Impact Investing: When Social Benefits Are in the Contract

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Wharton's David Musto discusses his research on impact investing contracts.

For impact investors, there are two bottom lines, says Wharton finance professor David Musto: making money, and making the world a better place. Katherine Klein, management professor and vice dean for the Wharton Social Impact Initiative, interviewed Musto about his latest research in the field. His forthcoming paper, “Contracts with Benefits: The Implementation of Impact Investing,” co-authored by Wharton adjunct finance professor Christopher Geczy,  Jessica Jeffers of the University of Chicago and Anne Tucker of Georgia State University, examines how social impact can be written into contracts when investors are looking to balance profits with social benefits.

An edited transcript of the conversation follows.

Katherine Klein: What is impact investing?

David Musto: Impact investing is a term that has gained a lot of currency recently. The term itself doesn’t go back that far. It’s usually sourced to about 2007, but it was referring to a practice that had grown significantly to that point. You will hear different definitions, but the definition that I think works best for our research is that impact investing is investing with profits in mind, certainly, but also some other social benefits, some other social purpose in mind. You can think of it as two bottom lines: making money and making the world a better place.

Klein: As a finance professor, what has intrigued you about this topic?

Musto: If you look at financial research and economic research in general, there’s a lot of research on managing other people’s money to make more money. That’s a fundamental activity in the economy. All of us have some of our money being managed by someone else, and what do we think they’re going to do with it? Well, they want to make more money. That is a perfectly fine thing to do; there’s a lot of virtue in that.

But if you think about laying another goal on top of that, then that really changes the relationship in a number of ways. Given the growth in impact investing, it’s time to take a look at how people try to structure these contracts to pursue more than one goal at a time, and then also what happens.

Klein: As you think about the pursuit of these two goals — a social or environmental goal, and a profit goal — is your hypothesis that they are negatively related, positively related, it depends, or there’s no relationship?

Musto: The initial intuition would be that if I am a fund manager looking at all of the ways I can invest your money, there are many different ways. If I trim that down by any method at all, including which of these different ways of investing for profit also serve some other goal, I have shrunk my investment opportunity set, and the best opportunity in that shrunken set is not going to be better than the best opportunity in the full set.

Logically, it could be worse because you have sliced away part of what you could have done. So, the initial intuition would be that that there is a tradeoff involved here. You gave up some possibilities because it’s important to you to serve this additional goal.

Klein: You said that is the initial intuition. Does that mean this is up for investigation?

“Given the growth in impact investing, it’s time to take a look at how people try to structure these contracts to pursue more than one goal at a time.”–David Musto

Musto: Yes, it’s certainly an open question of what actually happens to your pursuit of profit when you add these additional goals, when you limit what you are willing to do. It’s also possible that by picking an investment that serves a particular social purpose goal, this could turn out to be ex-post the more financially profitable thing to do, given changes in society and changes in regulation that differ the outcomes of projects in the future.

Klein: Before this paper, you were involved in research with the Wharton Social Impact team to look at how good is the financial performance of these impact investing funds. Tell us a little bit about what you found in that research.

Musto: This is a project where, with the Social Impact Initiative, we developed a database of funds that self-identify as impact funds. We could see money going out and coming back in. We can also see the appraisals of the companies that are still in process. You need all of those things. You need money going out, money coming in, and the value of what is still there as a sort of ongoing investment.

Putting all of that together, we [thought]: We can see now what is being made investing out in these portfolio companies by impact funds. Let’s run a thought experiment where we are not investing out in those impact companies, but we are investing in just small stocks or something like that. It’s something that is just some benchmark, an easily accessible investment.

Klein: Because you had to have some comparison to say how well are these investments doing relative to something else, correct?

Musto: Yes. So, we ran that thought experiment, and what did we come up with? Well, it was about the same. We did some statistical tests. I won’t get into the details of that, but the bottom line was that it was about the same. We’re not saying, “You’re doing gangbusters here. You’re making a huge amount more than you would have.” It was about the same.

Klein: When this report came out, it was important news for the field.

Musto: Yes, you know about that shrinkage that you associate with eliminating things that are not socially beneficial or that may be socially harmful. So, what has happened to your financial returns? Well, we’re not seeing a degradation.

Klein: This was looking specifically at private equity funds, right? They’re not publicly traded.

Musto: This is all private investment, yes.

Klein: Got it. What is the focus of your new research?

Musto: One thing to point out is that it is that same database, but it’s grown. We have more funds sharing their data. They were interested in the original research, and our partners helped us compile a bigger database. The point is that the database has not only cash in, cash out and audited financials, it also has the contracts.

Remember, there are contracts between the fund and the portfolio company. There’s also the contract between the fund and its investors. You have contracts going in both directions, so this allows us to see how people implement impact investing. We know how people have learned to write contracts just in solving the general problem of delegated money management, which is already a complicated management, and people only have to look at the newspaper to see how things can blow up in that arena and how the contract can be very important. That is a complex contract environment with a long history. The question is, is this taking that and adding something more? Your investors want to see not just profits but impact. You have multiplied the issues that could arise. You might think that these are well-meaning people; you don’t really need a contract to tell them what to do. Once again, look at the newspaper to see all the times that supposedly well-meaning people veered off of the path that their beneficiaries thought they were supposed to stay on.

