How Do Leading Impact Investing Firms Manage Their Investments’ Impact Risk? Some Major Observations (2024)

What is impact risk in impact investing?

The ability to bring about a positive social or environmental impact is a fundamental goal of impact investing. But what happens when an impact investment fails to make a positive impact (for example, when an impact investment project about homelessness fails to reduce levels of homelessness)?

Furthermore, while impact investment projects aim to create a positive impact, there is a risk that they may inadvertently create a negative impact. Take, for example, the seemingly clean energy investment of more than $200 million by the U.S. Overseas Private Investment Corporation (OPIC) in Buchanan Renewables – a firm that aimed to create biomass fuel from rubber trees in Liberia. Despite positive impact intentions, the investment project harmed local communities by destroying the only income source of many small family farmers through cutting down their rubber trees, and by contaminating local water supplies through unplanned operations.

Overall, in impact investing, impact risk encompasses positive impact risk (i.e., the probability of failing to attain the desired positive impact) and/or negative impact risk (i.e., the probability of creating a negative impact).

What are the sources of impact risks in impact investing, and how do impact investors mitigate them?

Drawing on data from 91 leading impact investing firms worldwide (e.g., Big Society Capital, Symbiotics, LeapFrog Investments), this study finds that impact risk in impact investing may arise from three major sources: the operations of investee companies, investor companies, and the broader impact investing ecosystem. That is, investment projects may fail to achieve the expected positive impact and/or may create a negative impact due to the substandard operations and irresponsible actions of investee companies, investor companies, and/or impact investing ecosystem.

I find that impact investors use a wide range of control mechanisms to manage the impact risk from multiple sources. Figure 1 provides a pictorial depiction of them.

Major observations regarding investors’ impact risk management practices

Observation #1: Avoiding “analysis paralysis”

I find that impact investors avoid “analysis paralysis” by avoiding sophisticated analysis-based control mechanisms that are unlikely to become functional due to the unavailability of complex data covering numerous attributes of an impact investment project. Instead, impact risk control mechanisms adopted by impact investing firms rely heavily on judgment and experience. This is because judgment-based control mechanisms provide investors with valuable tools to make sense of a highly uncertain and ambiguous context of impact risk management in impact investing.

Observation #2: Instead of “fully perfect”, go for “good enough” control systems

I also find that impact investing firms adhere more to the “satisficing” (rather than “optimal”) principle while designing their impact risk control mechanisms. They understand that, given the inherent complexity of managing impact risk in impact investing, designing and implementing a “fully complete and perfect” control system are not economically feasible and may be an illusion. Instead, impact investing firms adopt the “satisficing” principle to design control systems to ensure that they are “good enough” to provide investors with reasonable guidance to navigate the highly uncertain and ambiguous context of managing impact risk in impact investing.

Observation #3: Investors tend to focus more on managing positive impact risk than negative impact risk

Another insight that this study offers is in the area of relative emphasis on managing positive and negative impact risk in impact investing. Our observation suggests that most control mechanisms heavily focus on delivering expected positive impact rather than avoiding/mitigating unexpected negative impact. This suggests that impact investors pay more attention to managing positive impact risk than negative impact risk. The relatively higher degree of specificity, measurability, and data availability associated with positive impact risk might have prompted investors to design/implement control mechanisms focusing more on managing positive impact risk than negative impact risk.

Observation #4: Transferability of control roles between financial and nonfinancial risk management is not straightforward

The final insight of this study is to suggest that the transferability of control roles (i.e., the roles that a specific control mechanism plays) between financial and nonfinancial risk management is not straightforward. For example, prior literature shows that, regarding financial risk, the role of on-site visits as a control mechanism is mainly limited to conducting an ex-ante financial risk assessment in the pre-investment phase. The current study’s observation suggests that regarding impact risk, while on-site visits play an important role in the pre-investment stage in the form of collecting the necessary information to perform an ex-ante impact risk assessment, they play a more vital and elaborated role in the post-investment period, including serving as an impact evaluation tool, an impact validation tool, a compliance tool, and an early warning tool. Thus, we suggest that while adopting control mechanisms to manage nonfinancial risk, managers should be mindful of the fact that specific control mechanisms that play a limited (or elaborated) role in managing financial risk may play an elaborated (or limited) role in managing nonfinancial risk.

Overall Summary:

• In impact investing, impact risk encompasses positive impact risk (i.e., the probability of failing to attain the desired positive impact) and/or negative impact risk (i.e., the probability of creating a negative impact).
• Impact risk in impact investing may arise from three major sources: the operations of investee companies, investor companies, and the broader impact investing ecosystem.
• Impact investors use a wide range of input, behavior, and output control mechanisms to adequately address the impact risk arising from different sources.
• To avoid “analysis paralysis” in this highly ambiguous context, impact investors design their control mechanisms based on their long-standing experience and judgment as well as a trial-and-error approach.
• To avoid the illusion of designing a “fully perfect” control system (i.e., based on the “optimal” principle) in this highly uncertain context, impact investors design control systems that are “good enough” (i.e., based on the “satisficing” principle) to provide them with reasonable guidance to navigate the uncertain landscape of managing impact risk.
• Impact investors tend to focus more on managing positive impact risk than negative impact risk.
• While adopting control mechanisms to manage nonfinancial risk, managers should be mindful of the fact that specific control mechanisms that play a limited (or elaborated) role in managing financial risk may play an elaborated (or limited) role in managing nonfinancial risk.

Free link of the article: https://papers.ssrn.com/sol3/papers.cfm?abstract_id=4290149#:~:text=In%20impact%20investing%2C%20impact%20risk,i.e.%2C%20negative%20impact%20risk).