Impact investment: Private equity puts its money where its mouth hasn’t been

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By:
Felix Salmon
Published on:

Impact investing would seem an unlikely business for avaricious private equity funds. But many are embracing what they see as a new opportunity. Should we be sceptical or see private equity’s buy-in as proof of the impact investment concept?

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I was in the world’s largest refugee camp, in Kenya, with Malala, and I realized that a fraction of the cost of my handbag could help a girl there for a year.”

Cynthia Ringo, a senior partner at DBL Partners (it stands for ‘double bottom line’) is sitting on a small stage in a Nantucket luxury hotel as part of an event billed as the ‘impact capitalism summit’. She is explaining how her fund ended up investing in a luxury-consignment company.

Her colleague, Nancy Pfund, is sitting next to her and talking about how: “The end of life segment is the last expression of change for the baby boomers, but the funeral industry hasn’t been disrupted.” (Conspicuous by its absence was any mention of Juicero, one of DBL’s highest-profile investments, which imploded after journalists discovered that the company’s $400 juicing machine was no
better at producing juice than people just squeezing its bags with their hands.)

Brendan Doherty, the interviewer, is nodding along gravely. “We fly in used airplanes all the time!” he exclaims, with all the force of revelation.

Welcome to the ‘circular economy’, home to people like TerraCycle chief executive Tom Szaky, who is the kind of guy who refers to shampoo as “branded content” and who uses terms like ‘hyper-durability’ with a straight face.

It is certainly easy to be sceptical. For an extreme example, look at Jho Low, a businessman linked to Malaysia’s 1MDB scandal. When his back was against the wall and he needed to change the narrative, the first thing he did was to draw up plans for a $150 million Institute for Sustainable Business at his alma mater, Wharton.And welcome to the vanguard of impact investing, a place of speakers who “sit on the mission-related investing platform” at high-end consultancies or who talk about “empowering women through the game of golf,” while at the same time complaining about “greenwashing” and the way in which “impact has become a marketing buzzword”.

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Tom Szaky, TerraCycle 

Or, for a less extreme example, look at Goldman Sachs, which in 2002 found itself in possession of $30 million of Trillium debt, secured against 680,000 acres of Chilean Tierra del Fuego. Goldman ended up donating all of the Chilean land to the Wildlife Conservation Society, better known as the Bronx Zoo.

By donating the land to a charity based in New York City, Goldman received tax deductions at the federal, state and local level. Even after throwing in millions more of its own charitable dollars to help clean up and preserve the land, the bank ended up ahead of the game.

Was Goldman’s initial acquisition of Trillium debt an impact investment? Insofar as Goldman continues to expend charitable resources on the nature reserve, that clearly isn’t an impact investment, because there is no financial benefit to Goldman in so doing. It is charity, not for-profit investment. And the initial debt purchase, even if it ended up making an attractive return, was not made with any particular environmental intent. The investment came first, the impact came later.

Still, the impact is real and that sequence can be an effective way for large financial-services corporations to create positive impact in the world. Call it opportunistic impact: take an existing portfolio, look at it through an impact investing lens and find ways to make more money by taking actions that improve the planet.

Global Impact fund

That was the approach taken by Ken Mehlman, the former Republican National Committee chair and George W Bush campaign manager, when he stepped away from politics to lead external affairs and impact initiatives for KKR.

Mehlman has a broad remit at KKR. Any investment, made by any fund for any reason, is in principle eligible for his ministrations. By looking at everything, Mehlman’s team can identify all investments that are related in some way or other to the UN’s Sustainable Development Goals (SDGs) and then intervene in those companies to try to maximize their social impact while also boosting KKR’s own return.

The result is a kind of virtual impact fund spanning some $4.6 billion in private equity and infrastructure investments. Only Mehlman and a few KKR insiders know what kind of returns it has achieved, and no one can know how much value, if any, was added by Mehlman’s own interventions. But things seem to be going well.

The creation of a dedicated fund at KKR makes sense for at least two reasons. For one, impact investments tend by their nature to be on the smaller side, at least by KKR standards.After a decade at the company, Mehlman unveiled KKR Global Impact, a $1.2 billion dedicated impact fund that specializes in investments that might be too small for KKR’s bigger funds. All of the investments in the Global Impact fund are clearly impact investments: they all have to have quantifiable benefits in terms of SDGs, as well as meeting KKR’s financial return standards. And because they are all in one place, finally the rest of the world will be able to quantify KKR’s impact investing prowess. 


We take seriously the governance and stewardship of our companies and we want to leave them better than when we bought them 
 - Warren Valdmanis, Bain

If you are investing in, say, a young but promising education company, you are unlikely to be able to move the needle on a KKR fund that could be bigger than $10 billion, no matter how impressive your percentage return is.

By allowing for smaller cheque sizes, the Global Impact fund expands the universe of investments that KKR is interested in and allows the impact team’s expertise to be extended to many more companies.