It is an interesting legal question of what happens to contracting. We took those contracts from the same database and we engaged a team of law students. This is not just the Wharton School but also students from Penn’s Law School who had to code this. In other words, you are reading the contract and seeing these terms. Terms tend to be boilerplate from one contract to the next. You use a term or you don’t, and if you use it, it’s probably worded similarly, one to the other.

“Look at the newspaper to see all the times that supposedly well-meaning people veered off of the path that their beneficiaries thought they were supposed to stay on.”–David Musto

So, you can start coding up a contract, then you can start asking quantitative questions about what is ultimately a textual item.

Klein: Do the contracts written by impact investing funds look different from those in more traditional funds? How do they deal with the fact that there are these twin goals of impact and financial performance?

Musto: The main thing we see, and maybe this isn’t an enormous surprise, was the direct role of impact in the operation of the funds mandated by the contract. A fund will have a diligence process. Think of how a VC fund operates. They take pitches from easily 10,000 different startups. You have this gigantic order flow you have to distill down to the 10 or 20 companies they actually invest in. This is going to be mediated by different committees — investment committees, diligence committees and all of this. You can see the contracts would build in impact assessment into the process by which you make it or you don’t make it in that filtering process.

Klein: That is a screening process that would not occur in a traditional PE fund, right?

Musto: Absolutely. You also see more governance by the fund in the portfolio companies, more presence on the board. Generally, you are going to see some appetite for presence on the board. If I am investing in a startup, I want to have more say over what happens, but there is even more of that.

Klein: It sounds like the key differences you are finding when you compare these contracts to the contracts in more traditional funds is, first, impact written into these contracts, and second, more governance.

Musto: Yes. We refer to that in the paper as “operationalized impact.” That this is sort of guaranteeing that it ends up being part of the process.

Klein: Is your view that this counteracts window dressing? It means that as an investor you can actually be confident that we’re taking impact seriously as we are selecting portfolio companies. It’s not just marketing spiel that is not accurate.

Musto: I would agree that it is a fundamental part of the contract. One way to think about contracting is that it defines what you can get sued over. When I say that impact has to be part of the diligence process, anyone can sort of wave their hands at that. But we don’t see the paper trail of how exactly impact assessment entered into the choice of these funds, of these companies, and why you chose those and not others. Look, we hired you for a job and you didn’t do it. That would be bad.

Klein: Did you see differences between impact funds that are most focused on profits and those that might be more comfortable with concessionary returns? Is that an important distinction among impact investing funds with implications for how they contract?

Musto:Yeah, it’s just most directly. Of course, the compensation structure will alter a little bit in those situations. The compensation structure will be targeted towards a potentially lower threshold of expectations of profits in this case.

Klein: In those funds that are seeking concessionary returns, the way the folks who are working there are getting compensated is going to be less tied to profit. Is that what you are saying?

Musto: Essentially, the performance fee part of it will kick in potentially at a lower number. That’s one way to think about it.

Klein: In terms of this operationalizing impact, do these funds differ this way? Are contracts more focused on impact in concessionary funds, or do they pay less attention to building that into the contract?

“If there are impact investing fund managers reading this interview, we want your data, too.”–Katherine Klein

Musto: In that case, we didn’t see a whole lot of statistically significant difference. There are some suggestive things, but I think this is where I don’t want to go too far out on a limb. Of course, we’re always hoping to build out our database and get more documents to help strengthen our sample size so that we can make more precise comments about that.

Klein: It’s probably a good time to mention that the Wharton Social Impact Initiative is really eager to continue to build out our funds. If there are impact investing fund managers reading this interview, we want your data, too. Reach out to us.

Going back to your findings, what have you learned from this research?

Musto: I think you put it well about this question of window dressing. You can imagine a pension fund or some other investor investing in a fund that identifies as an impact fund, that says, “Look what we did. We’re making the world a better place.”

What’s really happened here? I think you need to look very closely at what they legally agreed to in order to draw any conclusions about what the pension fund has done by investing your money this way. When you break open these contracts, you see there is a lot of commitment to the social benefit in this contracting environment. It’s showing us that this is more than just optics.

Klein: Impact investing is a new field. Getting the data together is difficult, which is part of the reason we’ve been working on this so much. What are the important questions for researchers in your field, or maybe other fields, to tackle as impact investing grows in importance?

Musto: One thing we want to address is the success towards the non-financial goals. I mentioned the previous research was all about the financial goals. That’s half of it. The other half is going to be company specific, the goal is going to vary. Funds have different goals, and within the fund the companies have different goals. They would typically commit themselves to performance.

Their key performance indicators are going to reference a benchmark that they can be measured against. That would seem to be the other shoe here. Get those benchmarks, look at their performance. How did they do? What kind of success are they having towards these goals?

Klein: These questions of how companies manage these dual goals, when is there a tradeoff, when is there not, are topics that I think are interesting to academics across discipline whether you are in management, marketing or finance. I think it is very interesting to see a common question attract so much attention from so many different researchers.

What we have seen from these two papers you have done is, one, some encouraging news that you’re probably making market rate returns in investing. That is what the initial findings would say. Two, the legal contracts are building in impact. You can have some confidence that impact is being taken seriously. I think what you are saying is, three, we would really like to know more about what that impact actually looks like, which is an important challenge.

Musto: Absolutely. And because it varies so much one company to the next, how can we make aggregate statements about this? We’ll just have to see. We want to get the data, take a look and report back to you.

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