The case for a lower return on investment

The growth of impact investment strategies has been noteworthy in recent years, with private equity giants such as Apollo and KKR launching impact-branded funds. But it’s equally striking that the marketing for impact funds rarely highlights the trade-offs between social and environmental impact and risk-adjusted returns.

Instead, impact fund managers tend to promise investors the best of both worlds: the same level of return as you’d expect from conventional financial assets, but with much greater positive effects on people and the planet.

For today’s edition I spoke to the head of the UK’s national development finance institution, who argued that if investors really want to maximise their positive impact, they need to be willing to lower their return expectations.

Does this approach have any chance of catching on among private-sector fund managers, and would their investors be willing to sacrifice returns in pursuit of impact? Let us know your thoughts at moralmoneyreply@ft.com.

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impact investing

Should impact investors target ‘sub-commercial’ returns?

When Nick O’Donohoe took charge of the UK’s development finance institution in 2017, it had achieved an average annual investment return of 12.8 per cent in pound sterling terms over the previous five years.

During his time at the helm of the Commonwealth Development Corporation, now rebranded as British International Investment, that figure has fallen to 5.2 per cent.

For most investment bosses such a slump in returns would be disastrous. In O’Donohoe’s case, however, it reflects an explicit strategy aimed at sacrificing returns to pursue impact. In fact, it looks like the returns have been slightly stronger than intended.

The CDC was set up in 1948 with a mandate to do economic good “without losing money” — thus becoming, O’Donohoe suggests, the world’s first impact investment body. With total assets of £7.3bn ($9.6bn), BII now has investments in 1,580 companies in 65 African and Asian countries.

But in the years preceding O’Donohoe’s appointment, it had been criticised for pursuing commercial returns, in projects and places that looked to some like inappropriate recipients of development finance. Critics questioned investments in hotels and casinos, and in relatively prosperous nations such as China.

Under O’Donohoe, BII — which received its new name in 2022 — has set a new annual return target of “at least 2 per cent”: far below what most investors strive for. Recent investments have ranged from a solar project in Sierra Leone to an Indian company providing loans to “microbusinesses”.

O’Donohoe, who will step down from his position later this year aged 67, reckons that it would give a big boost to global development if more investors were willing to lower their return expectations for high-impact investments.

“We have to earn a positive return,” O’Donohoe told me in an interview. “But it’s not what you would describe as a commercial risk-adjusted return for the level of risk we take and the type of places that we go.”

O’Donohoe’s bluntness on this point contrasts with the promise of many private sector impact investors, to pursue environmental and social goals without sacrificing returns — an approach about which O’Donohoe “has always been, if I’m honest, a bit sceptical”.

“If you really want to generate really maximum impact, you’re going to have to make some choices which are going to lead you, almost inevitably, over a period of time, across a portfolio, to a less than optimal risk-adjusted return,” he said.

Development finance institutions around the world have faced pressure to take on more risk to drive impact — most notably the World Bank Group. Its new leader Ajay Banga has pledged to make more aggressive use of the institution’s balance sheet and take on riskier investments that will help draw in private sector capital to developing nations.

“I think it was fair for people to point out that maybe the balance was skewed in the direction of being too conservative, too risk averse, too worried about our credit ratings,” O’Donohoe said. “The pendulum’s definitely moved.”

How climate change factors in

Like other development institutions, BII has made climate change a major consideration over the past several years. All its investments must now be aligned with the goals of the Paris Agreement, and 30 per cent are categorised as climate finance.

This objective can have trade-offs, however, with BII’s separate goal to increase the proportion of its investment going to the poorest countries. “The pressure to do more climate finance inevitably pushes you towards more developed countries”, where there are more viable green energy projects, O’Donohoe said.

Meanwhile, campaigners have criticised BII over its continued holding of fossil fuel-related assets in various African countries. O’Donohoe said these investments had “reduced dramatically, both on an overall basis and relative to our renewable investments”, since BII announced a new policy in 2020 restricting future fossil fuel investments. BII had a “responsibility to make sure we exit those [assets] appropriately, effectively and in a way that makes sense for the taxpayer”, O’Donohoe added.

What taxpayers have to gain

The question of how international development assistance benefits the UK taxpayer has been a contested one during O’Donohoe’s time at BII. In 2020, then-chancellor Rishi Sunak announced that the UK would lower its foreign development spending to 0.5 per cent of GDP — having previously been one of the few developed countries to meet a shared pledge of spending 0.7 per cent of GDP. That reduced the flow of government funding to BII — although since it relies primarily on investment returns, the impact was far less than for other parts of the UK aid system.

The rebrand to BII was then announced by then-foreign secretary Liz Truss, who promised that the renamed body would boost the UK’s international influence and counter Chinese efforts to grow its own global clout through development finance.

O’Donohoe said it was appropriate for the institution’s name to reflect its nationality, and that “UK taxpayers should get some credit” for the work done by BII.

And while he stressed that “we don’t see ourselves as being in competition” with China or other nations, he noted that the global jostling for geopolitical influence was helping to drive government interest in development finance. “I’m tempted to say, if it helps get more money into Africa . . . not to complain about it,” he said.

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