In our Great Expectations study, we were targeting understanding the general venture capital and private equity field for impact investing purposes. We wanted to understand the interaction between the potential for mission preservation in financial performance. In particular, we want to understand how broad the industry is and was, and specifically wanted to try to understand if there was in a private investing context any cost to impact investing. We chose the Crucible, the point of greatest intensity of heat of conflict between social impact and financial considerations by looking at the moment of exit from private equity portfolios of underlying investment holdings. In the private equity space or in the venture capital space, it's very often the case that we see investment funds known as VCs or general partners, or PE funds or general partners as opposed to limited partners or LPs who are the investors, both targeting impact and financial performance. We wanted to understand at the point at which those funds were potentially getting the greatest outcome on a financial side, saw contemporaneously less consideration of the social impact side. It's at that point again that the conflict was greatest. The premise of course was that there has been a great inflow of capital to impact investing funds closing in the last decade. So this has certainly increased capital for companies invested in that have social impact targets and presumably under the null hypothesis so to speak that generate impact. General partners, those fund managers have to exit at some point. Typically general partners run venture capital or private equity funds for about 10 years, although there are often options to extend the time that a given fund has to live. That means there's a finite time that requires closing a fund down. The incentives of the general partners typically are lined with making investments, harvesting those investments, gaining cash flow from the harvesting of those investments, returning the flow to investors and moving on perhaps to raising another fund. The notion of exit is important because it's the resolution of the economic investment in the underlying fund or the underlying firm rather. When the firm is out, it's out, it can be out by taking the company public, by selling it to someone else, perhaps even another general partner or a venture capital manager, it can be combined with other firms, we could or the venture capital fund, the general partner could sell off assets, or it could wind down, in other words go bankrupt and perhaps have a partial resolution of whatever assets the company had developed. So our idea was that because those general partners have to exit investments at some point, taking your company public, combining with others, selling off the assets and so on, what can we then expect to see and what do we see both to the ESG impact mission and their performance at that particular point in time. We collected data on hundreds of potential pieces of information. In a survey, we collected more than 100 unique variables around a number of themes, funded transaction level financial performance, limited partner or investor as well as general partner relationships. Again, general partner, otherwise known as a GP, is the fund manager. Various elements of the general partner and portfolio company relationships, as well as various measurements for targets and actual social impact. We also in some cases received quarterly and audited financial statements, private placement memoranda, letters of intent, term sheets. Again, and more than 100 additional survey questions. We began this research just a couple of years ago in 2014 and we ask funds who self-identified or let us know that they contained impactful portfolio companies. This raises the notion of intentionality which is a defining hallmark of impact investments, at least in the eyes of some. The idea of intentionality, is that there must be some notion of the intention of having social impact in the enterprise or the commercial or the investment activity. If we happen to have unintended social impact, then some would not consider that to be impact investing. My own view is that we ought to be very very broad in our consideration of impact, but this is just one way of our understanding the industry. These are venture capital private equity funds who self identify or whom we know to contain impactful portfolio companies. So we're focusing on intentionality, measurability and then actually focus on those that have positive return expectations as opposed to those that have concessionary returns. And I'll show you what the distribution looks like. Concessionary returns might be those investment funds, general partners who may seek not to generate market returns, but who might in other words returns that are usual in the investment industry, but who might be willing to give something up, presumably to pursue social impact or to have social impact. And it's a controversial idea. We're going to focus on whether funds who are focusing and are targeting making money versus those that are not actually are successful. It's obviously a bit of a question if they specifically suggest they're not going to make money. Now, you may also ask yourself why would anyone invest in a fund that's not making money. Well, if they have social impact, some say that they may not be generating positive returns, but as long as they're not losing all the money, then it may dominate philanthropy because philanthropy from that angle and for those people, may be construed to be the equivalent of giving money away and having absolutely no return, having a hundred percent negative return, but having pure social impact. So you can actually view social impact across a spectrum, from pure profit maximization, ratio of Reward to Risk, net present value, internal rate of return maximisation say all the way to pure philanthropy where we don't expect any return give back but a hundred percent quote on quote loss and yet pure social impact. There might be a real number line of a spectrum, there might be an infinity of potential positions that you yourself might find yourself on as opposed to the extremes. We are targeting those that are somewhere along the spectrum, seeking both positive return as well as having social impact. Our database was just over 435 funds and compiled with help from B Lab, ImpactBase, EMPEA and Skopos our European family office. We distribute hundreds of nondisclosure agreements, about 48 fund managers