Investing for Impact

Bhagwan Chowdhry is Professor at UCLA Anderson School of Management; Shaun Davies is Assistant Professor at the University of Colorado at Boulder; and Brian Waters is Assistant Professor at  the University of Colorado, Boulder. This post is based on their recent article, forthcoming in the Review of Financial Studies.

Related research from the Program on Corporate Governance includes Social Responsibility Resolutions by Scott Hirst (discussed on the Forum here); and Socially Responsible Firms by Alan Ferrell (discussed on the Forum here).

Investing in the twenty first century is increasingly influenced by the mantra of “doing well by doing good”—the idea that investors can beat the market by targeting socially valuable businesses. Attractive as it may sound, opportunities for “doing well by doing good” must be limited or else businesses would not need special cajoling to allocate resources to social projects. An important question, then, is how socially-minded investors should direct scarce capital when a business is socially- valuable but not profitable enough to deliver market returns. This is the topic of our research article “Investing for Impact” forthcoming in the Review of Financial Studies.

Suppose some socially-minded investors are willing to sacrifice some financial return in pursuit of social goals such as reducing greenhouse gas emissions, increasing access to sustainably-sourced foods and products, or improving labor conditions. These “impact” investors identify opportunities that otherwise may not materialize because they are not sufficiently profitable. Our first insight is that, since investment capital from impact investors is limited, we must employ it judiciously and sparingly. Now, consider a business opportunity that generates ample social benefits and some financial return, but the financial return is not enough to be attractive to the large pool of profit-motivated investors who focus only on financial performance. Absent impact investors, the opportunity will not be undertaken. Impact investors could undertake the opportunity entirely by themselves. However, sole investment by impact investors violates our first insight because it does not economize on using their scare capital sparingly.

Instead, impact investors could provide an upfront grant that is just sufficient (not any more) to compensate profit-motivated investors for the deficit in their financial return. This is the best solution if profit-motivated stakeholders can credibly commit not to alter the business plan after receiving the grant to pursue profits at the expense of social goals. However, in practice, profit-motivated stakeholders’ incentive to renege on this commitment is likely to be large if, for example, renewable energy sources are prohibitively expensive and/or if sustainably-sourced foods are more costly and less desirable. The emergence of hybrid corporate structures, such as Benefit Corporations, are designed to protect the managers from such pressures. Our analysis shows that properly designed financial securities may further mitigate this pressure to renege.

To overcome this commitment problem, profit-motivated stakeholders could sell a portion of the business’s cash flow (e.g., an equity claim) at a premium to impact investors, in lieu of a donation. When profit-motivated stakeholders retain a smaller cash flow claim, their profit motives are softened, allowing them to commit to a socially valuable business plan. Moreover, because impact investors purchase cash flow rights at a premium, profit-motivated stakeholders are better off!

Selling financial claims to impact investors is costly though. Because the opportunity cost of using impact investors’ scarce capital is high, the premium impact investors are willing to pay on financial claims is limited. As such, joint financing between profit-motivated stakeholders and impact investors is optimal only if the benefit from committing to higher social output outweighs the cost of selling cash flow claims to impact investors. This is true only when the business’s potential social value is sufficiently large. This leads to the following insight. If impact investors place little value on a business’s social goals, the business should be organized as a for-profit firm with impact investors holding no financial claims (and if the returns are not high enough, such an opportunity will not be undertaken). If impact investors, instead, place a large value on the business’s social goals, the firm should exhibit joint financing via impact investing so that the firm can commit to a socially valuable business plan. In this case, impact investors hold some financial claim to the business’s cash flows even though it is somewhat wasteful from society’s point of view.

Our analysis shows that designing securities whose payoffs are contingent on observable metrics of social output (such as sustainability ratings) further improves social outcomes by allowing profit-motivated stakeholders to commit greater resources to social goals. In particular, we show that this commitment problem is most effectively mitigated when profit-motivated stakeholders hold pay-for-success contracts that provide larger payments when social goals are achieved. Social impact bonds, which are commonly used to fund public sector projects, are an example of this design. For instance, the Commonwealth of Massachusetts in 2014 raised $12 million from profit-motivated stakeholders, such as Goldman Sachs, in order to reduce recidivism in the Boston area by providing life skills and employment training to young, at-risk men. Contingent on the project leading to a successful reduction in re-conviction rates, the contract requires up to $16 million in success payments to these investors. The structure of this initiative is consistent with our analysis which suggests that incentive alignment between profit-motivated stakeholders and socially-motivated governments is best achieved when investors are paid more as a result of social success.

If profit-motivated stakeholders hold pay-for-success contracts, socially-motivated parties must hold opposite contracts. That is, contracts which pay more when social goals are not achieved. We coin these securities “social impact guarantees,” since they guarantee socially-motivated parties a larger financial return if social gains fail to materialize. While financial contracting on social outcomes in commercial firms is rare to date, our analysis shows that, when social metrics are available, impact investors should demand social impact guarantees rather than traditional debt or equity securities. In doing so, impact investors ensure that the financial claims held by profit-motivated stakeholders’ provide the necessary incentives to direct scarce resources towards the achievement of social goals.

As impact investing continues to grow in popularity, the opportunities for “doing well by doing good” will begin to dry up. Thus, we propose a new era of impact investing based instead on “doing the good that won’t be done,” and conclude that financial securities with payoffs contingent on observable and verifiable social metrics should play an essential and exciting role in this pursuit.

The complete article is available here.

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