Second, the Global Impact fund does not just expand the universe of investments it also, at least in theory, expands the universe of investors, attracting self-defined impact investors alongside KKR’s more traditional limited partners. Often the distinction can be hard to discern with the naked eye, since impact investors rarely invest all of their money in impact strategies; much of the rest will go to big hedge funds and private equity shops.

Assume, for the sake of argument, that the big thesis behind impact investing is correct – that investing in companies making the world a better place is a great way to get the kind of returns that KKR and its ilk are constantly searching for. Let us assume, in other words, that doing well financially is aligned with doing good socially.

If you grant that assumption – and senior management across the private-equity industry seems to be well-disposed towards it – then what do you do next? The answers vary greatly, both in terms of short-term tactics and in terms of long-term ambition.

The approach taken by Goldman and KKR is the simplest and often the most obviously effective. Once you have made an investment, various professionals in your company have the opportunity to propose actions and interventions that will make the asset more valuable. When those actions make financial sense, they get implemented, whichever group they come from.

An impact team working in such a manner by definition creates social impact because all they look for is ways to do that; but they also pretty much by definition create financial profits, because their proposals will not be adopted unless they do so. That is how Mehlman managed to get to work on $4.6 billion of deals before raising a penny for his fund.

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Former George W Bush campaign manager Ken Mehlman has a remit to build impact investment funds at KKR

This approach, however, while effective, is also pretty weak. It largely removes the impact investment team from the actual investment decisions where capital is deployed, thereby making it much harder to invest in mission-driven founders or companies. More broadly, if an investment firm genuinely believes in the impact investing thesis, then it should use that thesis to guide its investments; if they are not doing so, then surely they are leaving money on the table.

That is why KKR launched its own fund – and it is also why Bain launched a similar fund, Bain Capital Double Impact, in 2017. Double Impact is much smaller than the KKR fund, at just $390 million. It too is run by an ex-politician, in this case the Democratic former Massachusetts governor Deval Patrick. (His Republican predecessor Mitt Romney also famously worked for Bain.)

The big difference between Bain and KKR is not in their funds but rather in everything else they invest in. Warren Valdmanis, a veteran Bain managing director who is now at the Double Impact fund, likes to say that everything Bain invests in is an impact investment.

“We take seriously the governance and stewardship of our companies and we want to leave them better than when we bought them,” he says. “That’s true of every investment we make.” 


My hope is that in 10 years, we’ll put ourselves out of a job, because everybody is doing impact investing 
 - Warren Valdmanis

Double Impact, then, is in many ways a proof of concept; a small-scale example of what Valdmanis hopes that Bain will become globally. Most importantly, at Double Impact, Bain commits to measuring its social impact; its deliverables are not only financial.

The idea is one of evolution: that private equity started out as pure financial engineering and then evolved to encompass a broad suite of operational and strategic capabilities. Part of that operational expertise necessarily involves setting goals for portfolio companies and managing to those goals, whether they are sales or gross margin or customer satisfaction.

The bet at Double Impact is that if Bain sets high-level goals prioritizing social outcomes, then those goals will be as good or better, in terms of improving Bain’s total return, as any of its other management tools – and that, in turn, will encourage Bain to set and measure such goals across its entire portfolio. Meanwhile, because the SDGs represent very long-term secular trends rather than cyclical sectors, which can go in and out of fashion, the hope is that impact investments are less likely to be blindsided by exogenous macroeconomic shocks.

“My hope,” says Valdmanis, “is that in 10 years, we’ll put ourselves out of a job, because everybody is doing impact investing. I hope it’s going to happen everywhere. If we can show that you can make as good or better returns by investing this way, drawing capital into this is going to be very easy. We’re going to show that you can get both, you don’t need to make a trade off, and then everyone will demand it.”

Rise Fund

On some level, however, that is just not possible. Double Impact is an investor in a fitness chain called Impact Fitness, for instance, whose model is based more on improving health outcomes than it is on getting people to sign up for memberships they never use. That is great, but those less enlightened, non-mission-driven fitness chains are not going away and at some multiple of cash flows they might well become attractive to Bain or some other buyout shop. Not every company can be an impact investment, especially not if it deals in, say, tobacco or gambling or guns or coal. And it is just not realistic to expect an industry as opportunistic as private equity to confine itself to a small subset of its existing opportunity space.

Which is where the TPG approach comes in. The firm has set up by far the world’s biggest and most ambitious impact investment fund, the $2 billion Rise Fund, complete with a “founders board” featuring such boldface names as Mo Ibrahim, Laurene Powell Jobs, Pierre Omidyar, Paul Polman, Reid Hoffman and – naturally – not only Richard Branson but also Bono of U2 fame.

The Rise Fund is big enough to attract institutional attention. It is also big enough to be created from scratch, rather than being grown out of an existing impact or environmental, social and governance programme. Its size gives it unrivaled ambition: it has partnered with the Bridgespan Group, for instance, to attempt something no other impact investor has tried before, which is to quantify the “impact multiple of money” and to put the impact generated in dollar terms.

