ESG Investing

How Investors Calculate Impact Risk

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Generally speaking, the attractiveness of any investment is a function of its potential return relative to the related risks. In other words, investors want to be compensated for the chance that such risks may erode expected gains or the original investment.

As impact investing expands, a new measure has surfaced in the impact toolbox—impact risk. Defined by the Impact Management Project (IMP) as “the likelihood that impact will be different than expected and that the difference will be material” for the people and places targeted, impact risk is an important complement to traditional financial risk assessments.

Impact Risk: Fleshing Out Nonfinancial Factors

The IMP identifies nine factors within its broader definition of impact risk:

  • Evidence risk, or the chance that project data is insufficient.
  • External risk from nonproject factors.
  • Stakeholder participation risk that reflects a disconnect with targeted populations.
  • Drop-off risk if desired impacts quickly falter.
  • Execution risk, efficiency risk, and alignment risk, all of which stem from either poor resource planning or delivery.
  • Endurance risk, which captures project duration shortfalls.
  • Unexpected impact risk, a wild card that can cast a positive or negative spin.

This extensive collection of measures offers insight into the nonfinancial side of an opportunity—an especially important consideration for investors who build their portfolios around purpose and outcomes.

For example, consider Brazilian investment manager Vox Capital. Cited by the Global Impact Investing Network (GIIN) in its recent report Impact Investing Decision-Making: Insights on Financial Performance, Vox was an early investor in an affordable housing project in São Paulo, Brazil. Yet after the project was completed, it determined that residents still had limited access to basic services. When subsequent work with project leaders signaled the possibility of leaving residents more vulnerable over the long term, Vox stepped away and wrote off the investment due to impact risk.

Impact investors should assess impact risk as thoroughly as they do financial risk.

Regular Monitoring Remains Fundamental

Impact investors should assess impact risk as thoroughly as they do financial risk. As with all risk measures, it also requires consistent vigilance.

The GIIN recommends starting in the due diligence phase, gathering reviews of the sponsor’s social impact philosophy and the project’s business plan to confirm that they conform with the investor’s impact objectives. Periodic updates should include impact performance data, active issues, negative consequences, and mitigation efforts to allow for ongoing risk oversight and assessment.

By nature, impact measures are not neatly produced on an income statement, balance sheet, or cash flow statement. To counter this, nonprofit consultant New Philanthropy Capital developed an impact risk classification that assesses an organization’s commitment to its impact goals. The tool allows investors to score the depth of an organization’s conviction to impact within its principles, purpose, outputs, outcomes, and processes and practices.

Risk-adjusted returns matter to every investor, and in order to set realistic expectations on both the financial and impact fronts, impact investors must identify and understand all risks.

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