Nearly a decade after its arrival on the social finance scene, impact investing is still growing in popularity. Hedge fund managers have been slow to adopt the strategy, although other types of investment managers are already gathering assets in this space. Yet as the hedge fund industry continues to face performance headwinds, it may be time to take a closer look at how this type of sustainable investing may support alpha generation.
Defined as ”the intentional allocation of capital to generate a positive social or environmental impact that can be—and is—measured,”¹ impact investing blends the earlier concepts of investment screens and social selection criteria with the newer enhancements of intentionality and impact metrics.
Two developments have supported the growth of social finance. These include the business megatrend toward sustainability² and the emergence of social metric reporting. These developments indicate that the times appear to be changing, putting financial companies and investors right in the middle of the social evolution. And, they are responding positively to the idea.
Institutional investors are increasing capital commitments to impact investments on an annual basis, while investment by high-net-worth individuals has grown over the past two years.³ Investment managers continue to launch new and innovative strategies, even as regulators, the media, and universities show support for impactoriented themes. Social influence appears to be evolving on a global scale, indicating that impact investing may have sustainable, long-term appeal.
As the newest entrant to social finance, impact investing is still an emerging area. As of 2014, it represented a relatively small portion of the $6.6 trillion held in sustainable assets.? While it is challenging to calculate the current market size of impact investing, a partial glimpse is offered by the respondents to the annual survey conducted by the Global Impact Investing Network (GIIN). It reveals that, by instrument, the largest percentage of assets is held in private debt, real assets, and private equity, as illustrated in Figure 1. Together, private equity and debt strategies comprise 52 percent of the assets identified as impact investments. Respondent assets under management (AUM) total $77.4 billion across 156 entities, which include fund managers, foundations, banks, diversified financial institutions, family offices, and others (excluding retail investors).
As impact investing has grown, it has also gained definition as an investment style. Sonen Capital’s Impact Investing Spectrum provides a useful conceptual tool, which investors and fund managers may, for example, use to analyze their approaches to impact investing. In this six-part spectrum, shown in Figure 2, the investing world that is shown between Traditional Investing and Philanthropy describes a range of impact approaches and opportunities. The Sustainable Impact Investing and Thematic Impact Investing categories—which may be the sweet spot for hedge fund managers—suggest selecting targeted companies (Sustainable Impact Investing) and social and environmental themes (Thematic Impact Investing) while seeking competitive financial returns. The Impact First Investing category targets both social and environmental issues where the impact takes precedence over financial returns. For reference, the first category, Traditional Investing, is solely designed to achieve financial returns while disregarding any social or environmental impact. The last category, Philanthropy, is designed to achieve a specific social or environmental outcome, while disregarding any financial return.?
Hedge funds and social finance
Hedge fund managers have been active participants in social finance for a number of years. There are two funds with 2007 inception dates still in operation, with other more recent offerings available as well. Yet our research for this report uncovered no hedge funds that are currently selfidentified as impact investments. Neither the ImpactBase managed by the GIIN nor the fund data provider Preqin Ltd. lists an impact-oriented hedge fund or fund of funds.? This illustrates that in the impact space, specifically, hedge fund managers have opted for using impact investments as part of an investment approach, rather than launching a dedicated impact fund.
This signals that hedge fund participation in impact investments is largely at the overlay-manager level, with SRI— and ESG—labeled funds being selected by overlay impact managers as part of the client portfolio. In this case, the hedge fund manager may not be aware of the selection of their fund as an impact investment. Yet the impact manager, through the selection process and by quantifying the social impact of the portfolio, creates a client-level impact investment designed to generate alpha and social good.
A second method of involvement may be through behind-the-scenes influence. One fund manager we researched has worked for a number of years with the companies it is directly investing in to increase their social impact. While their hedge fund is designated by Preqin as an ESG fund, the manager considers itself as being in the impact space as well, through the social influence it exerts on private investments.
This may mean that visible and measurable social finance participation by hedge funds is currently through ESG and SRI strategies. Since managers self-report designations to data providers, market sizing for these areas of social finance is relatively transparent.
Preqin data summarized in Figure 3 shows that 18 hedge fund managers offered 29 ESG or SRI funds to investors at midyear 2016. An average of five share classes has been launched per year over the last decade. Three quarters of share classes are aligned to an SRI strategy, and the remainder are ESG-focused.?
This is still a niche market, however. Deloitte calculates under $10 billion in assets is held in these strategies, based on analysis of Preqin data supplemented by our research into publicly disclosing funds—as compared to the $3.1 trillion in hedge fund assets under management.
Key considerations for impact investing by hedge funds
The lack of a clear hedge fund leader in impact investing suggests there may be open space for early movers to gain a competitive advantage. The biggest value proposition for this strategy is that a growing class of investors wants to see these types of products within their suite of investment options. The value-add to managers is not only about interest in a specific fund, but also about how this creates opportunity to bring in new clients and deepen relationships with existing clients. Competition is fierce and any opportunity to show responsiveness to investor demands while being first in an untapped market is key. For managers taking a closer look at impact investing, and others already in the social space, we suggest the five following considerations.
1. Defining meaningful impact measures. The lack of standardization for impact performance measures is a key challenge for impact investment managers. While traditional metrics are measured in dollars of currency, social and environmental metrics vary in unit of measure according to the desired goal, such as energy consumption, carbon emissions, and employment generation.¹¹ The wide range of impact measurement practices and metrics makes it difficult for investment managers to efficiently integrate impact measures into investment decision making. As transparency around impact measurement and reporting increases, a growing evidence