returned signed Non DA's and 42 fund managers completed the survey representing 53 funds in total and about 557 portfolio companies. Ultimately, we think we found most of the largest players in the industry. As a footnote, I would also let you know that since we completed our initial research, we have nearly doubled the sample size and to my knowledge we don't expect results to have changed very much. The funds are of various sizes although there's a small number of very large funds for that counted as having committed capital of more than $100 million. Committed capital is that capital committed by limited partners to the general partner fund manager, which may then subsequently be called in for investment purposes which are held in the hands of the LP until the time that the fund manager calls the money. And then again, a larger number of small funds, 22 whose assets or whose capital range between zero and just under $ 20 million. Out of the 53 respondents, we found that 32 were targeting so-called market rate returns which we defined as those returns that are typical in the industry. To say it another way, over 60 percent of funds were seeking returns that were essentially competitive. On the other hand, roughly 40 percent were seeking below but close to market returns or were seeking ultimately capital preservation but not seeking any returns in general. The others, presumably were seeking purely concessionary returns. So, the bulk of our sample were not only seeking returns, but were seeking market rate returns, which is important for our study. Interestingly, the size of portfolio companies were very variable ranging from those that were startups essentially having no employees to name, about 15 out of 220 responses in our survey for companies were reported to have zero employees. The mode as you can see on the graph was between 20-99, and you can see that we have five companies that were reported to have more than 5,000 employees. So some substantial investments, although relative to the investment size as you might expect, already we see that we may not, or at least the funds in our sample, may not be able to dominate the voting at the board level, at the shareholder level. Regarding the activities of the fund companies. Also perhaps surprising was that a large proportion of the sample had already achieved profitability in the underlying portfolio companies. About 50 out of those that responded were deploying products and services,130 a little more than half already reaching a profitability stage. The rest were in beta or product development mode and with one not having an appropriate business line for the response. We then focused on four subsequent elements for your interest. The first was focusing on permission or the legal latitude for mission alignment. Was there permission or an agreement some way somehow in the legal governing documents for the investor fund that allowed them to have a mission requirement or a requirement that they have a mission alignment? In other words, impact requirement or possibility. Second, if they had permission or if there is a requirement for them to pursue social impact, Worthy's venture capital oriented funds or private equity oriented funds endowed with control at the point that is cradling the most intense conflict between good and gold. Did they have the right motivation? Was their financial performance there? And finally, when we aggregate performance across all our funds looking at exit and not looking at exit or including those that achieved the exit which generally is a positive event in the life of a firm, or when they did not, what was the aggregate performance level? To get at the first issue of permission or requirement to pursue mission orientation, the question that we asked for managers was whether they have contractual latitude or permission to protect the mission if there's a conflict with the economics. Specifically, we asked, do your funds Private Placement Memorandum, or side letters, or Limited Partnership Agreements, these are all governing documents or rather agreements include specific language that states any of the following? First, a requirement for the fund manager to consider social or environmental practices. All the governance aside, so E and s out of G. Secondly, does it explicitly allow the GP, the fund manager to consider social practices? So environmental and social, and then, do we have an explicit allowance for the fund manager to consider environmental now not social and environmental practices? And finally, do we have no reference for social or environmental issues? What we see is that 36 out of 40 responses here require social or environmental practices. It's actually an agreement or part of the formal governing documents of fund activity that requires one of the two: social or environmental practices. And then 11 and 17 again out of 40 so 25 percent say to just under half allow additional considerations typically on average additional considerations, and only three don't reference them. So the overwhelming majority reference social impact supporting mission orientation. Second, the fund managers have sufficient control over exit decisions. In other words, do they have the ability to ensure persistence of the mission? This is the kind of a critical question. If you talk to the founders of B Lab for example, part of the reason that they describe their founding of B Lab itself was that in their personal experiences at the point of exit when someone else comes into control of a company, that mission preservation and in the notion of social impact can be set aside. So now the question is, what percentage of votes does the GP as well as other investors aligned with the general partners impact mission, control in relation to decisions about the exit? In other words, can they force social impact? Well, what we see immediately is that the overwhelmingly large majority of respondents don't actually have the votes required to control what happens at exit. So now you can see the potential for conflict. The requirement to pursue social impact, the possibility and effect the goal of earning industry level expected returns, and yet a potential constraint on seeing what happens at the defining economic moment of exit at which the contrast is the greatest. The question then we get to is motivation. Have most exits been aligned or non aligned and are non-aligned exits higher implying the financial motivation for fund managed to exit in such a non-aligned fashion? Do we see exits