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The US Securities and Exchange Commission delivers an important warning when it requires a disclaimer in marketing materials to remind investors that “past performance is not a reliable indicator of future results and investors may not recover the full amount invested.”
A long era of easy money makes experienced, sophisticated investors skeptical of folks who claim they can have their cake and eat it too by both making an impact and generating financial returns. I am one of those skeptics who is frequently shocked at the investment ideas I hear and read about that have no basis in financial or business theory. When friends in the field ask for my thoughts on the latest idea they’ve been pitched, I look to evidence-based research to form an opinion.
Let’s turn to the financial theory of the Nobel Prize–winning economist Harry Markowitz, who famously once said, “Diversification is the only free lunch in investing.” Modern portfolio theory warns us that limiting an investable opportunity set due to impact can result in lower returns. Yet expertise in a limited opportunity set can allow investors to better select companies and/or create more value, which can negate the potential return differential. Thus, those considering impact investments must determine whether the advantages of expertise outweigh the costs of a limited investment universe.
For example, the VC firm Reach Capital invests in US ventures that provide effective education solutions in early-childhood, K–12, higher-education, and adult learning. To do this well and to achieve their impact outcomes, they need a whole host of specialty knowledge that is specific to education—from artificial-intelligence and edtech tools to career drivers and culturally relevant curricula. Every partner on their team brings prior experience as an educator, operator, or investor in education, leveraging their expertise to identify companies with real solutions.
It’s true that Reach’s impact lens narrows its investment universe even within the education sector, as it will not invest in education companies unlikely to generate impact, but that same lens has driven Reach’s strong financial performance.
Academic research also attributes two core factors that drive financial returns for investment portfolios. The first is beta, which is the systematic risk or volatility compared with the broader market.
There is sufficient basis to believe that impact investing will not inherently perform better or worse than another kind of investment.
Having a higher beta signals that returns may derive from a heightened correlation to the market, while a low or even negative beta suggests that returns are less related to or negatively correlated to the market’s performance. Note that beta can be affected by relative exposure to sectors, geographies, and macroeconomic drivers (such as energy prices or inflation).
The second factor is alpha, or an excess return from the investor’s skill—which can be related to picking the right companies, sectors, or geographies or to successful market timing.
Impact investing absolutely affects beta and alpha. Many impact investors overweight certain sectors (healthcare and technology, say) and underweight other sectors (such as energy and industrials) due to the availability of impactful companies in these markets. This results in their investments having higher or lower beta than the broader market, and a prospective investor must consider the limited universe when constructing their own portfolio. Alpha comes from an investor’s skill. The theory that impact expertise improves the ability to select successful companies creates the potential for greater alpha.
Both investment principles point to skill as the key ingredient to impact investing’s potential to generate a compelling financial return, despite fewer opportunities for diversification. This is why I insist that being a skilled investor is essential if you intend to be a successful impact investor. What determines skill, and how should you evaluate it?
If we look at investment training programs, from the CFA to the MBA, they typically teach the analytical skills needed to invest. Knowledge of how to analyze financial statements and determine appropriate valuations must be coupled with a strategic understanding of effective business models and the competitive landscape. The ability to evaluate management teams and culture is also essential. Broader perspectives and insights about markets and macroeconomic factors make an investor even more capable of selecting great companies. Discipline, focus, and effective decision-making also make for a strong investor. Investing is both science and art.
When evaluating an impact investor’s skill, I also look for a fundamental understanding of how the impact mission might affect, positively or negatively, a business’s profitability. People who refuse to evaluate these potential effects are leaving financial risks unaddressed.
Even as a staunch advocate for this type of investing, I can acknowledge some common reasons a company striving to drive impact might produce lower financial returns. Among them, the company might need to charge low prices to make its offerings accessible, or might maintain thin margins to ensure quality. The market it’s seeking to address might be small, or at least limited, and it might face high costs when trying to manage negative externalities. For example, it may be expensive for a company to reduce the carbon footprint of its manufacturing process to zero.
Chicago Booth’s Priya Parrish explains what the critics miss about impact investing.
