Due diligence in the impact investing space

Investors increasingly demand not only a solid financial return, but that their money is put to work as a force for good. This means that before investing on their behalf, investment professionals must take into account non-financial factors to generate social and environmental change, as well as financial aspects.

One of the difficulties is that the most useful data for measuring the impact on beneficiaries is not the easiest to collect and measure. This means we have to go further than traditional due diligence processes and make sure the investment provides returns in line with expectations and also achieves its broader goals.

Microfinance is a great illustration. Microfinance funds can accurately calculate the average size of loans and estimate the number of micro-borrowers benefiting from them.

But we also need to understand whether these loans stabilise or improve borrowers’ income in a sustainable way. Not all the loans necessarily generate tangible social benefits.

Impact investors need to spend time measuring the impact of this new income on living standards of beneficiaries. After all, the social impact varies, depending on whether the additional income is used to finance children’s education or improve housing conditions – or to buy televisions and cigarettes.

It is therefore essential to consider five additional elements when doing due diligence in the impact investing space: social outreach; pre-investment impact analysis; impact measurement; value alignment and impact management.

Let’s take these one by one. The first question is about social outreach. Which population is the investment trying to reach? Many investments are in what a traditional manager would call frontier markets, because impact investors try to reach the most fragile populations, or those struggling to access the most essential services. Women, migrants, small farmers in remote areas for instance, are strategic beneficiaries.

Secondly, through a pre-investment impact analysis, investors need to look at the depth and robustness of a manager’s methodology and the impact of the company’s investments. Investors should demand fund managers are serious about the impact they aim to generate, and that this mission is well reflected in the way they select their investees.

Thirdly, investments need to monitor, measure – and report – on that impact. This typically involves an annual social impact report describing the impact achieved at different levels: at a consolidated portfolio level, by each individual fund or company, as well as indirect contributions creating more dynamic and efficient ecosystems in the impact investing space.

Fourthly, it is important to assess values alignment and that the investment is aligned with the business’ mission and culture. It is crucial that social impact is at the heart of what a team is trying to achieve, and that it’s more than a ‘nice add-on’ to their traditional investment process.

Lastly, impact management is about trying to improve the impact of the money invested. Very few do this work at the moment and we expect that to change. In the same way a private equity firm improves a business through active involvement, fund managers in the impact investing space can detect potential and bring about change through their investments and shareholder rights.

As many of these factors cannot be captured by quantitative metrics, qualitative assessment should be a significant part of the due diligence process. Managers should systematically meet with the management company and try to visit some of their portfolio companies on the field. Because many of the funds do not have a five or even three-year track record, due diligence in the impact investing space typically is one-third more time consuming and resource-intensive than for traditional investments.

However, this additional time required pays off, because managers should be looking for long-term value.

At the moment, investment choices are concentrated around financial inclusion, such as micro-credit, or access to basic services such as rural electrification, sanitation or clean water. Impact investing can also make a difference by early-stage investing, which often helps the fund manager reach critical mass more quickly. Indeed, our own investment gives a quality signal to the broader investment community and is often enough to bring in others.

Impact investing in financial inclusion is, perhaps counterintuitively, inherently less risky than traditional models because loans are usually brought to people with very little or no access to banking. They depend on these loans to develop income generating activities, and are therefore very keen to pay back and access the next round of financing for their small business. We only invest in countries where there is a central credit registry and, most of the time, clients of these businesses are borrowing small amounts together with friends, family and neighbours. This gives everyone a stake in repayments and reduces default rates by more than half compared to those of traditional lenders.

Bertrand Gacon, Head of Impact Investing, Lombard Odier