Impact Financial Integration |
Impact Ratings & Financial Valuation MetricsWhich investments offer more or less expected impact?
There are many approaches to answer this question, and each comes with a different set of advantages and disadvantages. At Impact Frontiers, we focus on a methodology called an impact rating.1
An impact rating is a weighted sum of indicators that collectively cover multiple dimensions of impact, such as the number of people reached, how underserved those people are, and how much each individual is affected. Impact ratings can also cover environmental impacts such as reduced carbon emissions or avoided deforestation. The resulting impact rating then can be compared to impact ratings of other investments, and to quantitative measures of investments’ expected or actual financial performance.
Investors’ impact ratings encompass two factors. The first is the expected social and environmental impacts of the underlying enterprises on people and the planet. The second is the expected contribution of investors’ specific investments toward those impacts. This is variously called investor contribution, investment impact, and additionality.
The weights applied to each indicator may reflect the importance of the impacts to stakeholders, such as consumers, employees, and community members of investees. The weights may also reflect investors’ impact priorities, such as raising incomes of low-income populations or advancing gender inclusion.
Impact ratings make it easier for investors to obtain a more complex understanding of impact that goes beyond simple scale metrics such as “number of people reached.” Even among a set of possible investments already screened for positive impact, ratings can help investors to compare the different expected impact profiles of different investments and form a judgement about which offer the greatest expected impact.
Genevieve Edens, WaterEquity
Like any predictive tool, impact ratings are imperfect and subject to the availability and quality of data. They work best as part of a larger approach that includes secondary research, direct feedback from stakeholders, impact monitoring during the investment ownership period, and ex-post impact evaluation. Investors should monitor and evaluate the investments that the ratings help select to verify whether the expected impact occurs and refine their rating methodology based on what they learn.
Some investors are understandably reluctant to reduce the complexity of impact to a number. The reason to do so is not that quantitative approaches are intrinsically more rigorous than qualitative; they are not. The reason is rather that doing so increases the clarity of organizations’ impact goals and the quality and consistency of decision-making, and facilitates comparisons between the integrated impact and financial performance of different investments by articulating both dimensions of performance in a common format. Investors operate in a highly numerate financial context. If impact is to enter the financial equation, it must enter that equation in quantitative terms.
Catherine Dun Rappaport, BlueHub Capital
Financial Preference Rankings
To complement their impact ratings, investors can select a financial valuation metric to estimate which prospective investments offer more or less expected risk-adjusted financial return.
Many investors already have asset-class specific methods of financial valuation (e.g., net present value, internal rate of return, multiple of invested capital, or risk-adjusted return on capital). Not all investors calculate a single number that represents the expected risk-adjusted financial value of the proposed investment at the time of approval. Some instead use one or more hurdle rates or ‘screens’ based on credit risk score, transaction size, and other factors.
Some lenders use NPV to quantify the dollar value of financial concession, if any, that is implicit in certain transactions. The rationale is that if a loan has a negative NPV to the lender, that loan is economically equivalent in value to a grant in the amount of the negative NPV. It can be thought of as the “price” at which investors are purchasing impact.