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Business is no longer just about getting something done or made. Companies and the teams in them are placing more importance on how to make lives better and more efficient, for both people and our planet. Championing environmental awareness and sustainability, mental health and self-care, and equitable treatment of all is top-of-mind for many businesses today.
This has manifested within the private equity industry in the form of Environmental, Social, and Governance (ESG) investing. And since the COVID-19 pandemic, interest in both ESG and impact investing — which has some key differences from ESG — has surged. Let's dive into how these efforts are influencing investment firms and how yours can make a difference.
Impact investing is a type of investment strategy where your primary goal is to have a measurable and beneficial social or environmental impact. The intended impact could be on a large or small scale: e.g., offering capital for underserved communities such as SMB businesses in Latin America, or providing affordable lighting for any and all who need it, such as d.light.
Impact investing is often viewed as a type of philanthropy that private equity firms can undertake, but it's important to note that profitability is still a goal, albeit secondary.
Environmental, Social, and Governance (ESG) investing is where a firm considers the practices and efforts of a target investment company when deciding to invest. This could mean anything from how sustainable its manufacturing is to how much of a social impact it’s making. It even includes the company's organizational structure and how it approaches initiatives such as diversity, equity, and inclusion (DEI).
Though ESG in M&A is usually focused primarily on the practices of a company itself, a secondary goal of these practices is the same as with impact investing: making an impact on the larger environment or community. That said, the primary goal of ESG is its impact on the company's performance with the larger societal benefits as a secondary benefit.
Risk mitigation, increased consumer and/or stakeholder trust, and sustainable growth are all key tenets of ESG, in M&A especially. In fact, ESG leadership is a key justification for higher deal valuations, according to a survey from Bain.
As we mentioned earlier, the rise of ESG shows no signs of slowing. Even before the pandemic and recent economic downturn, many companies were altering their practices based on environmental or societal causes. For example, worry about climate change is causing more companies to adopt more sustainable practices. Events such as the Great Resignation are forcing topics such as workers' rights and employee well-being into the limelight as well.
This increased focus on helping people and the environment is creating massive opportunities for the companies that are paying attention — and for the dealmakers who wish to invest in them. In fact, according to Bain, most M&A executives (65%) expect ESG to increase in importance for their companies over the next three years.
But for those who want to do more, impact investing is the next logical step. In fact, just as ESG trends suggest, impact investing itself is increasing in popularity, more than tripling in assets under management (AUM) from 2017 and 2019, and now reaching $1.164 trillion.
Impact investing doesn't come without challenges, however. Even ESG in M&A is only "extensively assessed" in deals 11% of the time, according to Bain. Let’s dig into the top three challenges of impact investing:
First and foremost, impact investing is not about making the most profit. It's about making a difference while still returning a profit. However, a 2020 survey by the Global Impact Investing Network found that more than 88% of impact investors reported their investments were meeting or surpassing their financial expectations.
To succeed as an impact investor, the key is two-fold: first, finding the right opportunity, and second, understanding the return may be less than what your firm might get from other investments. A study by the University of California found the median impact fund had a median internal rate of return of 6.4% compared to 7.4% from non-impact-seeking funds.
For private equity firms to be successful with impact investing, they have to find the right balance of impact vs. profitability based on their particular portfolio and desired effect. For some firms, a high-profile but low-return impact investment can bring a level of distinction simply not possible through other means.
The second challenge many firms face is proving that you've actually "made a difference." For some industries, such as microfinance, measurement can be fairly simple (e.g., capital loaned). But more abstract concepts — such as improved mental health of retail workers — are inherently more difficult to measure. So depending on your firm's reasoning behind the investment, showing its impact (and why it was the right one) can be arduous.
The final major challenge to impact investing is simply how many opportunities there are. Companies that may qualify as an impact investment are often not the ones clamoring for a round of funding. And so for firms to find these opportunities, they have to depart from traditional inbound sourcing tactics and adopt more strategic and proactive origination methods.
As we detailed earlier, you'll need to find an opportunity with the right balance of impact vs. profitability for your portfolio, one that's doing the type of good you want to support as well as needs the amount of capital you want to spend. Adopting an investment thesis for this search or folding in your intended impact investment as part of a thematic sourcing strategy can be tactics to help you find exactly the opportunity your firm needs.
Taking on impact investing has its challenges, but there are a few tools top firms use to fuel success. Let’s take a look:
The first necessary tool is a deal sourcing platform. As we discussed earlier, finding the right impact investment will take more effort and require different methods than other types of deals. Many of these companies are new, small, and unfunded, making them difficult to find. The right deal sourcing platform can help you not only thoroughly map the market, but also identify potential target investments within its vast database of private/bootstrapped companies.
On top of this, a deal sourcing platform can also provide valuable insight into how your intended company is making its impact with information about its industry awards, media coverage, attended events or conferences, etc. This way, your firm can not only learn about the target investment's activities ahead of time but also find more opportunities to proactively build a relationship with them.
Next is a solution to help streamline your due diligence processes — a key part of any M&A pipeline. However, due diligence is more important than ever in impact investing deals to first, ensure the deal is legitimate, and second, know exactly what you stand to gain from the deal. A due diligence tool can also help you set performance benchmarks pre-investment to help prove an impact post-investment.
Additionally, due diligence software can help vet and establish transparency and accountability in your target companies. This way you can trust that your money is being used in a responsible and effective way, and daily practices and efforts are being done for your intended purpose.
Third, you will also need advanced reporting and analytics software. To measure the impact of your investment you’ll need to collect and integrate as much data from across as many sources as possible. From tracking eNPS scores over time to homes lit with low-cost lamps, reporting software will help to show how much of a difference your investment has made, both for the company and for those it seeks to help. Not to mention, these analytics and reporting tools have the added benefit of helping your firm and your portfolio companies be more data-driven and make better decisions across the board.
The key to any successful impact investing endeavor starts with finding the right opportunity — and SourceScrub can help. Our robust and comprehensive database of millions of data points on private, bootstrapped companies can help you find your perfect impact investing target opportunity. Let’s talk!