The Importance of Impact Due Diligence In Impact Investment

5th Jun 2020

The Importance of Impact Due Diligence In Impact Investment

Impact Investor thinking about impact due diligence with technological icons around her head

The Importance of Impact Due Diligence In Impact Investment

Impact due diligence is crucial in impact investing. While the practice of impact measurement and management (IMM) has become increasingly sophisticated and widespread in recent years, most investors focus primarily on what happens after, not before, investments are made.

This diminishes the potential value of IMM because the social and environmental performance reported by companies after receiving investments has, in many cases, little to no influence on either strategic or tactical investment decisions. For many investors, leveraging insights from impact analyses to guide portfolio construction and ongoing management— i.e., the second ‘M’ in IMM—remains an aspiration rather than established practice. 

As a result, while IMM helps impact investors more effectively understand and communicate their societal or environmental value to their investors and stakeholders, in many cases, measurement systems have not enabled investors to demonstrably achieve more positive impact than they would have otherwise. 

Most impact investors have clearly defined impact goals, which they use to screen out investments with negative impacts or screen in those expected to generate positive impacts consistent with their objectives.

Once investments are screened for impact, investment decisions are ultimately made by analyzing expected risk-adjusted financial returns. Few investors systematically examine which investments are expected to generate relatively more or less impact, which can help them more closely align their investments with their objectives and increase the likelihood that their portfolios reflect their values and goals.

According to the Global Impact Investment Network (GIIN) - Due diligence in IMPACT INVESTMENT has four core functions:

  1. As a risk management tool.

  2. As an opportunity to identify ways to add value to and improve the impact of an investee.

  3. As a way to identify the social or environmental impact, or both, of the business.

  4. As a means to respond to LP expectations.

Leaders in the field are also increasingly recognizing the crucial importance of methodically assessing anticipated impact. Systematic impact due diligence is one of nine of the International Finance Corporation’s Operating Principles for Impact Management and is cited by the GIIN’s Roadmap for the Future of Impact Investing as critical to exponentially enhancing the scale and effectiveness of the industry.

Next Generation assists companies with designing impact strategies, including the development of performance management frameworks and measures impact and return on investment achieved.  We do this by using our trademarked impact assessment methodology – The Investment Impact Index™.  We also use a technology platform to analyze and verify impact and produce impact reports.  

However, over time as we integrated and aligned our own IMM practice to a number of international principles and guidelines to ensure best practice, we have come to understand the importance of due diligence to not only define impact indicators which we use to measure impact after investments have been made but also to provide guidelines for the actual impact management process. 

The importance of due diligence to inform impact strategies was something we learnt over time. The real value of impact due diligence lies in the fact that it creates the impact baseline and/or impact targets against which we measure impact outcomes over time. We have now integrated impact due diligence as part of our service which we have aligned to the investment life cycle. It is clear from emerging practice and research in the practice of IMM that due diligence will become more important as the field matures.

Value of impact due diligence in impact investment

Impact due diligence creates value for a broad range of stakeholders across the impact investing ecosystem, including impact investors, investees and the ecosystem at large.

Key benefits include:

  • Fostering internal alignment around intended impacts and priorities.

  • Deepening understanding of investees’ activities.

  • Supporting the construction of more positively impactful portfolios.

  • Improving investor and investees’ ability to communicate impact.

  • Strengthening relationships between investees and investors.

  • Increasing the investee organization’s ability to attract additional capital.

In combination the benefits of widespread adoption of impact due diligence should attract additional capital to the field and thereby foster the formation of more inclusive and sustainable financial markets.

Emerging areas of best practice in impact investment

According to research conducted by Pacific Community Ventures - seven areas of best practice stand out among investors who have developed impact due diligence approaches. These include:

  1. Assessing impact using the five dimensions: 

    The Impact Management Project (IMP) is a useful and widely accepted set of norms for understanding and assessing impact. Investors should check their approaches against the five dimensions of impact to ensure they are comprehensively assessing expected impacts on people and the planet.

  2. Bridging the divide between ESG and impact assessments:

    When assessing anticipated impact, investors should ensure they are evaluating all impacts an enterprise has that matter to people and planet including those related to business operations (i.e. ESG considerations) as well as products or services. In this way, investors can evaluate all impacts that matter–not just the intended positive ones.

  3. Aligning with the SDG's:

    Since the Sustainable Development Goals (SDG’s) were released by the United Nations Assembly in 2015, investors have used these 17 goals as a means of articulating the connections between their investments’ impacts and the United Nations’ global development agenda. Incorporating the SDGs into impact due diligence helps ensure that prospective investments’ anticipated impacts align with the global development agenda, as well as enable effective communication about expected impact across a diverse portfolio.

    This best practice is most appropriate for investors whose strategies are intentionally designed to contribute to the SDG’s or whose objectives have significant overlap with the global goals.

  4. Elevating the perspectives of key stakeholders:

    Incorporating the perspectives of those who are impacted by investees helps investors better align on impact goals, mitigate impact risk, amplify stakeholder voices, develop feedback loops between investors and investees, and assess both investor and investee contribution. 

  5. Evaluating a commitment to impact and learning:

    Investors should explicitly assess investees’ commitment to achieving impact as well as their ability to improve, adapt, and learn.

