Impact Investing: The New “it” Trend in VC?
Updated: Mar 6
By Pinky Ghosh, Senior Research Analyst at King's Private Equity Club
Back in 2005, as a second-year bachelor’s student of Finance and accounting, I had the opportunity to present my thoughts on the importance of environmental accounting. Questions that surrounded me were,
“What exactly is environmental accounting?”, “How is the economy responsible for the environment?”, “What is the cost a nation has to incur for replacing the traditional energy resources with alternative resources?”, “Can a developing economy benefit from the shift in alternative resources, or the technology cost to implement these changes will be a road blocker?”
Fast forward 15 years, we continue to seek answers to these questions, albeit in a much larger perspective – ‘Impact Investing’.
What is Impact Investment?
The trending buzz word in the business world - ‘impact investing’ can be broadly classified as investing in entities that create a social impact. However, in economic terms, impact investing can be classified into categories such as profit orientation, the correlation between impact and financial return, intentional impact and positive effect on society (Grabenwarter & Liechtenstein, 2011).
Impact investing might not exactly fit into the definition of ‘economic Darwinism', where the natural selection of investment is based on profitability and payoffs. However, this natural selection argument based on payoffs has long been questioned, especially in light of the subprime crisis in 2007 (Yan, 2008). Economists are now stressing the critical evaluation of the fundamental concept of defining the performance of any business solely based on profits and wealth creation. According to Grabenwarter & Liechtenstein, there is a growing awareness in the market that the exclusive focus on economic terms and short-term measures of investment performance does not capture all dimensions of an investment. Especially a key element, which is the impact of a business on society.
The Role of Venture Capital (VC) in Impact Investing
Venture investment, a form of private equity financing, has not always been the default funding method traditionally. However, with the emergence of disruptive technologies, this market has seen periods of booms and busts and currently represents $300.5 billion in global investment per reports (FinSMEs, 2021). The quantum of capital that channels through venture investment into the economy underpins its pivotal role in impact investing and building sustainable economic entities. Especially considering the stages of the investment cycle for a company that is targeted through venture funding.
Table 1 Venture investment stage (Bocken, 2015).
The wave of sustainable investing started back in 2005 with the emergence of cleanTech investment, and per reports, 2009 was the year when the ‘Cleantech’ sector, for the first time, received more VC funding than any other sector. This was also driven by the American Recovery, and Reinvestment Act passed by Obama in February 2009. The Act supported $100 billion spendings into transforming the U.S. into a clean energy economy and ensured more interest from investors (‘Clean Tech VC’, 2016). Subsequently, VCs like Khosla Ventures raised a $1 billion fund in September 2009 dedicated to cleanTech investments. Per reports, cleanTech investments reached a record level in 2008-2009, and the sector attracted around $45 billion between 2009 and 2011 (‘Why the Clean Tech Boom Went Bust’, 2012). This was the period marked by investments in renewable energy, including biofuel, clean food technology, and clean transportation such as electric vehicles to address the impacts of global warming.
Some of the top sectors include:
· Solar-$1.2 billion-21%
· Transportation (including electric vehicles, advanced batteries, fuel cells)-$1.1 billion-20%
· Energy Efficiency-$1.0 billion-18%
· Biofuels-$554 million-10%
· Smart Grid-$414 million-7%
· Water-$117 million-2%
(‘Clean Technology Venture Investment Totaled $5.6 Billion in 2009 | REVE News of the Wind Sector in Spain and in the World’, 2010).
However, the uptrend did not last long due to the perpetual impacts of economic recession, availability of cheap natural gas, and the huge cost associated with hardware development, manufacturing, and adoption challenges. Apart from a few success stories such as Beyond Meat and Tesla, c.90% of these investments were written off, resulting in colossal losses for VCs and a steep decline in investment in the sector. By 2013, per reports, the sector was accountable for about $10 billion in investments and dubbed as the “noble way to lose money” by the generalist VCs (Day, 2020).
