Cogito Ergo Sum Ego Creo Impulsum

Of all the charts in the GIIN’s 2017 Annual Impact Investor Survey report, the one that struck me the most was this one.

Of 200 impact investors surveyed, 98% say their impact is in line with or outperforming their expectations.

This in a sector in which almost no one actually measures impact, a sector that still debates whether having the intention to create impact is an important description of an “impact” investor.

It’s like we have our own version of cogito ergo sum: “I call myself an impact investor, therefore, ipso facto, I create impact.”

 

 

Tomorrow: Facebook Livestream of Acumen Debates

Tomorrow (Wednesday) evening, at 6:30pm Eastern Time, I’ll be participating in the third in a series of Acumen Debates hosted by EY. The Debates are a fun format that create a livelier conversation than your typical panel. And the good news is that we’re livestreaming the event, so even if you can make it you can tune in on Facebook.

The debate topic is: Do impact investors need to compromise between financial and social returns?

I’ll be arguing, along with Debra Schwartz from the MacArthur Foundation, that there are many cases where compromises can and should be made. We will be debating against Greg Shell from Bain Double Impact and Hilary Irby from Morgan Stanley’s Investing with Impact Initiative, in a conversation moderated by EY’s Jon Shepard.

Here’s the link to watch on Facebook Live.

While I won’t tip my hand and share the points I plan to make tomorrow night, I do have one hope for the conversation, and for our sector as a whole. I hope we can all agree that, irrespective of the financial returns they can generate, if someone is going to be a truly great impact investor, they have to be passionate about impact.

This may sound like a truism, so let me explain by way of example. I read Fred Wilson’s blog every day, and the posts that make me smile the most are the ones in which he geeks out about technology: when he switches from iOS back to Android, or talks about the various wireless speakers he’s fidgeting with at home, or wades into conversations about Bitcoin and the blockchain. It’s apparent to anyone reading that Fred loves technology. It fascinates him. It’s what he’s passionate about. And I’m sure he can’t help but learn about the latest gadgets, all the time.

In the same vein, to be an “impact” investor (and putting aside if anyone still likes that term, which no one seems to these days), I would hope we’d be passionate about impact. And by “impact” I mean actual, tangible changes in people’s lives or in the environment. This passion would manifest, like Fred’s, in a deep, insatiable curiosity about what makes people’s lives better, and what leverage points might exist to make large-scale, lasting change. It would come across as profound attention being paid to improvements that happen in the real world, with all other indicators – including financial returns, which very well could be high – simply seen as means to an end.

These days, when I take part in and listen to conversations in our sector, I hear the most passion about funds, about returns, about fund structures, and about capital flows. It’s striking how comfortable we are talking about money. I’m looking forward to more days in which the passion we express, the deep curiosity we manifest, the conversations we can’t stop having, start and end with people, with communities, with what constrains and enables their lives.

 

What impact investing can learn from Vanguard’s 7x Growth

The Ford Foundation’s recent announcement of its plan to invest up to $1 Billion of its endowment into impact investments is yet another chance to ask if, or when, impact investing will become mainstream.

And by “mainstream” I mean normal.

One idea that’s been on my mind: rather than search for answers deep in the heart and soul of impact investing, we should look at the history of index funds.

The foundational academic article about indexing as an investment strategy was written 50 years ago, in a piece penned in 1966 by William Sharpe in The Journal of Business. Sharpe’s conclusion, among others, was that “The results tend to support the cynics: good performance is associated with low expense ratio.” Not shocking, but this was the opposite of the core logic of the mutual fund industry, one which justified high expenses by supposedly even higher performance.

Nine years after Sharpe’s article, in 1975, John Bogle founded the Vanguard Group, and in 1976 he launched Vanguard 500 (VFINX).  VFINX was and is a low-cost fund that mirrors the S&P 500. Investors in the fund are“buying” the entire S&P for a very low cost. The theory was simple: you won’t beat the S&P in the long run, so the smart thing to do is to get the S&P’s returns with as low an expense ratio as possible.

This one fund was a bet that, over time, investors would come to understand that consistently beating the market with an active stock-picking strategy is hard, and that beating the market by enough to make up for the cost of active management is nearly impossible.