What Do We Get Wrong About Impact Investing?Conversely, an impact company might produce higher returns on investment if it sells a product that fits its market well, or if it has unique distribution channels. Companies such as this often benefit from enhanced branding and customer loyalty, as well as better attraction and retention of talent. Insight into policy and demographic changes, as well as a strong ability to foresee and manage risks, might also give them a boost. Finally, one of the least known opportunities is for impactful companies to access non-dilutive capital (funding that doesn’t require equity in return).
These are just some of the potential effects. The takeaway is that there is sufficient basis to believe that impact investing will not inherently perform better or worse than another kind of investment. Success is all about the skill one has in understanding how the impact is created and how it is managed, both proactively and when times get tough.
Creating and managing a rigorous impact investment process is hard but rewarding. Investors can enjoy a greater connection to their values and interests. Who wouldn’t choose to get more than just a financial return from their investment?
Investing is still largely a human-capital endeavor, and companies that can attract and retain quality talent have an advantage. Talent pools are essential to successful investments, as it is people who conceive ideas, execute diligence and negotiations, and make decisions. Leading investment firms compete for the best talent, knowing how instrumental it is to financial performance. In the case of impact investing, the growth and increasing sophistication of the pool of impact capital is immense.
Trained and dedicated human capital may be the most compelling reason why impact investing can generate competitive risk-adjusted returns. As an impact investing executive in residence and adjunct assistant professor of strategy at Chicago Booth since 2017, I’ve seen firsthand how the next generation of business leaders wants to earn their riches while also doing good.
When I was a student at Booth a decade earlier, the culture was quite different. I never vocalized my interest in or intent to do anything related to social good, fearing that it would undermine my credibility with my peers. Instead of sharing my curiosity, I kept my head down and focused on acquiring the financial knowledge that I went to business school to learn.
Yet eight years after I graduated, the institution knew it needed an impact investor in residence and a course on impact investing.
What happened?
Business schools have many stakeholders, but primary are the students, who are perhaps more financially oriented than those of other graduate schools. Still, many millennials and members of Generation Z enrolled in MBA programs today think about purpose and mission not just as goals of philanthropy but as guides for how they live their lives, including how they spend and invest their money and choose career paths. The professional golden goose is a job that contributes positively to the world, is aligned with their values, and can still compensate them well. This simple logic explains why my courses attract so many talented students.
Chicago Booth is not alone in this trend. Northwestern’s Impact & Sustainable Finance Faculty Consortium is a global community of educators in these fields. Today, there are 400-plus members from about 220 universities (including Harvard, the University of Pennsylvania, INSEAD, and many other prestigious institutions) in more than 40 countries.
We have come a long way since I had to develop my own syllabus to teach everything from what makes for a good impact investment to how investors can manage their impact, and more. I applied what I learned, experimented with my personal investments, and used problem-solving skills to create frameworks and tools. Just imagine what these undergraduate and MBA students will be able to do with today’s more developed academic foundation and with this formal training at the start of their careers!
We are already seeing the fruits of this training in terms of the quality of talent in the impact investing field. Impact Capital Managers, a trade association of market-rate impact funds in venture capital, private equity, real estate, and private credit, began in 2018 with 25 funds that had $5 billion in assets under management collectively. Today, this network includes more than 100 funds and $80 billion of AUM in its membership base. Leaders of these funds hail from world-class educational institutions and esteemed financial training grounds including Goldman Sachs and Blackstone.
This groundswell in talent mirrors a shift in talent that took place in the early 2000s, from long-only active management to hedge funds. The potential to earn more, but from a more intellectually fulfilling way of investing, motivated the migration.
There will be winners and losers, as there are in every asset class and investment strategy. But ultimately, more and better-trained professionals will generate the returns that will drive the future of impact investing.
Priya Parrish is adjunct assistant professor of strategy at Chicago Booth and impact investing executive in residence at Booth’s Rustandy Center for Social Sector Innovation. She is a partner and chief investment officer at Impact Engine, an institutional venture capital and private equity investor focused on economic opportunity, environmental sustainability, and health equity. This is an edited excerpt from her book The Little Book of Impact Investing: Aligning Profit and Purpose to Change the World. Reprinted with permission from Wiley © 2024. All rights reserved.
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