However, the activity level has again picked up since 2019 with renewed interest and different nomenclatures such as ‘impact investing’ and ‘sustainable investing’. The focus shifted from hard tech investment in sectors like automotive and industrial to business models that tap into patented software innovation, especially surrounding food and agriculture, riding on the trend of the millennial culture of a sustainable lifestyle. In fact, the recent development in impact investing goes beyond reducing carbon footprint by encompassing social, cultural, gender and ethnic diversity that has a massive role in building any economy. “Sustainable entrepreneurs seek to manage the “triple bottom line”: they balance economic health (economy), social equity (people) and environmental resilience (planet) through their entrepreneurial behaviour” (Bocken, 2015).
However, to date, financial parameters that measure the risk-return profile of such investments continue to remain ambiguous with reliance on traditional valuation models that do not account for these impacts. Given the lack of alternatives, investors continue to rely on the traditional risk models adjusted returns and treat the cost associated with creating social impact as “philanthropic” (Grabenwarter & Liechtenstein, 2011).
Measuring Impact Investing
Social impact is often a web of complex factors which are difficult to quantify and benchmark. Venture capitalists have the responsibility of identifying businesses, which have the potential to generate economic returns while accounting for the triple bottom line. However, to attract VCs, impact investing must be measured. To do so, VCs must focus on a typical value chain – Input, Output, Outcomes and Impacts.
Table 2: Source (Grabenwarter & Liechtenstein, 2011).
According to Grabenwarter & Liechtenstein, the distinction between output and outcome is often missed by investors. Any impact investing must result in a change in a situation before the investment, and the change must be tangible and in quantifiable terms, further accompanied by an analysis of collateral damage. Going forward, this impact outcomes should be charted against the financial return.
However, the study does not highlight the embedded biases of the investor when analysing outcomes and stresses the intention of investing that follows an interpretive method of analysis.
Climate change, depleting natural resources, and socioeconomic disparities have compelled us to shift focus on sustainable growth. However, going forward, the key focus will remain on investing money and time in building a business model that encompasses financial return in tandem with social equity and the environment. The segment is still relatively underserved, especially given the widespread conceptions amongst VCs about lack of financial viability.
The study by the Global Impact Investing Network (GIIN) in 2017 showed that their average net return rate amongst the surveyed investors to be almost 50% lower. However, there has been some favourable changes, but the road ahead needs to be more defined and encouraging. There continues to be room for clear policies by the government. Further, the introduction of more standard practices in terms of impact investing and accounting will help in building a systematic approach for value creation (social, economic, and environmental) by impact investing.
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Bocken, N. M. P. (2015). Sustainable venture capital – a catalyst for sustainable start-up success? Journal of Cleaner Production, 108, 647–658. https://doi.org/10.1016/j.jclepro.2015.05.079
Clean Tech VC: A Decade of Failure. (2016). Retrieved 28 February 2021, from Technology and Operations Management website: https://digital.hbs.edu/platform-rctom/submission/clean-tech-vc-a-decade-of-failure/
Clean Technology Venture Investment Totaled $5.6 Billion in 2009 | REVE News of the wind sector in Spain and in the world. (2010). Retrieved 28 February 2021, from https://www.evwind.es/2010/01/06/clean-technology-venture-investment-totaled-5-6-billion-in-2009/3231
Day, R. (2020). Cleantech Investing Is Back. Will This Time Be Different? Retrieved 28 February 2021, from Forbes website: https://www.forbes.com/sites/robday/2020/08/17/cleantech-investing-is-back-will-this-time-be-different/
FinSMEs. (2021, January 20). Global VC Funding Rises to $300.5 Billion in 2020. Retrieved 28 February 2021, from FinSMEs website: https://www.finsmes.com/2021/01/global-vc-funding-rises-to-300-5-billion.html
Grabenwarter, U., & Liechtenstein, H. (2011). In Search of Gamma—An Unconventional Perspective on Impact Investing (SSRN Scholarly Paper No. ID 2120040). Rochester, NY: Social Science Research Network. https://doi.org/10.2139/ssrn.2120040
Why the Clean Tech Boom Went Bust. (2012). Wired. Retrieved from https://www.wired.com/2012/01/ff_solyndra/
Yan, H. (2008). Natural Selection in Financial Markets: Does It Work? Management Science, 54(11), 1935–1950. https://doi.org/10.1287/mnsc.1080.0911