(For some simple math to support this conclusion, think of it this way: historic equity returns are about 7% a year, and most mutual funds charge around 1.5% in fees (if not more). This means you’re eating up more than 20% of your return every year with the fees paid to an active manager. The assets that manager invests in needs to beat the market by more than 20% every year, forever, just to match the performance of an indexed fund. It turns out that this is very hard to do. A 1991 article by Sharpe drilled the point home: “To repeat: Properly measured, the average actively managed dollar must underperform the average passively managed dollar, net of costs. Empirical analyses that appear to refute this principle are guilty of improper measurement.” Now, this would be obvious if fund fees were sold as “20% of total expected return” instead of “1.5% of invested capital.” But I digress.)

Despite the analytical support of academics like Sharpe and others, Bogle and the Vanguard Group were often mocked, and even called un-American, for their tortoise-like strategy of mirroring the broader market instead of trying to beat it, all while charging investors spectacularly low fees. This strategy cut deeply against the story, heavily marketed by the big banks, that mutual fund managers added value to their clients, value that was more than offset by the fees they charged. The mutual fund industry exists to do many things, and one of those things to preserve itself. There was a lot to be lost with the growth of indexing, not only huge profits but also the very American story that it’s better to bet on the chance of winning than it is to be certain not to lose. These two reasons – marketing power and unchecked investor naiveté – are why it took so long for the facts to prevail.

And yet, despite institutional and cultural resistance, time is a powerful tool. Indexing has grown, ever so slowly, as a proportion of the market over the last four decades, reaching 20% of U.S. equity mutual fund assets in 2014. More interesting still, in the last three years, Vanguard’s assets under management have grown faster than the rest of the mutual fund industry combined. That’s right, according to a recent New York Times article, in the last three years, the entire mutual fund industry, more than 4,000 firms, took in $97 billion, and Vanguard took in $823 billion. Vanguard now manages $4.2 trillion in mutual fund assets, having quadrupled its assets under management in the last 7 years.

If this is analogous to what it will take to “mainstream” impact investing, then we have a few lessons to take away.

First, this is a long road we are walking. So let’s be prepared for a marathon, not a sprint. This means it’s time to stop, as we enter the end of our first decade, pretending that the tipping point is just around the corner.

Second, better data and facts, even for something as easily analyzed as public mutual fund returns, are hard to come by, easy to dispute, and alone they are not enough to tip the scales.

Third, economic incentives are powerfully aligned for the gatekeepers to keep things the way they are. Despite this, things can shift massively if clients speak loudly and uniformly.

Fourth, even a robust story that shouted “this is a better way to make money!” took 50 years to penetrate the prevailing wisdom. We’re twisting ourselves into knots to publish a handful of reports saying there aren’t financial trade-offs between impact investing and other approaches. It’s great to know that is possible. But data alone doesn’t tip the scales, what’s needed is a shift in mindset and a better story. And “we can make as much money as you” strikes me, in the face of the history of indexing, as weak sauce.

Finally, a request. I wasn’t able to uncover a proper analysis of the key milestones in the growth of indexing, but I’d love to find one. For anyone interested in growing the share of investment capital that takes social returns, stakeholders, the long-term view, the environment…anything beyond traditional thinking into account, I suspect that the rocky history of indexing holds more than a few clues about the pitfalls we can avoid and, hopefully, provides a map for shortening our 50-year journey just a bit. The world needs us to move faster than that.

The Third Plate and the Future of Impact Investing

Our food system is broken. While we have solved the problem of how to produce lots of calories for a low direct cost, this same food system has resulted in an obesity epidemic; it is why nearly 10% of the U.S. population has Type 2 diabetes; and, most recently, it likely is playing a role in the huge spike in colon cancer for people in their 30s and 40s.

What do we do about it?

I recently read Dan Barber’s The Third Plate. Dan is a famous chef, the co-owner of the acclaimed restaurants Blue Hill and Blue Hill at Stone Barns. The book’s title is Dan’s answer to the question, “what will the typical American dinner plate look like in 35 years?”

