Impact Investing: Navigating Risks For Sustainable Returns

Impact investments are a new and evolving form of investment that seeks to generate both financial returns and positive social or environmental impacts. They are designed to address global challenges such as poverty, inequality, and climate change by channelling capital toward ventures that create sustainable solutions. While impact investing has gained traction among investors, it also comes with a unique set of risks.

One of the primary risks is the possibility of not achieving the desired impact. This could be due to various factors, such as poor investment design or execution, or the complexity of the issue being addressed. Additionally, impact investments may face financial risks, including the risk of financial loss, market volatility, liquidity issues, and currency risk.

Another risk lies in potential political or regulatory changes that could adversely affect the investee company, leading to financial losses for investors. Negative publicity, mission drift, and operational challenges related to management, governance, or technology are other factors that impact investors may encounter.

Despite these risks, impact investing remains an attractive option for investors who want to contribute to global solutions while generating financial returns.

Market volatility, liquidity, and currency risk

Market Volatility Risk

Market volatility risk refers to the potential losses that impact investors may face due to fluctuations in the financial market. Impact investments, like any other investment, are susceptible to market volatility, where the value of investments can vary from day to day and year to year. This volatility can lead to unexpected losses for investors, especially if the market experiences a downturn. It is important for investors to understand and monitor market volatility to make informed decisions and manage their risk exposure effectively. Diversification and long-term investment horizons can help mitigate the impact of market volatility on investment portfolios.

Liquidity Risk

Liquidity risk is the risk that impact investors face when they are unable to sell their investments quickly enough to meet their financial obligations. Impact investments are often made in emerging markets or sectors, which can be more risky and volatile than traditional investments. As a result, investors may struggle to find buyers or be forced to sell at a loss if they need to liquidate their investments quickly. Proper due diligence, thorough research, and a long-term investment perspective can help impact investors navigate liquidity risk successfully.

Currency Risk

Currency risk, also known as exchange rate risk, arises from fluctuations in foreign exchange rates. Impact investments, particularly those made in developing countries or emerging markets, are often denominated in currencies other than the investor's domestic currency. Adverse movements in exchange rates can lead to financial losses for impact investors when they convert their investment returns back into their domestic currency. Currency hedging, diversification across multiple currencies, and a careful assessment of currency risks are essential tools for managing this type of risk.

While market volatility, liquidity risk, and currency risk are significant considerations for impact investors, they can be effectively managed through careful planning, diversification, and a long-term investment perspective. These risks are inherent in the investment landscape, and impact investors should incorporate them into their risk management strategies to optimize their financial performance and achieve their desired social and environmental impact.

Management, governance, or technology issues

For instance, a key risk lies in the potential for mission drift, where a company or organisation shifts its focus away from its initial social or environmental mission to prioritise financial returns instead. This could occur due to a change in management or a corporate acquisition, leading to a new set of priorities that negate the positive impact that was originally intended.

Another risk is negative publicity, which could occur if an investee company fails to live up to its social or environmental promises or becomes embroiled in a scandal. Negative publicity could not only lead to financial losses for investors but also damage the reputation of the entire impact investing industry.

The lack of standardisation around impact reporting and measurement also poses challenges for investors. It can be difficult to accurately compare different investments and assess their riskiness due to the intangible nature of social and environmental impacts. This lack of standardisation extends to the broader impact investing industry, making it difficult to define and track what qualifies as an impact investment.

Furthermore, impact investments are often channelled into emerging markets and sectors, which can be more volatile and risky than traditional investments. This increases the complexity of due diligence processes, as it may be challenging to obtain accurate information about companies or projects in these contexts.

Finally, the relatively novel nature of impact investing means there is a lack of data and established players in the field. This inexperience and paucity of data can heighten the risk for investors, making it challenging to navigate the unique set of risks and uncertainties associated with impact investing.

Political or regulatory changes

Political changes refer to shifts in government policies and priorities, which could directly or indirectly influence the business environment. For instance, a new government may introduce laws or regulations that hinder a company's ability to operate effectively, thereby impacting its bottom line. This could be in the form of increased operational costs, restrictions on certain activities, or changes in tax policies. For example, a change in government could result in the enactment of policies that are less favourable for environmental initiatives, making it harder for companies in the clean energy sector to thrive.

Regulatory changes, on the other hand, refer to modifications in the rules and guidelines that govern businesses. These changes can be industry-specific or have a broader impact. For instance, new environmental regulations could make a company's products or services less desirable or competitive, affecting their market performance and financial returns. Similarly, changes in labour laws or safety standards could increase operational costs and impact a company's ability to conduct business effectively.

The impact of political and regulatory changes on impact investing is particularly notable when investments are made in emerging markets or developing countries. These markets often present additional risks, including political risk, currency risk, and liquidity risk. The business environment in these countries can be more volatile and susceptible to political changes, and the regulatory landscape may be less stable or predictable. As a result, impact investors need to be particularly vigilant and proactive in monitoring and managing these risks.

To mitigate the risks associated with political and regulatory changes, impact investors can employ several strategies. These include conducting thorough due diligence, diversifying their investments across different sectors and geographic regions, and staying informed about the evolving regulatory landscape. Additionally, building strong relationships with local partners and stakeholders can help navigate regulatory complexities and adapt to changing political priorities.

In summary, political and regulatory changes are a significant risk factor in impact investing, and they can influence the success and financial returns of such investments. By being aware of these risks and implementing effective risk management strategies, impact investors can make more informed decisions and mitigate potential challenges.

Negative publicity

The lack of standardized impact measurement methodologies in the impact investing industry can also contribute to negative publicity. Without standardized definitions and metrics, it is challenging to compare different investments and assess their relative riskiness. This makes it difficult for investors to know whether an investment is truly impactful, potentially leading to negative perceptions if the expected social or environmental outcomes are not achieved.

Furthermore, the emerging nature of the impact investing market increases the risk of negative publicity. As impact investing is still a relatively new field, there is a lack of data and established players, making it challenging to assess the long-term viability of this asset class. This uncertainty can attract negative attention, especially if early impact investments do not generate the intended positive impact or meet financial expectations.

Additionally, impact investments are often made in emerging markets or sectors, which can be riskier and more volatile than traditional investments. Insufficient due diligence or a failure to understand the risks involved in these markets can lead to negative publicity if investments underperform or fail to deliver on their social and environmental promises.

To mitigate the risk of negative publicity, impact investors must conduct thorough due diligence, carefully assess the risks, and monitor their investments' social and environmental performance. Standardized impact measurement methodologies and increased transparency can also help improve the perception of impact investing and reduce the likelihood of negative publicity.

Mission drift

Impact investors often seek to balance financial gains with creating positive social and environmental change. Mission drift can occur when the pursuit of financial returns overshadows these social and environmental goals, leading to a shift in the organization's focus and priorities.

To prevent mission drift, impact investors should carefully consider the legal structures for their investments, such as limited liability companies or limited partnerships, depending on the nature of the investment and their objectives. Additionally, staying informed about evolving regulations and adapting their strategies accordingly can help investors navigate the regulatory landscape and maintain their focus on social and environmental impact.

Frequently asked questions