Chief Investment Officer Simon Chisholm talks to DG Publishing and states the case for investing with impact.
In recent years, two important trends have begun to converge. The first is the well-established move by mainstream institutional investors to integrate Environmental, Social and Governance (ESG) factors into their investment criteria. The key motivation, now largely beyond dispute, is that factoring that additional information into investment decisions can reduce risk.
The second trend has been the maturing of Impact Investing, which goes beyond ESG in seeking to make investments which actively (and measurably) contribute to social and environmental solutions. Prior to this, there had been a mis-perception that impact investment was smaller, higher risk and necessarily required a trade-off of return for impact. However, an increasing number of impact investment strategies have now emerged that can evidence scale, good risk-adjusted return and, interestingly, a number of risk mitigating factors in an institutional portfolio. This has shown how some forms of impact investment can also fit well with the scale and fiduciary duties of pension funds.
Resonance has been focusing on this aspect of impact investing during this interesting period, particularly through the use of property fund investment. As our funds in this area have built scale and track record, there are a number of learnings coming through. In this article I have tried to boil these down to the six statements below, unpacked with some examples, which give different perspectives on how impact investing can be a valuable diversifier and risk mitigator for institutional portfolios.
Focus on fundamentals
Pick models with strong underlying economic logic which address market asymmetries.
Far from constraining the opportunity set for investment, impact investing can actually open up good market opportunities, which traditional investment approaches have ignored or undervalued. A good example of this has been provided by Resonance’s property funds focusing on homelessness “moveon” accommodation for families and individuals stuck in expensive and inappropriate temporary accommodation.
At the core of this strategy is the strong economic logic that a huge proportion of this tenant group are ready for independent living and can make excellent tenants, but that private sector landlords lack the information and experience to make that judgement and manage that tenancy well. Homelessness organisations have that information and experience, and those with property management skills can therefore create economic value by serving this undervalued tenant group. And it’s a huge market – 80,000 individuals and families in temporary accommodation across the UK, representing a housing stock need of around £20 billion. And that is before considering the application of similar investment approaches to more diverse needs, such as tenants with learning disability, which can exhibit similar economic logic and focused impact.
Align impact and economics
Look for impact and economic drivers that are well aligned.
The strongest impact investment models are those where the impact and economic drivers are aligned, growing together in a mutually supportive way. Continuing with the example above, the selection of residential properties to invest in for tenants at risk of homelessness uses a number of important criteria which drive the impact.
Properties should be normal homes on normal streets “pepper-potted” around major cities (rather than big blocks, which replicate hostel environments). They should have good transport links and be in locations which feel safe and even aspirational. These impact drivers are well aligned with the economic drivers for creating a well diversified portfolio (avoiding excessive single asset concentration risk) and cherry-picking properties with good locational characteristics and potential for appreciation (also reducing risks of depreciation in downturn scenarios). This kind of alignment ensures that as an impact investment scales up there is no inherent tension between impact and economic goals – in fact, the two reinforce each other.
Choose your partners wisely
Find strong partners and allocate risk where it is best managed.
Not of course any great revelation, but as true of impact investment as in other areas of life. As Resonance, we have put particular focus on partnering with social enterprises – organisations which are skilled in delivery of both impact and business outcomes. Those partners need to have the organisational strength and experience to manage risks well – for instance, taking on specific tenant risks like voids, which they are best placed to manage. And for impact at scale they also need to have sufficient scale and reach themselves.
A case in point, Resonance has partnered for many years in London and the South with St Mungo’s, a homelessness charity and Registered Provider with over 50 years of experience in managing pathways for individuals and families out of homelessness, and a strong balance sheet. Now consider one of the biggest risks for institutional investors investing in the private rented sector – the reputational risk of being associated with private landlord behaviour which is not in the interests of tenants. What better landlord to back than one which has at the heart of its operational and impact model, a measurable focus on providing positive outcomes for tenants?
Avoid hidden risk
Structure to avoid mismatches of revenues and liabilities
Building on the points above, and getting a bit more technical, it has been interesting to see how some more traditional forms of investment have embedded inherent risks in their investment models, particularly through the mismatch of revenues and liabilities in the structuring of contracts: for example, very long term leasing arrangements which embed inflation clauses that do not match the underlying revenues of the counterparties signing them.
The UK Housing Regulator has recently begun to highlight this risk, which has been inherent in the market now for some years. By contrast, the property funds which Resonance has developed for scaling housing provision in areas such as homelessness and learning disability, because of their impact strategy, have spent more time on developing lease structures which reflect the underlying revenue streams of the organisations backing them. It is still possible to demonstrate the strong inflation correlation of these revenue streams with inflation over the medium to long term and that, coupled with the better fit with the users of those leases, is surely a lower risk way to invest in property than relying on paper promises of inflation clauses, which may have unintended and unexpected consequences.
Apples and apples
Make sure benchmarks are comparing like with like.
Again, a general principle but one with specific application to impact investment which we have seen in practice. Going back to the introduction to this article, there have perhaps been two opposite misperceptions in the market – that impact investment either necessarily results in a trade-off between impact and return, or, perversely, that impact investments should be expected to generate higher returns than an equivalent traditional investment in the same asset class due to additional “risk”. Both are of course wrong, and the simple test for institutional investors is whether an impact investment generates a good risk-adjusted return relative to the returns available for equivalent risks elsewhere.
For example, an impact property fund which invests in diversified, existing stock, without development risk or gearing risk and with well structured, long term leases, can deliver the same expected returns as an equivalent mainstream residential property fund. Those returns will be lower than potential returns from riskier property investment based on development risk or using gearing to increase exposure to property market cycles. But both have a place in a diversified portfolio.
Don’t overlook portfolio diversification benefits.
Continuing from the previous point, since impact investments can deliver good risk-adjusted returns at scale, compared to equivalent risk assets, it is important to then consider their value as part of a diversified portfolio. There is particular focus here on the potential for impact investments to demonstrate a lower correlation with factors affecting traditional investment returns, and therefore to have a portfolio diversification benefit beyond just an analysis of their stand-alone risk/return.
The most obvious example of this has been the growth of Social Impact Bonds (SIBs) where the return profile of the investment is entirely linked to the impact outcomes, and is therefore highly uncorrelated with broader economic factors which tend to be highly correlated for the rest of a traditional investment portfolio. However, the same can also be true for impact investment approaches in other asset classes.
As discussed previously, property impact funds can take a different approach to building residential property portfolios and have different revenue drivers – both highly attractive in themselves – compared to traditional residential property investment. But these differences also mean that they provide a valuable diversifier – as an illustration, balancing the traditional focus on property in prime areas, with potential high price volatility, with a more diverse portfolio around the periphery of major cities.
In conclusion, whilst many of the above principles could be said to apply across any form of investing, the interesting thing is how an impact investment approach is not only consistent with those principles but can in fact sharpen their application. Not surprisingly, this is beginning to generate significant interest on the part of institutional investors in how they can go beyond ESG and incorporate the benefits of some impact strategies into their portfolios.
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Resonance Impact Investment Limited, a subsidiary of Resonance Limited, is authorized and regulated by the Financial Conduct Authority (FCA). Firm number 588462.
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