By Jessica Droste Yagan and Priya Parrish
Impact investors build their investment strategies with an outcome in mind. They seek to invest in ways that measurably address specific problems in the world, such as increasing access to clean water or creating jobs in a specific neighborhood. We categorize the various ways that impact investors can intentionally create impact through the 5 P Framework. Impact Engine’s strategy focuses on the “Product” P by investing in companies whose products improve education, health, economic empowerment, or environmental sustainability. We believe that investing in product-based impact is one of the strongest ways to create alignment between scaling impact and revenues.
One of the other Ps in the 5 Ps Framework is “Process,” through which an impact investor may very specifically target and facilitate improvements in the management practices of its portfolio, such as reducing carbon or improving employee wellness. To truly be considered impact investing, these strategies should include active involvement with the business through the board of directors, a control investment, or other ways of directly influencing strategic decisions.
Related to “Process” impact investing, but at the passive end of the spectrum, is environmental-social-governance (ESG) investing, which is quickly becoming a ubiquitous strategy for investors who are thorough about managing risks and seeking opportunities to generate alpha. ESG investors understand that companies providing exemplary working conditions or minimizing the environmental impact from operations may both contribute positively to society and also improve financial returns. Typically, they build ESG data into their investment models much like any other financially-relevant data in order to build portfolios focused on these companies.
Although impact investing and ESG investing are different strategies which have developed as different industries, we believe that, at their best, each incorporates the other. A great ESG strategy will take into account the impacts of the products that are being sold. For example, MSCI ESG Fund Ratings include the weighted average of each portfolio company’s percent of revenue generated from goods and services with a positive impact on society and the environment. Likewise, an effective impact investing strategy will take into account that a business’s impacts will go well beyond its product, especially as it scales. Principle 5 of the Operating Principles for Impact Management from the IFC specifically calls out this opportunity.
In line with our goal of continuous improvement, we have recently revisited and formalized our thinking on integrating ESG into our decision-making and portfolio management processes. Materiality is a key driver in how and when we consider ESG factors. Because materiality will evolve over the lifecycle of a company, we accordingly focus on different ESG factors and with different levels of scrutiny as a company matures. Because we manage both early-stage venture capital and later stage private equity strategies, we are in a unique position to see this evolution over time.
In our venture strategy, we have always focused on a few components of ESG in our due diligence and portfolio management. Specifically, we note the diversity of the management team and board of directors as a risk or strength, we aim to ensure that customer security and privacy are addressed from the beginning, and that ethical practices and strong governance are in place. The venture strategy has not focused on the environmental impacts of our companies (outside of their products, if relevant) because we invest in early-stage software companies, and their environmental impact tends to be much less material than other factors.
More recently, we launched a private equity strategy that focuses on more mature companies across multiple business models (i.e. not exclusively software). This strategy also focuses on product-based impact, yet we see an increased need to assess ESG management in middle market companies due to the increased materiality of many factors on multiple stakeholders. For example, middle market companies often employ several hundred employees and have a more complex operational footprint and supply chain. For these companies, mismanaging ESG factors across business operations may offset the positive impact driven by its products, and the financial materiality of mismanagement is also more significant. Whereas the venture team will bring ESG issues up as needed and more informally, the PE team needs to be more formal and comprehensive in its evaluation.
In developing the PE strategy’s approach to ESG, our goal was to create value for our portfolio companies by identifying ESG risks and opportunities during the diligence process and sharing it with management teams. We then evaluate management’s ability and willingness to make these improvements and seek to actively work with them on these initiatives throughout the investment period. We feel this process can be beneficial to the company akin to the traditional private equity “value creation” process. What guides our investment decisions, from an impact perspective, remains a thesis about how the company’s products or services will drive impact along the dimensions of effectiveness, accessibility, and scale, yet we believe our ESG management process helps ensure total net impact of the company is positive.
We recently developed an ESG management tool for our portfolio companies to help achieve our goals, and will be using it and learning from it in the coming months. ESG practitioners have also developed many frameworks for assessment that can serve as valuable resources for impact investors. We incorporated some of the best practices from the ESG industry while making adjustments for our firm’s objectives and focus on product-based impact business strategies:
SASB’s materiality map is a useful guide to identify the ESG factors that are most financially material to a business, yet we’ve found it valuable to apply our own additional view of what is material for each portfolio company. We also believe that certain factors, such as Employee Engagement, Diversity & Inclusion, are material to all companies.
Sustainalytics, an ESG Ratings provider for public companies, utilizes a two-dimensional framework that measures a company’s exposure to material ESG risks and how well a company is managing those risks. This aligns with our objective of helping companies manage ESG risks, but we added a third dimension — manageability. This helps us avoid businesses with material risks that cannot be managed or have unrealistic expectations of management’s ESG performance.
Finally, B Lab’s Impact Assessment is a comprehensive set of questions that helps to assess a company’s policies and practices in relation to workers, community, customers, the environment, and governance. While not all questions are relevant and material to each portfolio company, we’ve found it useful to think through the applicability for each investment and value the inclusion of all stakeholders in their questionnaire.
At Impact Engine, we are committed to continuously improving our process to generate better financial and social outcomes for society, our companies, and our investors. The fields of impact and ESG investing are rapidly changing, and we’re excited to adopt new tools as they emerge and learn from our and others’ experience.
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