The Responsible Hand: Overcoming the Shortcomings of Impact Investing
For impact investing to truly harness the power of the market, we need to directly align shareholders’ value with both social impact and profit.
Despite all the hype around impact investing—allocating capital to businesses that generate both a positive social impact and a financial return—there is little evidence of its effectiveness. Impact investing, like any resource allocation mechanism, can be truly effective only if it has the following components: direct incentives to motivate impact, direct incentives to achieve impact efficiently, and clarity on the suitable trade-off between the promotion of economic and social returns. These are necessary conditions for the market to guide efficient resource allocation, but current instruments within the impact investing arsenal all suffer from the lack of one or more of these components. An idea that emerged out of the Massachusetts Institute of Technology in 2011 provides a theoretical solution to the challenge: Socially Responsible Equity (SRE), a concept that Nobel Laureate Amartya Sen says “shows considerable originality and imagination.”
SRE is a form of corporate ownership in which shareholders can collect only a portion of the current and future cash flows. The level of measured social impact by the corporation determines the size of this collectible portion. In other words, impact controls the percentage of the profits available to shareholders that is distributed as dividends. First presented at the 2011 European Business Ethics Network Annual Conference in Dublin, SRE was viewed to have much applicability for enterprises that can both internalize enough financial returns to secure market rate investment and make a huge positive impact on society.
If there are no direct incentives for maximizing social impact, such as linking investment returns to the amount of impact, impact is bound to be limited, especially in the long run. Currently, flexible-purpose corporations or benefit corporations allow managers and directors some legal freedom from the demand for maximizing profits. In states like California, Hawaii, Maryland, New Jersey, New York, Virginia, and Vermont, executives of benefit corporations can make decisions that shun profit-maximizing options as long as they can justify them with social benefit. The fiduciary duty of these directors to create social impact is limited to passing some minimum threshold set by some third party certification process. These institutions and their associated profit distribution rules do not incentivize these managers and directors to think more “aspirationally” about creating a very profitable company that drives the greatest possible impact—there is no financial motive for increasing social impact. Furthermore, the organizational drive for social impact can vary over time and depending on board members. It is prone to the shifting passions and motivations of incumbent managers and directors. The value of a corporation to its owners must be tied directly to the amount of impact it generates (in addition to profit). SRE achieves this goal by making distribution to shareholders contingent on impact.
Then there is the issue of efficiency. While investors in Pay for Success and Social Impact Bonds are incentivized to pick grantees that can deliver impact, they are not directly incentivized to pick ones that can do so in the most cost efficient manner. Also, these instruments can be effective in accomplishing short-term social goals, such as reducing the recidivism rate of a particular cohort of former inmates, but neither induces grantees to invest, longer term, in on-going social goals. One strength of the market is that it forces corporate efficiency by rewarding profit making; it cuts unnecessary costs, yields highest-factor productivity, stimulates investments, and reduces waste. Just as conventional corporate ownership does, SRE gives corporations every reason to operate efficiently and profitably in the long run. While incentivizing impact, SRE ensures that the value of ownership is still critically dependent on profitability. Sen comments that SRE could be very useful in “getting the market to take note of broader goals—that is, broader than self-centered profit maximization—…to reconcile the pursuit of social objectives, without losing the dynamism that goes with the market mechanism.”
Social enterprises often bring together two types of investors: those who primarily seek social impact and those who primarily seek financial return. Many advocate a blended value approach, or ask enterprises to adopt the double or triple bottom line. These often end up creating a daunting task for managers who are left to determine what the right “blend” should be. Shareholders may all place different relative weights on social impact and financial returns, and the set of owners might change as shares change hands. The information asymmetries, ambiguities, and instabilities around what the “correct blend” for shareholders is will generate obstacles to efficient corporate governance, as well as other inefficiencies. SRE removes these issues by directly stabilizing and stipulating the balance between profits and social impact that constitute shareholder value.
SRE provides a method by which impact investing may fully leverage the market’s ability to efficiently drive social impact, and its practice will be a great mark of progress.