being aligned? And then if you're not aligned do you get higher returns? Again, this notion of alignment and mission preservation and impact revolves on definitions. We describe two things. First an align exit, and second, the deeply aligned exit came. Let me start with an aligned exit. We define an aligned exit as a manager believing the mission will persist. In other words, simply asking a question, do you believe that the social environmental impact persisted after the company had its exit? Contrast that with a deeply aligned exit, when the illegal agreements which we see most GPs not having the authority to enforce but they could be convincing, to those legal agreements have statements, in other words, binding statements matching seller statements. The text was, does the realization agreement include a statement to pursue the social environmental impact objective of the underlying company? Well, what we find at a top level is that most exits were indeed aligned however, most of the alignments were in fact not deeply aligned. The majority of our answers were favoring alignment, which we'll ultimately call embedded alignment and not deeply aligned. In fact, the ratio is more than two to one against deeply aligned impact the realization agreement including a statement to pursue the impact after exits, after the disposition of the company, or and or its assets and an aligned exit strongly favoring an aligned which is kind of a belief notion. You might be in the right industry, the right activity, it might be implicit, but there's nothing legally governing it. And of course, if you a complete write off, then you typically had no exit. The question of performance then arises. So what we looked at were three different categories. First, all market rate seeking exits across funds, pulled together across funds, second, market rate seeking exits excluding the write offs typically write offs or minus 100 percent return so we're excluding those. Obviously the return will be higher in that case. And then those that are aligned. Okay, so taking anything that's not aligned. Either deeply aligned or with this embedded notion of alignment. We look at multiple performance metrics. First is an IRR, we call it a Gross IRR, internal rate of return. It's a tricky metric for use in private investments, but it's one of the most common metrics. We're going to look at a slightly modified version which we think is more accurate called the modified IRR or MIRR. We look at two so-called PMEs or public market equivalents and then a cash multiple which is also once again a very common way of thinking about private investment performance. Internal rate of return is a nearly ubiquitous measure used in private equity and private equity performance. The internal rate of return as a technical matter is the discount rate that sets the net present value of a stream of cash flows to zero. Technical idea. The essence of it is to try to think about what cash flows are given off by a private investment and then bring it back to the present by discounting it at a rate generally that is indicative of its risk. However, the internal rate of return has some challenges and I would argue that the industry presents it as a comparable to the traditional notion of a return which academics would call the time-weighted return. Those are not comparable directly in my view, in the IRR is overused in the profession. If you are an investor or someone looking at performance of impact investments, I would counsel you very strongly to use several different kinds of performance measures, impart, the IRR has the problem of over emphasizing early cash flows and there are a couple other anomalous behaviors that I'm going to push aside for now. But in this one in particular, if we have outstanding early cash flows, the IRR implicitly presumes reinvestment of those cash flows like early successful exits at the solve for rate of return. The essence of the problem is that it boosts up the internal rate of return beyond what is legitimate. The modified IRR takes an externally defined rate like 12 percent which sometimes we would say is something like the expected return roughly speaking for the fund or the investment and reinvest cash at that level, even if the cash is being cast off to outside investors. And you'll see immediately what the difference in that technique does. It essentially cuts returns down substantially. Almost in fact in some cases by more than half. So the first two lines of the market-rate seeking exit performance table, list the gross IRR and the modified IRR for the three categories I mentioned all market-rate seeking exits, those market-rate seeking exits that excluded write-offs, and then the aligned exits subset. You find that the internal rate of return at the gross level is about 18.6% as a return, as an IRR. Which is of course substantial if you compared it to a traditional return. The modified IRR of that time period was about half at about 9%. When we look at market-rates seeking exits, the returns go up when we exclude write-offs. 18.6 goes to 35. You can see how the modified IRR impact, because of the differential timing of unsuccessful cash flows versus cash flows result in just a slight increase in performance. And then ultimately, when we look at those seeking exits and those aligned exits, we see the aligned exits have about the same performance. Now, we're not giving you measures of statistical significance here, but it's easy to see that the aligned exits, although we went down both in the IRR and the modified IRR, don't go down very much. About one and a half percent for the gross IRR, for the more accurate modified IRR, just 50 basis points over the time of the investment. So it's not very much. And certainly statistically speaking, we probably could not reliably say there's much of a decline at all when you look at social alignment versus the opposite. In addition, when we look at public market equivalence, we see returns go the opposite way. Again, performance viewed from yet another angle. PME stands for public market equivalent. The essence of the calculation is to take an investment in some kind of private activity and impact-oriented business. And for every dollar invested, do the mental experiment of also investing it in some investment outside in liquid markets, like the S&P 500, or in this case, a microcap index. Why microcap? Because typically, as we showed just a minute ago, a good number of the funds really are very, very small and in fact, interline