming they had permission, were they given sufficient control to make investment decisions? Were they motivated to pursue mission-aligned exits? And how did that affect financial performance?

“In traditional investment arrangements between fund managers and investors, general partners are held to professional standards and legal requirements to make investment decisions that deliver maximum risk-adjusted financial returns for limited partners,” the authors wrote. “However, in impact investing, virtually all GPs surveyed in the sample reported that LPs permitted them to pursue impact as part of the investment decision-making process, and in most cases required them to do so.”

The report found 90% of managers have investment or legal documents that explicitly allow them to consider social or environmental issues, and 70% require them to do so.

The survey also found, though, that while LPs give some control to GPs, it’s usually not a controlling interest. To control exit outcomes, which produce liquidity for the fund, mission-aligned investors need to have the majority on the board of directors, but two-thirds of respondents said they controlled less than half of the votes on company boards, and 9% said they had zero votes.

“Although impact funds’ own charters may provide latitude to consider nonfinancial factors in exit decisions, funds may not be in a position to influence these decisions to an appreciable degree,” according to the report.

Still, GPs are optimistic about their ability to maintain their missions. The primary reason for that optimism, according to the report, is that the mission is inherent to the portfolio companies’ business model.

WSII asked managers if they believed realized investments maintained the company mission after exiting the fund, referring to those as “aligned exits.” It also asked if realization agreements included language that indicated acquirers would continue to pursue the mission. If so, those were referred to as “deeply aligned exits.”

Just 5% of managers said they did not believe a company continued to pursue its impact mission after exiting the fund.

WSII said that a common critique of impact investments is that investors have to settle for lower returns to satisfy their altruistic goals. However, the report found that 60% of firms are actively seeking market-rate returns while fulfilling their mission.

The overall internal rate of return of realizations for the portfolio companies from market-rate-seeking funds is 18.59%, according to the report, and for mission-aligned exits, it was 33.52%.

For all exits, the gross IRR was only slightly higher at 35.01%, the report found. However, “A key point to highlight here is not that aligned exits produce similar returns as non-aligned exits but rather that this early data suggest aligned exits can demonstrate significant financial success,” the authors wrote. “Concessionary financial returns are not required for the social or environmental impact of impact investments to persist, at least as reported by fund managers in this sample.”

The report found that the 170 market-rate seeking investments in the sample had a public market equivalent of 0.98 compared with the Russell Microcap/Russell 2000 index and a PME of 1 compared with the S&P 500. The PME is a time-weighted measurement that assesses performance relative to a market index, gross of fees, expenses and carried interest.

“Market-rate-seeking impact investments in the sample, therefore, may be financially competitive on a gross basis with other equity investing investment opportunities,” according to the report. “This financial performance may be why impact fund managers often assert that there is little inherent tension between profits and ‘purpose.’”

— Check out Big Money Managers Fall Short in Disclosing ESG Investment Strategies: Report on ThinkAdvisor.