Impact Financial Integration | Implications for Investment Decision-MakingIntegrated data and analysis can inform investment decision-making rules that better optimize impact and financial performance
Introduction
Investors develop various methods of using integrated data and analysis to inform decision-making on individual transactions. Three methods emerged as the most common in the first Impact Frontiers cohort:
- Benchmarking Using Portfolio Scatterplots: Some investors consider transactions’ expected impact relative to their expected risk-adjusted financial return, simply by estimating where proposed transactions would fall on their portfolio scatterplot.
- Benchmarking Using Radar Charts: Some investors create new tools that benchmark financial and impact characteristics of proposed transactions against those of similar transactions already in the portfolio. Investment teams provide these benchmarks as part of the deal proposal to investment committees, who in turn are unlikely to approve transactions that compare unfavorably to the existing portfolio on impact valuation, financial valuation, or both.
- Hurdle rates: Other investors articulate impact-financial hurdle rates that define the minimum impact rating they would require of transactions with a given financial valuation. These hurdle rates are typically on a sliding scale. That is, these investors are generally willing to provide greater flexibility on expected risk-adjusted financial return for the investments with the highest impact ratings, while requiring greater profitability of investments with lower impact ratings. A hurdle rate can be a hard-and-fast rule or can be used more as a guideline to which exceptions can be made.
All three methods enable investors to quickly decline proposed transactions that compare unfavorably to their existing portfolio on expected impact or financial performance, and to prioritize the highest-impact transactions for approval if financially prudent. Learn more about each method below.
Benchmarking Using Portfolio Scatterplots
Some investors, as part of investment due diligence, simply estimate where new prospective transactions would fall on the impact-return scatterplots of their existing portfolio.
Proposed transactions that are clearly low on impact, on financial risk-adjusted return, or both, can then be screened out early in the deal origination process.
Benchmarking Using Portfolio Scatterplots
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Benchmarking Using Radar Charts
Other investors created radar charts with which to benchmark various financial and impact characteristics of proposed transactions against those of similar transactions already in the portfolio.
Investment teams provide these graphics as part of the deal proposal to investment committees, which in turn are unlikely to approve transactions that compare unfavorably to past transactions on impact valuation, financial valuation, or both.
For instance, one of our partners created the following graphic to benchmark the expected impact of proposed loans against that of existing loans that offered similar levels of expected profitability.
Borrower Performance Against Portfolio Metrics
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Impact-Financial Hurdle Rates
Impact / return hurdle rates quantify organizations’ ability and willingness to provide greater financial flexibility for the investments with the highest impact ratings, while requiring greater expected profitability of investments with lower impact ratings.
IDB Invest Impact Rating (Delta) vs. Financial Contribution Rating (FCR)
*simulated data based on IDB Invest's three business segments; hurdle rate shown in gray
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“IDB Invest’s Impact Management Framework is grounded in a portfolio approach that integrates both impact and financial sustainability into investment selection and portfolio management using two key tools.
First, the DELTA (for Development Effectiveness Learning, Tracking and Assessment), which is a rigorous, fact-based scoring system that assesses the expected positive and negative social, environmental, and economic impact of each investment. At origination, each project is assigned a score ranging from zero to 10, which is tracked and updated throughout implementation. Embedded within this score is an approximation of the economic and social rate of return of each investment, complemented by a stakeholder analysis to ensure that the most important direct and indirect effects are considered, a sustainability assessment, and an assessment of IDB Invest’s additionality.
Second, the Financial Contribution Rating (FCR), which measures the financial contribution of each operation to IDB Invest, based on the risk-adjusted return on capital (RAROC). The FCR ranges from zero to 10 and is based on the concept of Economic Value Added, which translates the RAROC into a dollar amount.
Proposed investments need to meet predefined impact and financial rating thresholds to be approved, with decreasing financial contribution requirements for highly impactful projects. In this way, IDB Invest is able to purposefully build a balanced portfolio across the two dimensions.”
