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The Financial Times reports that Morgan Stanley Capital International’s World ESG Leaders Index has tracked the MSCI World Index because the constituents of this index for environmental, social and governance (ESG) leaders are very similar to those of its regular world equities index. ‘Greenwashing’ is perhaps at work. This is a form of spin used to deceive the public that an organization’s products, aims and policies are environmentally- friendly when they are not. This is the broad state of affairs in impact investing in general.

Impact investing emerged as part of efforts to enhance the role of markets in the pursuit of economic development. Its premier industry association, Global Impact Investing Network, defines impact investments as those “made with the intention to generate positive, measurable social and environmental impact alongside a financial return". The idea draws its inspiration from the playbook of venture capital (VC) investments in startups. That playbook comprises three core beliefs surrounding innovations, entrepreneurs and venture capital financing. Foremost, there are disruptive innovations, riding especially on the back of latest technologies, which can have a significant, even transformational, impact on major development problems. The second belief is that some entrepreneurs can successfully commercialize these technologies on scale. The third belief is that such entrepreneurs and their innovations succeeded on the back of an incentive-compatible venture financing approach. However, there are several reasons why we should be cautious in extrapolating this approach to solving persistent development problems.

One, the beliefs described above, based on salient success stories, bear a subtle bias for certain categories of innovations and entrepreneurs. A second concern is about achieving impact on scale. For all the hype around innovation, impact investing has little to show in scaling up development innovations. A third reason is the differences between innovations that cater to regular daily lives and those seeking to address development challenges for the poor whose lives are not ‘regular’.

Finally, The VC model itself may be unsuitable. Its 5-7-year investment tenure system is not only built on management and success fees, it has to run on the treadmill of continual fund-raising and portfolio construction, which has to mix genuine impact investments with commercial ventures to drive returns. This model, given its obsession with growth and valuations, has downplayed the need for the patient long-haul capital needed for ESG innovations and also diluted the disciplining role of finance in many businesses. It also has an upstream effect; even early-stage funding rounds are at high ticket sizes needed to justify the viability of the model. These force entrepreneurs to chase rapid growth and seek large sums even at a stage when it’s not clear how many pivots are needed. This crowds out entrepreneurs wanting to solve difficult problems, as funds chase de-risked growth enterprises that are relatively mainstream.

As Jonathan Ford wrote in the Financial Times (‘Ethical investment is about morals not markets’, 4 November 2020), “Impact investment only has real meaning if it means funding activities that would not otherwise happen. Otherwise, where’s the impact? You are simply dressing up ‘business as usual’ investments that would be made anyway."

Simply, the prevailing categories of impact investing include investments in (a) businesses in low-income geographies, (b) which are Fin-tech to Ag-tech to Z-tech and (c) which signal intent to generate impact. This is too broad and dilutes the significance of impact investing. Clearly, the original intent was to focus on social impact. The definition of ‘impact’ and its assessment therefore becomes critical.

We propose two first-order tests to identify impact investments:

One, a social impact test: More than enhancing general economic welfare, including environmental benefits, the investment must directly improve the lives of the poor. And two, a counter-factual test: The investment would not have been made by investors seeking commercial returns.

Instead of direct measurement of impact, we propose a second-best approach involving whether the innovation is delivering the promised value proposition to its consumers. We need two metrics, retention and intensity. The former refers to the end-user, client or buyer staying on with the entrepreneur’s service for some minimum period (as a repeat subscriber or continuous user). The latter refers to the depth of use (upgradations or greater purchases either by quantity or types of service). How relevant the value proposition is to the buyer would be seen in the intensity of use among those buyers who meet a minimum level of retention.

Investors who truly want to be impact investors need to examine their toolkit. They must ensure they support enterprises that genuinely create a socially-desirable impact while generating returns that reflect reality and the patient nature of capital needed to achieve those outcomes.

This is an abridged version of the full length paper that has been published in SSRN which can be accessed here: (bit.ly/2O9gQQ5)

These are the authors’ personal views.

Gulzar Natarajan, Mahesh Yagnaraman & V. Anantha Nageswaran are respectively, a civil servant; India country director, Acumen; and part-time member of the Economic Advisory Council to the Prime Minister

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