A frontline perspective on impact investors’ “scope” choices — by David Riester
I was recently on a panel about “non-traditional sources of capital for clean energy projects” espousing the benefits and further potential of “impact-oriented family offices” investing in the energy transition. This investor class has always been a favorite of mine since Vision Ridge[1] made GSSG Solar (a company I co-founded) their first investment back in 2013. In the years since I’ve watched and interacted with this varietal of institutional investor regularly – a mezzanine loan with New Island here…a project sale to the Lego family’s group there - while watching the universe grow at a blistering pace. There’s now about $50b of capital in this very specific investor niche, and almost half of that is in the US[2], which is about twice what it was in 2017 and 4x what it was a decade ago[3]. Expand this universe to include the foundations and endowment capital pools with an impact investment mandate (as I will for this piece), and we’re talking about almost half a trillion dollars. You may roll your eyes and question motives/sincerity if you insist[4], but I think it’s awesome and one of the truly heartening phenomena unraveling in the world today.
After the panel, a gentleman approached me and said: “I appreciated your advocacy for impact investors, but I’ve given up on that group; my experience is that in the end you end up giving them months of free consulting but are left with their cold feet and no check.”
I could sympathize with this man, having had that experience a few times myself. Though it is certainly not unique to impact investors - and I’ve no empirical data to support this claim - it does seem a more common experience with impact investors. Why?
Caveat emptor: I’m about to paint an extremely varied universe with very broad brush-strokes. Please know I do so with appreciation for the many exceptions to the following observations, and the knowledge that intentions are nearly always good.
I think the problem has two dimensions: 1. Desire to invest directly instead of passively, and 2. Strategy (focus area) breadth
Direct vs. Passive Approaches to Impact Investing
One of the primary decisions an institutional investor makes is where they want to operate on this spectrum. On the most passive end, the investment team would invest in “fund of funds” – passive investments in a diversified pool of passive investments – and public market “index funds” tracking some ESG index. Fund of funds get you diversification and, in some cases, “access” to fancy, oversubscribed, velvet-ropey venture capital and private equity funds. The “price” is two layers of fees and carried interest, and less flexibility/control with regard to the exposure and impact ultimately achieved. On the most active/direct end, the investment team makes direct investments – venture-style “series X” deals, private credit, or direct infrastructure purchases, usually.
Logically speaking, the impact investors’ scale should determine the approach taken. Bigger capital pools can support bigger, more specialized, more sophisticated investment teams without that SG&A crushing net investment returns, while smaller pools must (should, at least) have some good asset allocators and manager selectors while otherwise keeping the team lean.
Early in my career, I was able to try these hats on and get to know a lot of different institutional investors (at Cambridge Associates, an endowment/foundation consulting firm). Two years of experience in my early 20’s doesn’t make me an expert, but I can confidently confirm: it’s way more fun and sexy to cut deals on the bleeding edge of “climatetech” or “sustainable ag” while sitting alongside legitimate players directly experienced in those sectors… then it is to make a few fund-of-fund commitments and dump some money into a public ESG index fund. In other words, unfortunately what’s (usually) prudent happens to be soul-crushingly uncool. I’ve ranted about the problematic allure of sub-optimal impact investing approaches elsewhere, if you care to go deeper.
And herein lies the problem: a lot of matrons and patrons of impact-oriented family offices are at a point in their life or their “wealth journey” where they want to do something fun. Something cool. I struggle to be critical of this. It’s no different than being tempted to allocate your $10k of annual charitable giving to your already well-endowed alma mater, instead of sending that same amount to, say, the Against Malaria Foundation, where the avoided suffering would be orders-of-magnitude greater, but your donation may feel a touch Sisyphean. It’s not as emotionally satisfying, and we’re flawed, emotional beings. So, we’re left with a pronounced bias toward direct investment strategies that results in sub-optimally applied impact capital.
I don’t have a solution to this problem, other than to leave the impact investor community with the challenge to check in with themselves: is “impact”[5] being conflated with direct action? Is a more direct approach being pursued at the expense of impact achieved? One could be forgiven if a bit of ego burrowed its way into the calculus; but what a victory of character it would be if such a blemish was identified and addressed.
