This is an extract from A Portfolio Approach to Impact Investment (Y. Saltuk, J.P. Morgan Social Finance, October 2012), a report written as a practical guide to building, analysing and managing portfolios of impact investments for professional investors. Since completing this work, we have been using the framework for managing our own portfolio and representing the profile of our targets and investments. For the full report, visit: www.jpmorganchase.com/socialfinance.

Throughout, the term “social” is used to include both social and environmental concerns. Also, the term “institutional investor” refers to non-individual investors, including foundations, financial institutions and funds.

In traditional financial analysis, investment management tools allow investors to evaluate the return and risk of individual investments and portfolios. This research presents a tool to analyse impact investments across the three dimensions that determine the performance of these assets: impact, return and risk. Throughout, we reference the experiences of impact investors with case studies of how they approach each step of the portfolio construction and management process. The content for this research was informed by our own investment experience as well as that of 23 institutional investors that we interviewed. Figure 2 gives an overview of the report structure, and we provide a summary of the key findings.

Figure 2: A Portfolio Approach to Impact Investment
Source: J.P. Morgan

Building an Impact Investment Portfolio

Find a home for the portfolio

To successfully build a portfolio of impact investments, investors need to assign an individual or a team to source, commit to and manage this set of investments, and institutions are setting up their organizations in different ways to address this need. 

Some institutions establish a separate portfolio with its own management team, while others employ a “hub-spoke” strategy where a centralized impact team partners with various portfolio managers across instrument types (such as fixed income and equity) to manage the portfolio’s multiple dimensions. Still others bring the total institution in line with the impact mission. Table 2 shows some examples of investors including foundations, pension funds, financial institutions and fund managers, and their organizational structures.

Table 2: Organizational Structures across Institutional Investors
Source: J.P. Morgan

Define an impact thesis

Once the organizational structure is in place, the portfolio management team will need to articulate the impact mission of the portfolio to set the scope of their investable universe. For many impact investors, the impact thesis is usually driven by the value set of an individual or organization and can reference a theory of change, often with reference to specific impact objectives such as access to clean water or affordable housing. An impact thesis can reference a target population, business model or set of outcomes through which the investor intends to deliver the impact (see Table 3 for examples).

Table 3: Illustrative Components of an Impact Thesis
Source: J.P. Morgan

Define financial parameters

Alongside the impact thesis, the investment team will determine the investment scope with respect to the parameters that can drive financial performance. These parameters include the instruments that will be eligible for investments; the geographies and sectors of focus; the growth stage and scalability of the businesses that will be targeted; and the risk appetite of the investor.  

Abandon the trade-off debate for economic analysis
In setting the investment scope and return expectations, we encourage investors to abandon broad debates about whether they need to trade-off financial return in exchange for impact. We rather propose that investors rely on economic analysis on a deal-by-deal basis of the revenue potential and cost profile of the intervention they are looking to fund, and set risk-adjusted return expectations accordingly.

A Framework for Impact, Return & Risk

Once the target characteristics of the portfolio are defined, investors can map the following across the three dimensions of impact, return and risk: a target profile for the portfolio, the expected profile of the individual opportunities and the profile of the aggregate portfolio, which can then be assessed against the target.

Map the target profile

To illustrate how different investors might map their portfolio targets, we present the graph of our own J.P. Morgan Social Finance target portfolio – the shaded grey area in Figure 3 – alongside the profile that might be targeted by an investor with a higher risk appetite and a lower return threshold (Figure 4), and the graph that might represent the target for an investor pursuing only non-negative impact with a low risk appetite (Figure 5).⁴

Figure 3: J.P. Morgan Social Finance Target Portfolio Graph
Source: J.P. Morgan

Figure 4: High Risk Investor’s Target Portfolio Graph
Source: J.P. Morgan

Figure 5: “Non-negative Impact” Investor’s Target Portfolio Graph
Source: J.P. Morgan

Map the individual investments

Next, we map out expectations for an individual investment based on assessments of the impact, return and risk. Once that investment is mapped, we can then compare it to the portfolio target as shown in Figure 6. Although we show an example in which the individual investment profile does fit within the portfolio targets, in general investors may not require that each investment necessarily fits within the target range, so long as the aggregate does. 