In response, Dan sketched three plates to show the evolution he imagines: the first plate, from the 1960s, had a large, corn-fed steak with a small side of industrial farmed vegetables; the second, from today, had a farm-to-table organic grass-fed steak with a side of organic heirloom carrots; and the third, futuristic plate, had a “steak” made of carrots garnished with a sauce made from leftover beef trimmings.

Dan’s point, with this third plate, is that the current high-end, farm-to-table, farmers’ market approach to food is a luxurious niche that doesn’t address the core issues of the food system: while the foods themselves may be natural and healthy, they are, in Dan’s words, “often ecologically demanding and expensive to grow,” and, by definition, they work at the edges of the system as a whole.

(Cue: impact investing theme music)

The Third Plate is Dan’s exploration of a better solution, a deep dive into whether the carrot-made steak really was the future of food, and what it would take to get there. The book recounts his exploration of Soil, Land, Sea and Seed – the book’s four sections – and what the future of each of these food categories might be.

Like all good narratives, this one is told through people. Each of the book’s many protagonists – whether Klaas Martens, a farmer in upstate New York, Miguel Medialdea, a Spanish biologist, Steve Jones, a seed breeder at Washington State University, or many others – are all rebels of sorts who reach the unavoidable conclusion that whether you’re growing a stalk of wheat, raising an acorn-fed pig, or cultivating the world’s most delicious fish, the only way to produce truly outstanding food is to create food that is in harmony with a broader food system.

Take Miguel Medialdea, the Spanish biologist who raises a bass so delicious that the first one Dan Barber tastes, which, unfortunately, was overcooked, is described thus:

The fish was incredible. Even overcooked and tough – even D.O.A. (“dead on arrival”), as line cooks like to say when a fillet has seen too much heat – it made my mouth water. It was so richly flavored, you’d be forgiven for comparing it to a slowly cooked shoulder of lamb or a braised beef short rib. I’d never known bass could be so delicious.

How does Miguel Medialdea’s Venta de la Palma produce such a bass? It’s a complex system of interplay between salt and fresh water, an 80,000 acre fish farm which feels like a loosely managed system in which Miguel has set up the major pieces, nudges things here and there, and then lets the system do most of the work.

I won’t attempt to describe all of the inner workings of Venta de la Palma – Dan does it better. But I was struck by a moment in Dan’s conversation with Miguel at the end of another meal, in which Dan tries to uncover the secret of what could make a bass so delicious. Was it the scale of the property, which meant no overcrowding and, therefore, almost no disease or parasites? Was it the intricate canal system, which provides a natural filtration system against pollution?

To try to make sense of it all, Dan casually asks Miguel how long it takes for one of his bass to mature.

‘Thirty months,’ Miguel muttered, seemingly to no one in particular.

‘Thirty months!’ I said. ‘It takes two and a half years to raise…a bass?’

‘Yes, that’s the average, which is more than twice the aquaculture average.’

I asked how the company could make money.

‘So far there’s profit, enough to keep us working at an optimum, not a maximum.’

This was the kind of answer Miguel, and Klaas, and Steve Jones kept on giving: that one of the fundamental constraints that had to shift in order to operate a healthy food system is a move from maximum profit to optimum profit. They propose that the only way to create the world’s best food is by creating and maintain a system in balance, and each one of them concludes that such a system is not one that is optimized for extracting every last bit of value that they, personally, can squeeze out of it.

To illustrate the point, at another juncture in this conversation, Dan is shocked by the 30,000-strong flamingo population on the farm. Since these flamingos eat 20% of the farm’s fish and fish eggs, wasn’t their presence a bad thing?

Miguel shook his head slowly, with the same calm acceptance shown in the face of losing half of his goose eggs to hawks.

“‘We’re farming extensively, not intensively,’ he said. ‘This is the ecological network. The flamingos eat the shrimp, the shrimp eat the phytoplankton. So the pinker the bellies, the better the system.’ The quality of the relationships matters more than the quantity of the catch.”

If Miguel’s job is to optimize the overall health of the system, then key indicators of success are the data, like the pinkness of flamingos’ bellies, that tell you about systemic health. Profit may result from this system, but the system is not engineered primarily to create profit.

