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.
Quantifying Implied Impact
It is often the case that impact investors, after having seen a number of deals through to exit, observe that the actual risks are a lot lower than they expected. This observation of real risk is backed up by the emerging track record of impact investment, which confirms that the real right-off rates are often lower than may have been expected and often lower than other asset classes.
One requirement therefore is to improve the financial data available to investors by collecting and aggregating the actual financial performance data of impact investments and to present it as a live data-series. Impact investment needs a financial index and market data such as provided by Bloomberg or Thomson Reuters. An initiative to do exactly this is currently underway in the form of EngagedX – the financial index for social impact investment – which is currently developing a pilot in the UK and preparing for global rollout in 2013.
Evenett and Richter argue that improved data, such as from EngagedX, will allow analysts of impact investing to properly unpack the current perceptions of risk into its constituent parts of real financial risk and Implied Impact. Aggregated Implied Impact data for the overall impact investing market and its segments will also provide a useful benchmark for distinguishing between legitimately suppressed financial returns and plainly poor financial performance.
A conundrum of impact investing has been how to quantify in standard financial terms the observable capital pricing variance of Implied Impact™ when it occurs; and to do so in a way that is both consistent with the real world observations of the actual capital pricing decisions of impact investors, as well as to generate generic capital pricing curves that capture both risk and impact in a way that can guide impact investors when assessing new deals.
Similarly, and to integrate with mainstream financial calculations, the Implied Impact model should be consistent with investment decisions according to three scenarios.
- when a discount is applied to capital pricing by impact investors to acknowledge the explicit impact achieved by that investment;
- when no significance is placed upon the impact attributes of an investment with no capital pricing adjustment for impact (“impact-agnostic” investors); and
- when capital is priced at a premium because of the perceived higher risks associated with impact investments or when invstors know that the investee requires additional non-financial support, requiring greater management resources on the part of the investor compared with a similar mainstream investment.
[i] Bishop Green, The Capital Curve for a Better World, http://www.mitpressjournals.org/userimages/ContentEditor/1265819288419/INNOV-TECH4SOCIETY_025-033_bishop_12-29-09.pdf also CAF Venturesome (Kingston et al), others ?
[ii] Bishop Green, The Capital Curve for a Better World, http://www.mitpressjournals.org/userimages/ContentEditor/1265819288419/INNOV-TECH4SOCIETY_025-033_bishop_12-29-09.pdf