By being anchored in investor expectations and relative required returns, Implied Impact therefore provides a “top down” approach to assessing and quantifying impact which contributes to the unresolved debate on “bottom up” methods of measuring impact. It does not claim to substitute for bottom-up impact measurement. Instead it opens up the ability for a dialogue between investor expectations and requirements on the one hand and the bottom-up measures of their impact provided by social organizations that have been invested in on the other hand. Through that dialogue it provides a way for both investor expectations and the bottom-up measures of operational impact to be tested and revised.
Implied Impact helps put impact investing into the opportunity cost framework of returns that investors expect to achieve in other investment markets and thus supports the investment discipline of the impact investing market. It offers a way, albeit top-down, for quantifying impact and social return across impact investing, and across different impact-generating underlying activities undertaken by the social organizations invested in. And it therefore offers an approach by which the differing types of impact reported by different social organizations from different activities can be compared with each other for investment purposes, which supports the impact investing market’s goal of aligning capital allocation with impact achievement.
Looking at implied impact as a function of the capital pricing spead with mainstream investments highlights the varying levels of financial return on impact investments prevailing in the impact investing market. Often, pricing of impact investments is at a fixed price (a fixed interest rate on loan investments for example) for a given impact investor across different impact investing sectors and types of social organization. This suggests either that impact investments are not being priced by reference to expected impact, or that perceived risk and expected impact are perfectly aligned so that a constant risk-adjusted total blended return is achieved without variance in the financial return.
The implied impact / implied social return approach then, helping the impact investing market to continue maturing and to become more efficient in aligning capital allocation and impact generation, usefully raises questions about the rationale for this variance which is either in required total return or in required social return. There are at least six, and possibly more factors that can be investigated as to whether the variance in required social return can be explained by:
1) differing views) on the level of risk relating to the relevant impact investments – this would justify different levels of total return [FN “impact averse possibility]
2) differing views (between different investors) on the level of expected impact from the relevant impact investments – this would explain how different total returns for different levels of risk (and maturity) could be achieved even given a constant financial return element across different impact investments (burt only if risk and impact were perfectly correlated)
3) uncertainty as to the ability to assess the level of impact achieved in different impact generating sectors – this would either justify different total returns if it is a matter of different perceptions of risk or explain different levels of expectation of impact
4) difference in impact investing investment styles – along a spectrum from more “finance first” impact investors to more “social first” impact investors. Such differences in investment style though ought to be reflected in different allocations of total return as between the financial return element and social return element rather than in differences in required total return for a given level of risk and maturity unless differences in style also drive different perceptions of risk or requirements of return
5) whether some impact investing is not consciously priced for risk
6) whether some impact investing is not consciously priced for differing levels of expected impact – whether in other words the approach taken is to “get away” with as low a financial return as possible in return for a general commitment to impact rather than establishing a trade-off between the impact element of blended total return and the financial element of the blended total return. [FN “impact agnostic”]
By putting impact investing into a framework of investor required returns and investor expected returns (and on a basis that is at least compatible with investment markets more generally) the implied impact approach helps shine a light on the pricing assumptions underpinning impact investing. It doesn’t judge those pricing assumptions but helps create a framework for clarity on what they are.
Ongoing work
In developing the Implied Impact model, Evenett and Richter propose that Implied Impact could be used to augment conventional financial calculations to support more accurate representation of real world financial observations. Further work is proposed in the following areas to develop a more robust theoretical framework for how the Implied Impact model can be applied:
- Capital pricing
Total pricing of capital for risk, maturity and social return - Risk based pricing
RAROC - Capital Asset Pricing Model (CAPM)
Adapting CAPM - Option Pricing
Adapting the Black Scholes option pricing model
– Including calculating the accounting liability for selling options
– Futures contracts
– Portfolio management for impact investors - Institutional investors & wealth managers
Help with asset allocation for mainstream investors - Impact measurement
Helping impact metric debate with reconcinciling disparate impact metrics - Comparative investment evaluation
Identifying a coefficent that can be applied to impact investments to compare them with mainstream investments on a like-for-like basis - Brand & Goodwill
Helping with calculating brand value and goodwill - Payment-by-results contracts
For governments to use in benchmarking fair pricing of Payment by Results contacts and Social Impact Bonds - Tax relief
To assist government in determining appropriate levels of tax relief for impact investors, to provide a quantitative basis to calculate the appropriate rate to either neutralise the financial disincentive of impact investing or to actively stimulate the market through offering investors superior after tax returns - Macro-prudential stability
Reduce homogeneity of global financial system through adding a variable in standard calculations such as RAROC, CAPM and the Black-Scholes formulae. This will add variation to automated trading systems based on investor’s appetite or aversion for Implied Impact and lessen the likelihood of herd mentality as a result of identical results when crises occur though helping to reduce the systemic risk. Will introduce heterogeneity through introducing analogue flux and diversity in the system - Regulators
Helping the regulators in quantitatively assessing the social return dimension of investments when marketing and selling of products
Implied Impact ( Ï ) 