What a fantastical notion, that profit might be a result and not the goal.

The parallels to our economic system are, I hope, obvious. When I compare the dialogue within impact investing with the conversations happening in the food system, I’m struck by how much we, in impact investing, have so far failed to have a rich, nuanced conversation about where profits fit in the new system we say we aim to create. In my experience, all conversations about profits – or returns – in impact investing quickly devolve into discussion of the financial return a given investment or strategy produces, with both sides losing when they debate the “right” level of return without a broader conversation about whether this return is a result of or the ultimate purpose of the investment.

The much deeper conversation we need to have is around whether to be a successful impact investor, or to be a successful player in an ecosystem funded by impact investments, one needs to have the willingness and the capacity to optimize for the health of the system, and not just one of its outputs (profits, or returns). Meet any of the colorful characters in Dan’s book and you come across rebellious tinkerers who bristle at the status quo at every turn, because they’ve learned, through a life’s worth of experience, that the traditional food system is broken.

Do we have a similarly clear point of view about whether the mainstream capitalist system works or is broken? Do we believe, as we watch everyone from Bain Capital to TPG to the Ford Foundation commit billions of dollars to impact investing, that we can create the kind of deep change we know the world needs if we are unwilling to confront this question head on? Are social entrepreneurs and impact investors the equivalent of food revolutionaries who see that we have no choice but to upend the whole system, or are we hangers-on to the edges of mainstream capitalism, excited to build out our small terrariums without ever questioning the bigger ecosystem?

My belief is that our breakthroughs will only come once we start saying out loud that our ultimate goal is to build a global economic system that is extensive, not intensive. And then, once we recognize that such systems can be built, to ask ourselves what it would take to move that from niche to mainstream.

My belief is that to get from here to there, we need more folks who are willing to think like Miguel. These are people who can deconstruct and reconstruct a food system (or any other system) and, in so doing, can reprioritize the factors they’ve been told to optimize. These are people who are willing to walk the long, hard, stupid road from nowhere to somewhere. These are people who won’t stop tinkering and experimenting and learning and failing and doing it all over again…until, one day, they can consistently produce an output that is better than anything that’s come before it and that enriches the health of all the players in that system.

It’s OK for us to acknowledge that we don’t yet know the right indicators of systemic health, as long as we say that we’re willing to put ourselves on the line to create them.

We start by asking: what is our equivalent of the pinkness of flamingo bellies?

Matthew Weatherley-White on How to Turn the Capital Markets Upside Down

In further proof that most important innovation involves the reassembling of existing ideas in new, surprising and powerful ways, I’d encourage you to check out this talk by Matthew Weatherley-White at SOCAP 2016.

Matthew’s big idea goes something like this:

In Austria, organ donation rates top 90%, in Germany they’re below 14%. Why? Because in one you have to opt in to donating your organs, and in one you need to opt out. And what could be more important, or more personal, than organ donation?

So maybe the way to make investing with a purpose mainstream is to stop fighting to change people’s minds and instead make it a default strategy.

Discuss.

[If you’re not seeing the embedded video below, you can click here to see it.]

If I were to describe the video in joke form, it would go something like…

Q: What do the Twilight Zone, organ donation and ESG investing have in common?

A: ???

(If you can make that into an actual joke, you win a prize.)

A New Epistemology of Solving Complex Problems

I’m in India, spending the week with the Acumen team and with the Acumen India Fellows for their fourth seminar. Last night, at the end of the first day of seminar, we were joined by Vijay Mahajan, one of the most esteemed social sector leaders in India. Vijay is the founder of Pradan, which he ran from 1983 to 1993, and was then the founder of BASIX which grew to be one of the largest microfinance organizations in India prior to the microfinance crash in 2010.

Vijay is a truth-teller, who speaks plainly and without adornment about his experiences. Our conversation was an intimate one – just us (20 India Fellows, me, Jacqui Papineau and Bavidra Mohan, together with Vijay and his colleague, documentary film-maker Girish Godbole), with Bavidra interviewing Vijay before an open Q&A.

