Issue #2
The missing dimension of Impact
Your reactions to the first issue of this newsletter has caught me by surprise! I wrote articles in the past, but never got such response. Beyond the 347 subscribers, I was moved by how many of you reached out to me. Today, I would like to focus on the “orthogonality of impact”.
The triptych “risk-return-impact” has been popularised by Sir Ronald Cohen, among others. As Chairman of the Global Steering Group for Impact Investment and co-founder of Apax Partners, one of the most successful venture capital firm globally, his voice in favour of impact investing is precious. And his book “Impact: Reshaping capitalism to drive real change” clearly deserve your attention if you have not already red it.
This simplified vision is very powerful to generate interest in the sector and motivate action, but it can be misleading when it comes to practice.
For example, I read more and more articles mentioning this triptych to contextualise impact and talk of related topics, like a recent overview in the French “Revue Banque” looking at the direction of accounting. I understand the practicality of this shortcut, but we need to be careful in our definition of “risk” if we want to measure the right things.
Pretty much the whole gamut of financial instruments can be used to invest in impact. A venture capital fund could buy shares of a company developing solutions to distribute clean energy in rural Africa. Or a social impact bond investor could finance a reinsertion program in which the government would reward the company for the number of beneficiaries who found a job after six months. A philanthropist could give money to finance social projets. In each of these examples, the investor seeks an impact and a financial return. The later will be highly risky for the venture capitalist, somewhat less risky for the bondholder and certain for the philanthropist who made the donation. This financial return risk is the risk investors are accustomed to and know how to manage. It is the “risk” in the “risk-return” diptych.
But there is another risk: that of not reaching the targeted impact. What if those beneficiaries who found a job in our previous example were not able to keep it? The reinsertion program would not be such a success… Trying to have an impact is always complex and uncertainty is the rule.
The catch is that the risk of reaching the expected financial return is not the same as the uncertainty of reaching the targeted impact. The two risks are different and must be looked at separately.
These risks are of different nature and cannot be modelled in the same way. The financial risk is often modelled as a bell curve, or “normal distribution”: we are likely to reach some financial return around our expectations and there are more chances to be closer to the expected return than further away. With impact, situation are most of the time unique and non-linear. This means that the impact will be reached or not: the rain forest we are trying to protect will have been saved or will have been burnt down; the rural community that needs access to clean water will have it or not.
Also, money is fungible: one can make a bit more on a project and a bit less on another, the overall gain will be the same. Not so with impact! Creating jobs in one project and burning down the rain forests in another will not count as success.
For these reasons, we need to keep financial risk and impact uncertainty distinct. And the triptych becomes a pair of diptychs: financial risk and return & impact expectation and uncertainty.
Looking at these two dimensions separately is what some call the “orthogonality of impact”. This means the two dimensions are independent in a mathematical sense. Now, obviously, this is not entirely true. The two dimensions can be linked either contractually, like for the social impact bond, or practically, like for the rural electrification project that will grow and connect more people when it is profitable. Still, looking at the financial risk and the impact uncertainty separately will help manage both better and maximise both financial returns and impact.
As usual, this is meant to be an open discussion. So do not hesitate to share your comments, ideas and questions!
As usual, this letter, originally published on LinkedIn, is meant to open a discussion: join it here.
Lenny Kessler