    Specifically, investors should evaluate whether investees’ impact thesis is clearly defined, their understanding of key stakeholders’ needs, the robustness of their IMM systems, whether they have financial incentives linked to impact performance, and their ability to change strategies and tactics based on results.

  6. Adopting a portfolio wide approach:

    Investors should develop a consistent impact due diligence approach that enables direct comparisons of different types of investments across a portfolio. This is an essential component of effective, impact-driven portfolio management. Sector-specific questions and indicators are in some cases necessary to achieve a sufficient level of rigor in impact due diligence, particularly for those with diverse portfolios.

    However, investors should adopt sector-agnostic frameworks and generalizable questions and indicators, where possible, to ensure impact due diligence processes are more easily implementable and results are comparable.

  7. Prioritizing accessibility:

    To ensure that their impact due diligence approaches can be easily adopted, investors should use consistent language, appropriately balance rigor and efficiency, and seek to understand the expectations of internal and external audiences.

    While new impact due diligence systems will take time for staff to learn, investors should strive to build ones that are not burdensome to facilitate adoption. This will encourage investor and investee relationship-building and set internal stakeholders up for success in performing their impact due diligence-related roles.

Approaches to due diligence in impact investment

Most approaches to impact due diligence fall within three categories (Source: Pacific Community Ventures: Impact Due Diligence Guide). These archetypes are not mutually exclusive, as many investors employ two or all three approaches. 

Whatever approach is selected, investors should conduct impact due diligence, whether it be a narrative of expected
impact, due diligence questionnaire, or quantitative tool, in parallel with financial due diligence. This enables investors to more efficiently integrate impact due diligence into existing processes and streamline data collection. 

  1. Narratives of expected impact:

    Written descriptions of anticipated impact enable investors to consistently document their impact-related expectations. Typically appearing as a paragraph in an investment memorandum, narratives of expected impact are often the first formalized approach investors employ to evaluate impact expectations.

    While using this method alone lacks the standardization of an impact-focused due diligence questionnaire or systemized due diligence tool, narratives of expected impact can allow investors to develop an understanding of the types of questions and information that should be collected using questionnaires and quantitative tools.

  2. Due diligence questionnaires:

    Impact-focused due diligence questionnaires (DDQ) are sets of questions about prospective investees’ impact that usually all potential investees are required to answer. Impact DDQ’s can be standalone documents or integrated into ‘traditional’ DDQs that assess an investment's expected financial risk and return.

    Impact DDQ’s allow investors to implement a consistent approach to impact due diligence and are typically used to gain a holistic understanding of a potential investee’s objectives, anticipated impacts, unique characteristics and applicable risks. These primarily qualitative assessments can be utilized to gain a nuanced understanding of prospective investees’ anticipated impact.

  3. Quantitative tools:

    Quantitative tools help investors translate both qualitative and quantitative information about prospective investees into standardized, numeric scores that can be more easily compared across a portfolio as well as all prospective investment opportunities.

    To develop quantitative impact due diligence tools, investors select relevant indicators based on their investment strategy and impact themes, relying on the IRIS+ taxonomy of investment themes, IRIS+ metrics and Core Metrics Sets where possible, and develop scoring guidelines to inform the assessment. Each indicator is then assigned a weight to ensure the tool reflects the investor’s priorities.

    Quantitative due diligence tools then produce expected impact scores that can be used to inform investment decisions.

Our approach to due diligence in impact investment

As mentioned earlier, due diligence for us is part of an integrated IMM system.  It informs the impact strategy, it guides investment decisions, it identifies impact dimensions and it ultimately contributes to the impact an impact investor aims to achieve.

Our framework for due diligence focuses on 6 aspects:
1. Strategic Fit:

How well would the investment opportunity help advance the investor's mission?

2. Value Proposition:

How relevant is the value propositioned in the specified domain?

3. Organizational capacity:

How does the potential investee organization plan to achieve its objectives and does it have the resources it needs to do so?

4. Additional Risks:

Are there other risks that would adversely impact the investment's ability to deliver financial or social returns?

5. Sustainability Standards:

Notwithstanding the proposed value proposition, does the potential investee organization meet standards of social, environmental and governance performance, with accountability and transparency?

6. Deal Structure:

Is the deal structure appropriate for the unique circumstances of the potential investee organization and of the investor?

Whilst we have an extensive checklist and due diligence questionnaire to guide our due diligence process, the outcome of our process aims to assess four aspects specifically:

Impact Return:

Impact return captures a qualitative score of the impact that will be generated by the deal.

The score on this dimension combines the appraisal of the value proposition with the organization's capacity to deliver on that proposition, the scope of the impact, and its potential for scale.

Impact Risk:

Impact risk relates to the potential threats to execution and the possibility that the impact might not be realised. It is derived from the risk assessments in various categories, including value proposition and organizational capacity, among others.

Importantly this score also considers the possibility of mission drift. Unlike traditional risk-and-return analyses, there is no established correlation between impact risk and expected impact return.

Financial Return:

Financial return captures the expected financial return on the capital invested.

Financial risk:

Financial risk captures the uncertainty of the financial return and the potential for financial loss.

Visit us for more resources:

If you want to know more about our impact management framework– you can also check out our infographics that outline our impact management process by clicking here.

You can also visit the Next Generation website to learn more about the creators of the Impact Investment Index, as well as make use of a variety of free resources that includes articles, videos, presentations and more.

Please reach out to us should you wish to discuss your impact management and measurement needs.