Variations in capital pricing

Implied Impact reflects observable variations in capital pricing and is not a measure of the actual impact achieved. The Implied Impact coefficient quantifies the capital pricing deviations that have previously been identified[i] with respect to impact investing, but for which there was hitherto no way of analytically compensating for these variations within standard economic and financial calculations.

There are many impact metrics and methodologies that measure impact itself, some even seek to articulate the result as a monetary value equivalent, but none have been able to come up with a consistent mathematical approach that can be incorporated within existing financial and economic equations. The Implied Impact coefficient may be a helpful interlocutor between the impact achieved and capital pricing of investments.

Traditional risk-adjusted return model

For the traditional investment universe, it has become accepted and relatively easy to develop capital pricing curves for different asset classes based on the fairly straightforward combination of risk and return[ii]. The analytical framework of risk-adjusted returns was only relatively recently developed in the 1970s and mainstreamed in the 1980s with the introduction of Risk Adjusted Return on Capital (RAROC)[iii] calculations. Nevertheless, it is the case that the capital pricing curve for impact investing typically does not conform to the traditional risk-adjusted return models that equate higher risk with higher returns.

It is precisely this observable deviation that the Implied Impact model seeks to address. The intention is that the Implied Impact coefficient will assist in mapping the capital pricing curve of impact investing, particularly in relation to standard capital pricing curves and potentially providing a mathematical basis for tracking the difference between the two.

Based on the accepted risk-adjusted return framework, it is often said that impact investments generate below market-rate returns compared with similar risk-adjusted mainstream investments, or in other words that the risks associated with impact investing are disproportionately higher than reflected by the financial returns available. Other pundits argue that this is not the case at all, and that impact investments perform well in terms of other investment criteria such as the ability to generate steady yield with lower volatility. There is probably truth in both these opinions but to date there is little holistic and quantitative data that enumerates this pricing spread both in terms of the overall capital market of impact investment or by sector subsets.

Risk versus uncertainty

Evenett and Richter argue that much of the risk premium associated with financing social ventures is misplaced. They suggest that the real financial risks associated with these transactions are bundled together with uncertainty that is derived from poor understanding of the underlying business models of social sector organisations. They say that this can result in the unfair generalisation that impact investing is riskier than conventional investing and that below market-rate returns need to be accepted.

This dichotomy is at the heart of the Implied Impact model and it is believed that the Implied Impact coefficient will be able to shed light for the first time on accurately differentiating between real financial risks of impact investing and the Implied Impact of these transactions.