The idea is controversial in the impact world, where there is a lot of resistance to the concept of trying to compare fundamentally incommensurate SDGs like nutrition versus infrastructure or gender equality versus mountain ecosystems. Who is to say which impact is greater? Well, the Rise Fund would love to be able to say exactly that, and, moreover, would love to be able to set a minimum impact hurdle rate for its investments alongside a similar financial goal.

No private equity fund would be content with mere profitability; the profits need to be high. The same, surely, should be said for impact funds, which should have the discipline to reject projects that make the world a better place but only do so marginally, with relatively little impact considering the millions of dollars invested.

To that end the Rise Fund has created Rise Labs, a company putting together a rigorous framework that can be used to distil any impact down to a dollar number, so that – finally – investors will be able to see, at least in theory, a time series for the impact that has come from their own and others’ investments. Such a series might even be able to answer the still-open question of whether or not for-profit investments can improve the world more effectively than philanthropy or foreign aid.

For the time being, the new methodology is only being used in-house to judge the success of existing investments and to help narrow down investment opportunities to companies where, in the words of Rise Fund senior partner Maya Chorengel, “impact and business success are collinear”.

Chorengel rejects the idea that the Rise Fund is in any way simply a rounding up of the ‘impactiest’ of the investments that TPG would have made anyway. Many of the firms that the fund has invested in, she says, would never have sought out private equity at all, for fear that being owned by capitalist rentiers would drive them off mission.

Chorengel is optimistic in terms of sector growth. Her fund, when it launched, was more than five times the size of the Bain fund, its nearest competitor, and she definitely sees capacity for more funds in the $2 billion range. Because the methodology is only now emerging, she says, it is a bit early for much bigger funds to be raised, of $5 billion or so, but if and when the Rise Labs framework starts becoming broadly adopted, then anything is possible.

Confusion

That is a big if, and, judging from the delegates at the Nantucket summit, we are still a long way from getting there. There were a lot of fund managers there and a decent number of business owners vying for their attention. All of them were pretty happy to spend a couple of sunny July days in an atmosphere of sea breezes and free-flowing rosé, engaging in wonkish discussion of impact quantification with like-minded individuals.

Surprising consensus emerged on a number of issues – that the SDGs were the best framework for deciding if a certain investment counted as an impact investment, for example, and that it was crucial that impact funds raise money not only from self-proclaimed impact investors but also from investors more broadly. For that reason alone, they have to aim to keep their returns at or above the rest of the market.

There was also broad consensus that the investing public – even the subset of the investing public with millions of dollars in liquid net worth – was generally utterly clueless about impact investing, and if they were not clueless, they were confused.

They have been bamboozled by marketing claims, mostly coming from public equity funds, which have basically no impact because all they do is buy shares on the secondary market, and they have no idea what the difference might be between impact, on the one hand, and all those three-letter acronyms (ESG, SRI, SDG, DAF) on the other.

Normal humans do not like to spend a lot of time thinking about their investments, and ‘impact,’ as an idea, is still relatively new and ill-defined. Which is why it is more useful as a jargon term for professionals than it is as a marketing term aimed at retail.

But even the professionals were conflicted, happier talking about the limitations of capitalism than they were talking about the limitations of, say, the SDGs as a classification tool. (Take just about any company in the world and you will be able to find half a dozen or more SDG goals it can credibly claim to advance.)

And while they were all at pains to pay lip service to the importance of measurable results, there was also an undercurrent of feeling that if you were doing good in the world and making money, then maybe that should suffice. After all, wasn’t it excess quantification that got us all into this mess to begin with?

Impact investments have always been out of the reach of the middle classes, but the big hope underlying the funds at Bain, KKR and TPG was that they might at least become something high net-worth individuals might look at. In reality, however, it rarely seems to be playing out that way. Financial advisers tend not to know or care about impact investing, retail investors don’t know how to ask and the result is that the space is still dominated by a handful of very large foundations and endowments, along with some family offices and individuals so rich that they can simply start their own funds (which they do, with alarming regularity).

The big private equity shops have done a decent job of raising money for their impact funds, but most of that money has come from a pretty small pool of investors. Outside that pool, no one is clamouring for things like greater granularity in impact quantification.

There is a reason why KKR and Bain put politicians in charge of their impact funds, while TPG wheeled out Branson and Bono – and it’s the same reason why Al Gore is running a similar fund in the public equity space. The real future of the asset class lies in storytelling ability, much more than it does in technocratic measurement advances. Those stories will generally be told the old-fashioned way, one-on-one, and investment decisions will be made based on how persuasive the story is.

The impact moniker has taken off precisely because of the stories it implies; it is a much better marketing tool than words like ‘development’ or ‘governance’. What we are really seeing with the first generation of impact funds at private equity firms, is a testing of the waters in terms of marketing.

The only way that the space will grow is if they can get investors interested in it and persuade them to demand an impact allocation. The products are there: now they just need to go out and get sold.