Upon hearing Bavidra’s first question, around lessons about leadership, Vijay paused and thought hard for what must have been 20 seconds before responding. Just watching such an esteemed individual, who must have been asked a similar question hundreds of times, really stop and think before giving an honest answer was a display of humility and respect for our group that itself spoke volumes.

From that moment on, everyone in the room was silently hanging on Vijay’s every word, with most scribbling furious notes of Vijay’s pithy insights. My single biggest takeaway stemmed from a comment Vijay made early on in the discussion, when he said:

Anything that could be solved with single variable maximization was solved in the 20th century…we need to create a new epistemology of complex problems for the 21st century.

I’ve always felt that impact investing and social enterprise are something brand new. If this work is going to realize its true potential, we are going to need to think about two-variable approaches – or, better stated, leadership that embraces opposable mind thinking and sees potential where others see only contradiction.

I must admit, until last night I had not aspired to creating a “new epistemology” but I think Vijay is on to something. Ultimately we need a strong theoretical and analytical grounding to explain what it would mean to take truly new approaches to solving centuries-old problems, problems that are based as much on caste, social exclusion, geographic marginalization, and politics as they are on simple microeconomics. And, as Vijay reminded us, such a theoretical underpinning is not entirely new. Indeed, in 1956 economist Herbert Simon developed the notion of “satisficing” rather than “maximizing” behavior as being a more accurate description of how individuals and firm managers behave. Perhaps we need more satisficing firms of we are to solve this new batch of problems.

Indeed, the more I think about it, the more it strikes me that Vijay’s statement summarizes the core fault line within impact investing and social enterprise: is impact investing just about extending the market, a chance to extent single-variable (profit) maximization to areas where it hasn’t yet reached? Or is single-minded profit maximization (versus profit achievement), as a binding constraint, anathema to the real task of tackling social issues?

There’s no doubt that there is work to be done on both sides of this fault line. It is an overstatement to say that all single variable maximization problems were solved in the 20th century, and there are huge emerging swaths of the population – hundreds of millions of people – who are optimally situated to benefit from the extension of 20th century approaches to them. However, I believe that impact investing will fall far short of its potential if it limits itself to this approach (indeed, isn’t it just “investing” to find businesses that fit age-old criteria and invest to help them grow)? What I am seeing after nearly eight years doing this work is that that, outside of narrow verticals (e.g. financial services on mobile platforms), the social sector leaders who are working to reach marginalized populations do not act as if single-variable maximization is enough.

By the way, it bears mention (lest anyone jump to conclusions) that just because one agrees that a narrow profit-maximization mindset is not enough does not predetermine anything about what business models need to look like, what form an organization should take (for-profit, non-profit, or some other form), or even about financial returns. Rather, this is a conversation around what sort of problem one believes one is working on, and an assessment up-front of whether the tools that we created in the 20th century are up to the task of tackling the problems of the 21st century.

Vijay’s closing thought, with which I heartily agree, was that “we cannot build great theory if we keep on reporting practice wrong.” Our challenge, from the outset, is to have the audacity to imagine the world as it could be, and the humility to share the real lessons of what it takes to create large-scale social change. Vijay certainly shared his real lessons with us, and I know that I and the Acumen India Fellows will follow his lead in continuing to take problems head-on, and honestly share what we are learning with other practitioners, so we can all build a better future.

(And maybe, just maybe, we will eventually find a way to develop a PhD 21st in the Epistemology of Solving Complex Social Problems…)

Give Impact Investing Time and Space to Develop

Note: this piece originally appeared on the HBR Blog.

Impact investing has captured the world’s imagination. Just six years after the Rockefeller Foundation coined the term, the sector is booming. An estimated 250 funds are actively raising capital in a market that the Global Impact Investing Network estimates at $25 billion. Giving Pledge members described impact investing as the “hottest topic” at their May 2012 meeting, and Prime Minister David Cameron extolled the potential of the sector at the most recent G8 summit.  Sir Ronald Cohen and HBS Professor William A. Sahlman describe impact investing as the new venture capital, implying that it will, in the next 5 to 10 years, make its way into mainstream financial portfolios, unlocking billions or trillions of dollars in new capital.