Breadth of Focus Area
In how many different areas of potential impact is the impact investor hoping to make an impact? In a vacuum, naturally one is inclined toward inclusiveness. When you’re talking about things like eliminating food scarcity, ending child abuse, and reducing the existential threat to our species posed by climate change, etc, the human brain struggles to land on “nah…not that one.” Again with the human nature thing.
But there are costs to addressing a wide swath of impact investment areas, and I believe these costs are systemically under appreciated. In fact, it’s more common to see scope breadth marketed as a feature! There’s a neat way to identify such instances by spotting the code-phrase: “…at the intersection of _____ and ____ “. Impact investors seem to subconsciously concoct narratives to justify dabbling liberally in many sandboxes that share no sand. “Interdisciplinary” is a cool word that oozes sophistication and thoughtfulness, but I’ve never seen any compelling evidence to support the idea that interdisciplinary impact investment strategies result in reduced suffering when compared to simple, focused ones. Here’s a glimpse into how many different areas an impact investor might add to their mission:
That’s the United Nations’ “Sustainable Development Goals” (“SDGs”) map. Their “Principles for Responsible Investment” group (“PRI”) was tasked with explaining each category and the sub-sectors within as succinctly as possible, yet still needed 112 pages to do so[6]. Having genuine know-how and expertise within any one of these 17 categories is a major accomplishment. To give you a sense of the scale of this undertaking, the largest private impact investor in the world – the Gates Foundation – focuses on six SDGs (1-6, if you’re curious).
The costs of taking on too wide a mandate is inefficiency, manifested primarily in three ways.
- Mis-allocated capital (impact). If an impact investor doesn’t really know what they’re doing, they have a lower probability of deploying capital to the companies/projects/institutions that maximize impact.
- Mis-allocated capital (returns). The same shortcoming is also likely to result in sub-par investment returns, which means the pool of money available to make further impact going forward is smaller than it would otherwise be. Plus, there’s another secondary effect here; a quiet and immeasurable one, but important nonetheless. Poor results are often blamed on the “space” or the investment type, when much of the failure should be attributed to bad investment selection, underwriting, negotiating, structuring, or monitoring. I see this all the time in renewable energy; here’s what it looks like: I stumble across a random, not especially qualified or impressive solar developer and discover their business is robustly supported by a highly regarded impact investor. “How the hell did THAT come to pass?” I wonder. It’s always a tale of “right place, right time” for the developer. Usually, with hindsight, that same story would be described quite differently from the investor’s side; something like “we dipped our toes in the energy infrastructure game and opportunistically invested in a development ‘platform’ that really just turned out to be a regional developer, and have since decided not to focus on the project development space”. With a large enough sample size, I’m certain the returns for investments of this nature would be below average on a relative basis.
- “Leakage”, and Herd Mentality. To “catch-up” on sub-sector knowledge, or to fill in inevitable knowledge gaps that arise from investment professionals being spread too thinly, impact investors often turn to very expensive consultants, or consortium memberships. While these parties can be highly qualified and well-intentioned, an over-reliance on them is simply inefficient. Too much capital is spent on plugging up the knowledge gaps that could otherwise go toward the investments themselves (“leakage”). Additionally, this approach to shoring up a team’s knowledge and expertise results in “group think” and a “herd mentality”. Fearing making a stupid investment arising from lack of knowledge, an investment team might understandably veer towards “the herd”, where there is safety in numbers (“well, if this ends up being a stupid investment at least I won’t be the only one who made it”). A good example of this is all the cloud software companies focused on energy and climate. A tremendous amount of capital has been wasted on different variations on the same ideas (solving clean energy problem X, Y, or Z by “routinizing” the ______ process using “proprietary algorithms” and cloud-based software solutions). But I doubt anyone was fired over their investment in one of these, because virtually every impact investor made a few. Meanwhile, somewhere in the Caribbean, a huge diesel generator still hums away powering an entire beautiful island…because the developer of the perfect replacement PV+ESS project couldn’t get a bank loan.
The post-panel anecdote I opened with has thrown a new lens over similar experiences of my own, viewed in hindsight. Thinking back upon all the times I’d hoped to get something done with an impact investor – where it felt like a perfect place for an impact investor to invest – but ultimately didn’t close a transaction, there’s a theme: fear of making a bad investment. “Well, of course, that’s only natural”, you say? Or “Dave maybe they weren’t buying what you were selling because it was junk, and/or you’re a poor salesman?” Maybe. Maybe. But another way someone finds themselves with cold feet is because they are out of their comfort zone. And one doesn’t have a real comfort zone if they are spread a mile wide and an inch deep. In that setup, comfort is only found with the herd… safety is only found in numbers.