Figure 6: One Investment in the Context of Portfolio Targets
Source: J.P. Morgan

Map the aggregate portfolio and compare to target

Once the portfolio begins to grow, we can consolidate the individual investment graphs into one graph representing the characterization of the portfolio as a whole, aggregating the individual graphs by either overlaying them or averaging them (simply, or on a notional-weighted basis). Then, this aggregate can be compared to the target profile for the portfolio to ensure alignment.

Expand the dimensions of the graph, if desired 

Investors should consider the three-dimensional graph as a template. For some, the simplicity of this approach might be appropriate for aggregating across large portfolios at a high level. Others might prefer to use a more nuanced framework that better reflects the different contributing factors of the parameters represented on each axis – impact, return and risk.⁵ As an example, we could consider an investment graph across six dimensions, splitting each of the three into two components, as shown using a hypothetical investment in Figure 7. Alternatively, an investor might choose to show four dimensions, where risk is split by financial risk and impact risk. 

Figure 7: Illustrative Graph in Six Dimensions
The bold blue hexagon illustrates the profile of a hypothetical debt investment.
Source: J.P. Morgan

Once the targets have been set and the portfolio begins to grow, investors are then faced with managing the investments to ensure that the portfolio delivers both impact and financial returns in line with the targets.

Financial and Impact Risk Management


Identify the risks in the impact portfolio

On an individual investment basis, the risks that arise for impact investments are often the same risks that would arise for a traditional investment in the same sector, region or instrument. Just as we abandon the trade-off debate on return across the asset class and encourage deal-by-deal analysis, we encourage investors to assess the risk profile that results from their particular impact thesis and motivation. 

There are also some cross-market risks to consider, including the early stage of the market and its supporting ecosystem; mission drift; the responsible combination of different types of capital (including grants); and the moral hazard of recognizing impact failure or financial loss. The development of the market over time should erode some of the risks associated with its early stage and ecosystem. While some of these risks will remain in place, investors will likely develop better processes for recognizing and dealing with them. 

Manage risk through structural features

Once the risk profile of the investment is determined, investors manage it using structural features such as seniority in the capital structure, fund intermediaries and compensation-related or covenant-based incentives. With respect to the currency risk that arises for investors allocating capital internationally, some investors referenced diversification across countries as the preferred means of management.

Manage friction between impact and return 

Many investors cite that they pursue opportunities where the impact mission is synergetic with the financial return pursuit. Several organizations also acknowledged that, at times, friction can arise between these two pursuits. Some of the challenges referenced include the investee’s growth coinciding with a reduction in jobs; the investee maintaining mission; or ensuring impact measurement. Some investors manage these challenges by building covenants referencing the mission into the deal. 

Portfolio diversification

Investors often find a softer approach to diversification to be more suitable to the private nature of this market. Rather than setting exposure limits as can more easily be done for public equity portfolios, impact investors tend to start with a more opportunistic approach. They assess the merits of investments mostly on a stand-alone basis, while monitoring the broader concentrations in any sector, geography, instrument or impact pursuit. Once the portfolio reaches a critical mass, many of them become more strategic about diversification, considering an investment’s individual merits alongside those in the context of the broader portfolio.

Looking Forward

Challenges should ease over time

To be successful today, investors need to be realistic about the stage of the market, employing patient capital, bringing a dynamic approach and taking an active management role to the investment. Whether investing directly or indirectly, they need to navigate a broad ecosystem to ensure success. Investors today share a collaborative spirit in meeting these challenges with the broader goal of catalysing capital towards impact investments. This research has been a first step towards sharing the experiences of these field builders to help investors establish a strategic approach to portfolio management for impact investments.

About J.P. Morgan Social Finance

J.P. Morgan Social Finance was launched in 2007 to catalyse the growing market for impact investments and accelerate the delivery of market-based solutions to social, economic and environmental challenges. Our business is dedicated to growing this market through client advisory services, principal investments and research. 

Disclosures

J.P. Morgan is the global brand name for J.P. Morgan Securities LLC and its affiliates worldwide. This research is written by Social Finance Research and is not the product of J.P. Morgan’s research departments. For further disclosures, please see the full publication at www.jpmorganchase.com/socialfinance.

Copyright 2012 JPMorgan Chase & Co.