companies are very, very small. So, choose either one they sort of give you a range, but sort of a very tight range. The public market equivalent is above one when the private investment outperforms the public investment, and below one when the private investment underperforms the so-called easily available, highly liquid low fee. In this case, index zero fee alternative. It also brings to bear the possibility of an illiquidity challenge. If I can beat the private investment by investing in the S&P 500 that I could easily gain access to through a mutual fund, then wow! That really says something because I'm giving up liquidity by investing in a private investment firm. Who knows how long? Years. But potentially, up to 10 or more years in the longer sense. What we find across all dimensions as you can see in the table, is that the microcap PME for the market-rate seeking exits is above one. That doesn't specifically focus on firms that have not had exits. It doesn't consider those funds that are seeking concessionary returns. What it does say, when there's an exit it ex-post seems to have outperformed public markets substantially. And by the way, when we go to the aligned exits returns actually go up. Finally, cash multiples. It looks like if you had an exit, you earn 2.3 times your cash investment. For those that excluded write-offs, which of course is somehow like an unfair kind of calculation, you earned for those successful exits 4%. If you were aligned, it went even a little bit higher. Again, statistically speaking we probably can't tell apart aligned and unaligned. Potentially, on the other hand what we don't see is dramatic evidence of underperformance, as long as there's an exit and as long as you're aligned or not aligned. The alignment, non-alignment question appears to be not heavily correlated with performance. To examine performance in the aggregate then, we consider public market equivalence among other results not reported, and calculate statistical confidence intervals. If you want to pick up the article, you can see how we did it. We use a statistical technique called the bootstrap. In any case, what this gives us is the median outcome for our sample based on a statistical procedure, for the microcap public market equivalent for those firms that are held at cost as opposed to fair market value. In other words, for those firms that we have not allowed to have variation according to other fund investments beyond the initial purchase price that could bias the results up. So we're going to hold those at cost. And then finally, the S&P 500 PME and also S&P 500 with those funds held at cost instead of marking them to market, or using a fair value calculation provided by the fund. What you find is generally that the reported medium public market equivalents are just below one. Now, that contrast to what we saw a second ago with exits. And that's logical because we presume the exits will be generally successful except for those that are written off. When we specifically take those that are written off out, returns go even higher. Here, everything is included in the soup. What we find is that the microcap PME is just below one irrespective of whether we use the ratio unadjusted, or we hold fund firms at their initial investment level without allowing any appreciation or depreciation. The worst to get is 0.88. Now, you may think to yourself well this is strange because this impact fund underlying portfolio companies are underperforming the market. Well, when we compare the results in this table to those in the industry more broadly, for example, the research of Kaplan Insure a number of years ago, or others, they also find that VC investments in general have public market equivalents just below one. And in fact, the range of outcomes corresponds very closely to our lower and upper bound, call it 95% confidence intervals for the PME ratios. To say one other way, what we find in impact corresponds very closely to what we find in non-impact. Once again, highlighting at least the possibility that there may not be a performance give up in this space. It's not an investment promise. It can't be. Past performance is not indicative future results. We might have biases in the research, unintended, unaccounted for biases that we don't see. Although we feel the sample is the best that exists, at the end of the day, the same advice that one might consider in the general venture capital investing space, which is that you really do need to be better than the median, or better than average applies here. If you are on the top decile, if you are in the top quartile, performance can potentially be extremely good at the median. It's sort of what we expect compared to the general industry. So, at the end of the day what we find is that it impacts investments in our sample maybe financially competitive with other equity opportunities, specifically in the private space. The financial performance may be why impact fund managers often assert that there's little tension between profits and purpose, for those that are specifically identifying market-rate opportunities. We thus define the notion of embedded impact. Impact fund managers, we think, use a pre-investment screening process to invest only in companies with products or services that are inherently, organically, impactful, making, or finding impact that is core to the business model along the dimension of impact. That has to do certainly with company culture, with company industries, and so on. Now, there's much more to do in this space, and so there's more to ask and to answer, but this fundamental notion of costs will come up again in a future lecture. So, to sum it all up, what we find is that apparently private market impact investments don't look that different from private market non-impact investments both at the exit and in general. The idea that there may be not a stronger tradeoff between performance and impact, despite the ex-ante critique that I myself first would have offered when thinking about the constraint of impact investing, may ultimately allow fiduciaries, those that have financial responsibility to advance financial benefit of those whose interest they represent to consider impact investing. It's still the case that you have to be good at investing. That's true in the non-impact space, but there appears not to be such a grand mitigation again, highlighting a theme in the arena of impact investing that awareness of potential cost is critical, and in some areas there may be a relief.
