Once a small philanthropic area, impact investing is fast becoming an option for institutions seeking to achieve market-rate returns while generating positive results in a broader sense.
A lack of data makes it hard to accurately gauge the growth of this part of the investment spectrum, but research by the Global Impact Investing Network has attempted to put a figure on the size of the market. Its Sizing the Impact Investment Market report, published in April, suggests that it stands at $502 billion across 1,340 organisations globally.
Private equity firms have been watching investor appetite for the strategy with keen interest, and giants such as KKR, TPG and Bain Capital have launched large impact funds in recent years. But what is happening in private debt?
The growing importance of the asset class in impact investment is perhaps illustrated by the GIIN publishing a report on its financial performance last year as a first step towards “developing benchmarks for investors and fund managers to understand and compare the performance of private debt impact investing that use a variety of strategies”. It found private debt and fixed income to comprise the largest asset class in impact investing, at 34 percent of investors’ reported assets under management – higher than real assets (22 percent) and even private equity (19 percent).
A number of mainstream players in private equity are adopting impact investment strategies with a view to generating impact at scale. However, for private debt it occupies a different space. Setting aside US-based community development loan funds, which are run on a not-for-profit basis, the vast majority of private debt impact funds target emerging markets – indeed, only two of the 50 in the GIIN financial performance report did not.
Part of the reason for this is that private debt impact strategies have grown out of development finance institutions’ involvement in emerging markets. Many DFIs started with a focus on debt rather than equity – the US’s Overseas Private Investment Corporation, for example, was established to provide political risk insurance and loans.
Much of the private debt impact capital has been directed at the micro-finance sector, as Amy Wang, investment manager at PG Impact Investments, explains: “While standard private debt fund managers tend to steer clear of financial services plays, activity in the private debt impact market has been underpinned by micro-finance-type investments.” Yet this is beginning to shift. “We are starting to see a slice of fund managers develop more multi-sector approaches,” says Wang. “Where in 2012, these accounted for just 2 percent of the private debt impact market, multi-sector strategies now make up about 10 percent of the market.”
The issue, she says, is that micro-finance has traditionally been underpriced: “Many African businesses have been able to attract funding at lower rates than their governments and so the loans have been low yield. While write-offs are low at around 3 percent for subordinated debt and 1 percent for senior, if the asset class is to attract more institutional investor attention it has to demonstrate higher yield.” Multi-sector funds, by contrast, are a much more investible prospect, as they should be in a position to price risk more accurately, while offering investors diversification benefits.
The UK’s CDC Group is watching the growth of private debt impact strategies closely. The group focuses on equity investments but has a corporate debt arm that lends directly, and is looking at developing a private debt fund investment strategy.
“Over the past 12 months, we’ve seen more fund managers marketing private credit investment strategies with an impact objective,” says Richard Palmer, head of corporate debt. “Institutional investors are also coming to a realisation that while these strategies may not provide the kind of upside that equity can offer, downside risk can be mitigated, historical performance has been reasonably good and debt investment can still successfully deliver high-impact outcomes.”
Institutions with an impact focus on emerging markets may also be warming to private credit, as exit routes in their private equity portfolios have been slower to emerge than anticipated. “One of the advantages of private debt over equity in these situations is that they are not reliant on an exit event such as an IPO to realise returns,” says Palmer. “Equity exits have been difficult to achieve in some emerging markets, but an amortising tranche of debt is self-liquidating over time.”
The growth of private debt impact strategies in emerging markets also looks set to be driven by a similar trend to that seen in more developed countries, with banks retrenching from parts of the lending market as a result of increased regulations and restrictions on their use of capital.
To attract funding to fill this gap, private debt funds recognise that they need explicit impact objectives. “We see private debt funds in our markets emphasising development impact to attract anchor investment from DFIs,” says Palmer. “DFI anchoring, and the minimum environmental, social and governance requirements that come with this, will hopefully then mobilise additional commercial investor interest in the fund.”
For developed markets, too
Yet while growth is likely to centre around emerging market opportunities, at least in the short term, there is also some movement in developed markets. Last year UK asset manager M&G launched its first multi-sector private debt impact fund. Seeded by M&G Prudential, Big Society Capital and the Swedish Foundation for Strategic Environmental Research, the £44.5 million ($56 million; €50 million) fund has since attracted a handful of other investors.
“We are a large investor in private debt,” says Richard Sherry, manager of the M&G Impact Financing Fund. “And we have invested in a range of impact assets over the years. Many others have launched ESG funds, but we wanted to create a private credit fund that targeted positive environmental and social impacts and that would appeal to mainstream institutional investors.”
“Over the past 12 months, we’ve seen more fund managers marketing private credit investment strategies with an impact objective”
The fund is therefore broad in its remit. “Impact strategies often aren’t designed to suit institutional investors,” he says. “To attract them, we have to provide an attractive return and private debt is well suited to that, given its higher returns than public credit strategies. We also need to offer investors diversification. The few private credit impact funds that invest in developed markets tend to focus on specific sectors, such as renewables, but many institutions seek to invest in a more diversified set of opportunities.”
The fund is largely pan-European, though it has selectively invested in the US and Australia. Its strategy is centred around 12 thematic areas such as green buildings and transport, sustainable food, agriculture and forestry, renewables, education and economic inclusion. It has already provided financing for the regeneration of London’s Greenwich Peninsula, for solar projects in the US and for UK housing associations.
So, are we likely to see mainstream private debt players enter the impact space in the near future? Although there is scope for growth, there are likely to be limitations.
“One of the constraints in emerging markets may well be the number of investible opportunities, not only from a risk perspective, but finding borrowers that are aligned with the impact principles of the investor,” says Palmer. “Origination and structuring of private debt investment can take as long as equity investment, and you need to be selective.” Having an on-the-ground presence is also important, he adds.
In developed markets, the issue concerns the ability to build adequately diversified portfolios. “We are at the start of a wave,” says Sherry. “As investors become more comfortable with impact strategies, the demand for funds will increase. However, funds need to launch products that are sufficiently broad, and not many have the breadth of experience and coverage necessary.”
The wave looks set to grow. How big it becomes will depend on funds’ next steps.