As this sector moves from the margins to the mainstream, it’s important to consider: What will it take for impact investing to reach its full potential?  This question is hard to answer because, in the midst of all of this excitement, there aren’t clear success markers for the sector.  Without those, the institutions managing the billions of sector dollars won’t be able accurately to assess the risks they are taking and, more important, the returns, both financial and social, they hope to generate.

Impact investing is not just a new, undiscovered corner of the investing world. It has the potential to join traditional investing and government aid and philanthropy as a third way to deploy capital to address social and environmental issues. A fully developed impact investing sector will incorporate the best features of markets—rigor and speed; quickly evolving business models; strong revenue models; and access to capital as ventures show signs of success—with the best features of government aid and philanthropy—serving unmet needs; reaching populations that are bypassed or exploited by the markets; investing in goods with positive externalities; and leveraging public subsidy to extend the reach of an intervention—to solve social problems.

Impact Investing_Time to Develop_1

Because impact investing really is something new, the old ways of assessing risk and return are not enough.  And yet, like a moth to a flame, those in the sector are endlessly drawn to discussions around what constitutes the “right” level of expected financial returns.  There is no single right answer to this question.  Under the broad umbrella of impact investments lie myriad sectors, asset types, and investment products, most of which still need to be developed and understood.  It looks something like this:

Impact Investing in 2014: Colorful, full of potential, and highly disorganized

Impact Investing_Time to Develop_2Note: Each circle represents a business and each color represents a business vertical (e.g. sanitation, housing, mobile banking).

To make sense of this kaleidoscope, three things need to happen.

First, impact investing needs time to develop. This is a nascent sector where entrepreneurs and investors are still figuring out business models, developing new financial products, and proving exit strategies and exit multiples, and only a handful of players are using agreed-upon metrics for assessing social impact.  Whether it’s solar lighting, mobile authentication, micro-insurance, mobile banking, drinking water, urban sanitation, low-income housing or primary health care, entrepreneurs need time to test, modify, and refine business models.  These entrepreneurs are looking for support from risk-seeking investors who have an appetite for failure, are willing to be pioneers, and who value the social returns they’re creating.

As the sector grows through this period of creative destruction, models that don’t work will die out, models that survive will attract copycats, operating costs will go down, and winners will rise to the top.  The sector will organize itself across the spectrum from philanthropy to investing, and the resulting clusters will demonstrate the differences in risk, financial returns, target customer, and social impact across the various sub-sectors of impact investing.

Impact Investing in the Future: Developed clusters across the spectrum

Impact Investing_Time to Develop_3

Second, in addition to time, the sector needs a framework to measure success, one that makes sense of the sector’s inherent diversity.  Akin to the Morningstar Style Box, such a framework would allow an investor to easily identify best-in-class social and financial performance across and within the various sub-sectors of impact investing.

Third, the sector needs practical, widely-adopted, and standardized tools to measure social impact.  This is easier to describe than it is to do.  Although investors value both financial and social return today, the sector only measures financial return well. The big, unspoken risk is that we’ll end up ranking and sorting impact funds by the only thing they can be ranked and sorted by – money – without assessing or valuing the different levels of social impact these funds have.

The future of impact investing depends on our ability to embrace what we’ve learned over the course of economic history: solving social issues requires both private and public capital, a combination of risk-seeking investors and incentives and subsidies from public actors to make it easier and more attractive to reach underserved segments of the population.  Hospitals, parks, educational systems, sanitation infrastructure, low-income housing — globally, risk-seeking investors build these solutions in partnership with the public sector, which plays its part to adjust incentives, act as a major customer, and provide subsidy where needed.

What the sector needs is enthusiasm about the future and patience around the time it will take to get there.  In traditional investing there is a premium on liquidity, low beta, and lower risk, all of which justify higher or lower returns. In impact investing, we need to find a way to place that same premium on social impact by valuing the public good being created – just like we do in early stage R&D in science, IT, health, and biotechnology. We allowed microfinance and the venture capital industry the time and space to develop over a few decades. Surely we can do the same for impact investing.