Getting a direct investment done on the frontlines of any impact area is what I call a “threshold game.” A threshold game is one wherein getting close does not count, AND getting “over the threshold” generates a “win” just about as good as any other. In other words: you only need one, but being close to getting many doesn’t do you any good, and there’s no prize for second place. A brief tangent, just for fun:
To connect this to the topic at hand: ”looking at” 20 potential direct investment opportunities in an “SDG” has absolutely zero impact. Closing one, is better than seeing 100 and doing zero. Any capital source behind an impact-oriented investment team should hold that to be unequivocally true. It follows that investment mandates – and the teams put in place to execute upon those mandates – should be calibrated to actually do transactions, not just skim the surface of many potential areas, while filling the matron’s/patron’s desk with shiny pitchbooks for cool, futuristic, world-saving widgets, and attending “summits” where would-be investors all try to figure out what other would-be investors are “looking at”, while debating the precise definition of “additionality”. That’s an exercise in ego scaffolding and buttocks-covering, not making an impact. I see a lot of KPIs tuned to additionality, but perhaps too few designed to protect against an excess of puffery, chatter, note-sharing, and subsector looky-loos.
I’d love to see more of these investors do fewer things better. Instead of focusing on “the intersection of sustainable agriculture, climate resiliency, and the energy transition” for your $500m foundation, maybe just do sustainable agriculture. If you are committed to making direct investments within that tightened focus-area, OK – now you can do it with a team of three savvy folks who can confidently source, negotiate, underwrite, and close investments in that sector. Or, similarly, instead of focusing on “the Energy Transition” – which is a sprawling, endless space – maybe tighten that up to something like “Supporting municipal electrification projects”, or “providing capital to enable the accelerated retirement of coal plants and the necessary infrastructure to replace them without sacrificing grid stability”. There’s plenty to do there; plenty of investable opportunities both passive and direct. And we could really do with some smart capital focused on that specific turf. Plus, these sorts of tighter mandates build brand and reputation. And that creates a powerful feedback loop, while also doing no harm whatsoever to one’s dinner party conversation fodder.
A website landing page with sweeping statements about saving the world with XYZ pool of wealth is fun for a couple days. Everyone gets to feel great about themselves and the many fascinating pitch meetings to come. But eventually one actually put the capital to work in an impactful and prudent (i.e. risk-adjusted-return) way. I think there are two ways to “shift into that gear”: 1. Accept that the wider focus area calls for a passive investment approach, or 2. tighten up the mandate for direct investments and narrow in on serving fewer impact areas…better. In either the passive or direct model, increased specialization and focus within the impact investor community will result in better returns, and greater impact.
[1] www.visionridge.com; Vision Ridge was initially an appendage of the family office of an ex hedge fund ace who decided – as many others have, sometimes mimicking his model – to port the wealth created in that sector over to “seed” a new pool of impact capital. In this case, the group was successful in leveraging the initial personal investment into a much larger pool. This sort of “impact leverage” is, in many cases, the dream – parley a respected investor who wants to do some good into a “splash” much larger than that person’s capital can make on its own. Doesn’t always work out, but it did in this example.
[2] https://thegiin.org/assets/2022-Market%20Sizing%20Report-Final.pdf
[3] https://www.pioneerspost.com/news-views/20230630/institutional-investors-fastest-growing-source-of-capital-impact-investment
[4] There’s a really strong wave of cynicism – almost nihilistic, or at least Nietzschean – with regard to philanthropy and altruism of late. Much of it comes on the heels of Sam Bankman-Fried’s fall from grace and the resulting “Effective Altruism” bash-fest, but if you sense a broader distrust of altruism and/or a demand for some sort of moral, motivational purity, you’re not alone. Our demand for perfection gets in the way of much progress.
[5] The very word “impact” carries a certain expectation of action or movement, no? So one can appreciate how it may feel perverse to pursue impact with one’s money but do so passively and/or deferentially.
