Why is impact investing slapped with an ‘impact measurement’ tax?

Never call yourself an impact investor.

It’s not uncommon for investors to have motives beyond financial returns. Many asset allocators invest in sectors like education, defence or healthcare because they value their societal impact.

They don’t charge you extra for investing in those.

LPs in defence-focused funds, for example, have no problem accepting that what they’re investing in is really “defence”. They can simply look at the portfolio and say “Ah, yes, these are defence companies”. No one demands a bespoke framework to measure how ‘defence-oriented’ these companies are or insists on expensive third-party verification of their defence activities.

But if you call yourself an impact investor or step on the impact landmine in some other way (eg, by investing in startups in low-income countries), you’re slapped with the “impact tax”. Suddenly, LPs can’t just look at your portfolio and say “Ah, yes, these are startups in low-income countries. Yes, this is impact.” Now, they need you to prove it, and it’s expensive.

The current industry euphemism for the impact tax is “impact measurement and management” (IMM).

According to a survey of 278 impact investors by the Global Impact Investing Network in 2020, the average impact investor allocated 12% of their overall budget and 25% of staff time to IMM, with 53% of them hiring external consultants. That’s a lot of money and staff time!

The average impact investor allocates 12% of their overall budget and 25% of staff time to IMM. That’s a lot of money and staff time

Imagine investing in a healthcare fund where the investment team says, “The first three quarters went okay, but for Q4 let’s change things up. Instead of investing, let’s catalogue all the end users for every company we’ve invested in, hire photographers to get inspirational pictures of people who look like medical patients, and bring in a consultancy to develop our own special ‘Health Outcomes Framework’ and put it all together in a 50-page report.”

This sounds ridiculous, but it is exactly what’s happening in the impact investing industry. 

• Read: ‘Dangerous errors and misunderstandings’ plague impact investing

Two possible justifications

Why is impact investing uniquely taxed in this way? In theory, IMM serves two functions that justify its enormous cost.

The first is that it helps GPs – that is, the people who manage the funds – to make better decisions around impact. The second is that having a quasi-regulatory framework for impact investing makes it easier to attract capital.

Does IMM help GPs make better decisions around impact?

No. GPs don’t use IMM to make investment decisions. For them, it’s forced marketing spend. It’s paperwork they fill out after they’ve already made an investment decision – paperwork they only do because it helps them get funding.

You can figure this out yourself by asking any impact GP how IMM informs their investing decisions (assuming you’re not an LP who might give them money). No GP has a story that goes “We were/weren’t going to invest, but then we ran the company through our IRIS+ framework and decided to change course.”

You could look at the GIIN survey results, which show that by far the most common thing GPs measure in their IMM practice is “what outputs occur”. The majority do not measure how much effect occurs, and the vast majority do not measure the length of effects or whether the effects would have occurred without their intervention. In other words, they don’t analyse impact. All they do is record the “what”. They’re simply gathering pieces of data they can point to, to say “see, we’re doing impact” (for example, jobs created). In the same survey, GPs say their primary use of data is “reporting to stakeholders”.

GPs say their primary use of data is “reporting to stakeholders”

Even the very impact consultants who force IMM on the industry immediately drop the fiction that IMM is about “maximising impact” when they’re trying to sell their services to GPs. Go look at how leading impact consultants advertise their services. Notice how the value proposition is mostly or entirely about using IMM as a marketing tool, not about using it for impact analysis.

Should impact investing have a quasi-regulatory framework?

In a piece in Impact Alpha, the CEO of an impact consultancy which recently raised $10m in venture funding compared impact investing to car manufacturing, saying that until car manufacturers standardised and agreed on safety protocols, the industry couldn’t mature. The same is needed for impact investing, she says.

But there’s a big difference between these things. Cars are regulated because they’re massive metal machines that can go 100 miles per hour. They’re extremely dangerous. Even with regulations, there are more than a million car deaths every year.

What are the actual risks associated with impact investing? The investing part is already regulated just like any other form of investment. Why is the impact part regulated to the tune of 12% of a fund’s budget? A tax this big should be a response to a serious risk of harm. So far I haven’t heard anybody, anywhere make the case for any harm that comes from the “impact” part of investing.

The investing part is already regulated just like any other form of investment. Why is the impact part regulated to the tune of 12% of a fund’s budget?

Tolls on both sides

I would argue that what we’re witnessing from impact consultants is pure rent-seeking.

Rent-seeking is an economic term describing behaviour in which entities earn income not by providing value, but by manipulating the system to extract some kind of toll.

In this case, impact consultants extract a toll from both sides of the market – from GPs who manage impact investment funds and the LPs who provide them with capital. To GPs, they say, “Hire us to independently verify your impact performance for the approval you need to secure funding”. To LPs, they say “Hire us to make sure you’ve covered your a** when it comes to impact measurement, which is really hard to do.”

• Opinion: Forget pie-in-the-sky measurement methods – impact investing just needs third-party certification

If impact consultants were simply meeting a demand on both sides of the transaction, their role might be justified. But they manufactured the demand themselves. And the existence of the demand is a huge net negative for the impact industry.

The primary selling point impact consultants offer to LPs is that without their consulting services, LPs risk investing in GPs who misrepresent their impact, either through deceit or because impact is so hard to measure.

Impact consultants are arsonists selling us fire extinguishers

In other words, while calling themselves champions of the impact industry, impact consultants drum up demand for their services by claiming that the industry is full of fraud and incompetence. They’re arsonists selling us fire extinguishers. Their very existence undermines the industry and prevents capital from flowing toward worthwhile causes.

For emerging GPs, impact consulting is like a protection racket. If you pay the consultants, they’ll protect you. If not, well, you must be one of the bad ones they’re always warning LPs about.

For large and established GPs, the situation is closer to regulatory capture. It’s in their interest to keep barriers to entry high. An established GP managing assets worth tens or hundreds of millions of dollars is happy to pay impact consultants $100,000 a year to keep money flowing to them rather than to new entrants who can’t afford the protection price.

If new impact GPs have to spend tens or hundreds of thousands of dollars to hire impact consultants before getting funding, how will we get new impact firms?

If impact consultants and the advocacy organisations they sponsor keep convincing large asset allocators that impact investing is hard to navigate, risky, and riddled with fraud and incompetence, how are we supposed to bring in more capital?

The path forward for our industry is straightforward. Operationally, we should do what every other industry does.

GPs of other industry-focused funds are not expected to spend 12% of their budget and 25% of their staff time proving that their investee companies are really in the industry the GP says they’re in. We shouldn’t be doing that either. We should spend approximately 0% of our time and budget doing that. Every LP can find this information on their own from even the most minimal financial diligence process.

Culturally, we need to reject the premise that ‘impact’ requires costly measurement. Nobody in our industry should be asking “How do you measure impact?” or “What’s your impact framework?”. When those questions do get asked, the answer should come in the form of a three-sentence response rather than the form of a $50,000 framework from a name-brand consultancy.

• Jesse Clain is a general partner at The Takeoff Fund and is based in Somaliland.

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