Introduction

The following was adapted from Evolution of an Impact Portfolio: From Implementation to Results, a landmark report released in October 2013 by Sonen Capital in collaboration with the KL Felicitas Foundation (KLF, or the Foundation). The report demonstrates to investors that impact investments can compete with, and at times outperform, traditional asset class strategies while pursuing meaningful and measurable social and environmental results.⁶ 

In 2004, to meaningfully address the world’s most pressing social and environmental issues, KLF began a process that would eventually allocate 100% of the Foundation’s capital to impact investments. Over the seven-year period of 2006-2012, the Foundation moved from 2% of assets allocated to impact to over 85%, while generating index-competitive, risk-adjusted returns. This article highlights Sonen Capital’s strategy for building impact investment portfolios, utilizing our experience in investing KLF’s assets as a case study to concretely illustrate this approach.⁷

Creating an Impact Investment Policy

Constructing KLF’s impact investment portfolio required following a framework through which investors could move towards action – from establishing to executing and maintaining an impact investing strategy. This cycle, depicted in Figure 8 and described in greater detail in Solutions for Impact Investors: From Strategy to Implementation⁸, provides a roadmap for other investors to build impact investment portfolios. A central component of this process is developing a comprehensive Impact Investing Policy, the critical link to translating a strategy into a tangible implementation plan.

Figure 8: Impact Investing Cycle
Source: Solutions for Impact Investors: From Strategy to Implementation. Rockefeller Philanthropy Advisors, 2009.

KLF’s Impact Investing Policy was designed to incorporate impact criteria into the portfolio construction process and, to the extent possible, select impact investments that satisfied the Foundation’s Investment Policy Guidelines.⁹ The selected policy targets reframed KLF’s Investment Policy with respect to asset allocation to achieve both financial and impact objectives. 

Anchored by rigorous financial analysis and ongoing assessments of factors affecting macroeconomic conditions, these asset allocation targets are also still designed to diversify KLF’s investments across and within asset classes, while achieving lower volatility and risk over time to protect portfolio capital and achieve competitive returns across market cycles (see Figure 9 for KLF’s impact investments). 

Figure 9: KLF Impact Investments by Impact Strategy and Asset Class
Source: Sonan Capital, LLC

Portfolio Construction

As the Foundation’s assets were moved into impact, a balance was sought between financial and impact considerations. An effort was also made to reconcile KLF’s mission with the realities of a growing industry and to maintain adequate diversification across risk exposures. As an early mover in the implementation of impact investing strategies, KLF’s Return-Based Impact Portfolio evolved as the industry itself matured. At the outset of portfolio construction, there were not enough accessible and/or suitable impact investments to achieve desired asset allocation targets. Due to these constraints, the portfolio, at times, was heavily over-allocated to fixed income or cash products, and a positive by-product of this was exposure to mission-aligned impact themes. In these instances, KLF’s mission overrode portfolio optimization goals. As the impact investment universe expanded, so did the opportunity-set through which KLF could express preferences based on impact themes and investment views according to asset class targets. 

Despite the potential challenges of such early adoption, KLF’s Return-Based Impact Portfolio remained competitive with widely accepted financial benchmarks based on the portfolio’s stated asset and risk exposures, with no indications of a so-called “pioneer penalty”. On a weighted total portfolio basis, KLF’s Return-Based Impact investments performed in line with their asset-class exposures while providing for diversification benefits.

Importantly, the impact industry has since matured enough to offer a more complete set of investment options, and it has become increasingly possible to find financially compelling investments across asset classes that achieve the required impact criteria. 

Adding “Impact” to Investment Due Diligence

In addition to the fundamental financial analysis and discipline that goes into investment decision-making, KLF used a specific impact lens based on the Foundation’s charitable mission and its founders’ values to further refine the investment selection process. This included an assessment of a potential investee’s impact strategy, impact reporting capabilities and fit with the Foundation’s mission. To this end, meetings were set up with portfolio managers and analysts, and each team’s investment process was studied to understand how investment decisions were made, all in an effort to understand how ESG or impact factors are integrated to add value.

KLF’s impact investments were allocated across all asset classes, making it possible to identify specific social or environmental impacts for each. As a greater number and wider spectrum of impact investment opportunities continue to become available to investors, all asset classes are expected to be capable of delivering risk-adjusted, financially competitive and mission-aligned impact returns to investors.

Due diligence for public strategies 

To construct a diversified impact investment portfolio, we classify investment opportunities principally according to three categories, listed in order of lowest to highest impact:

• Negative screening (Responsible): When high-impact opportunities are unavailable as a result of portfolio construction necessities, investors may opt to screen out issue areas such as tobacco, firearms or alcohol. Investors should note that the use of sometimes arbitrary negative screens can reduce the efficiency of portfolios and may entail certain risk/return trade-offs.
• Positive screening (Sustainable): Investors can add value to the investment process by incorporating ESG criteria or sustainability considerations into manager or security selection. Positive screening allows managers to express themes and investment ideas through best-in-class approaches or through careful selection of companies that manage their ESG risks and opportunities in a proactive manner.
• Social or environmental themes (Thematic): Thematic strategies look to focus on a particular social or environmental trend by expressing investment ideas that are best positioned to benefit from exposure to the theme. Typically, managers identify and invest in the most progressive companies (or other issuers) with strong ESG performance within a theme.

After categorizing strategies, quantitative screens for financial track records are applied. Impact investors should analyse not only the returns of a strategy, but also attempt to understand the underlying drivers of returns and risk, including the factors to which each strategy is exposed. After promising candidates have been isolated in each asset class, investors must thoroughly analyse managers’ impact strategies. As investors become more comfortable with the options in the impact marketplace, they can begin to think about “impact allocations” – allocating their investments optimally across various impact approaches and target themes – in addition to asset and risk allocations.

Due diligence for private strategies

For investors able to access private market investments, alternative strategies are critical components of an investor’s diversified asset allocation strategies. 

Private investments offer both compelling economic exposures and the potential to capture unique impact opportunities through highly thematic exposures. For example, private strategies can provide exposure to direct impact in themes important to investors, such as clean energy and technology, community development, sustainable forestry, sustainable ranchland and financial services for base-of-the-pyramid (BoP) communities.¹⁰

Just as in the public markets, private investments require extensive financial, impact and operational due diligence. Investors should be aware that the due-diligence process is iterative and non-linear; new quantitative and qualitative data points, enhancing the quality of due diligence and ongoing monitoring, can surface by integrating impact criteria into the investment process.

Investors will need to balance the desire to invest directly in companies or projects with the need to remain diversified (i.e. invest in funds). For example, KLF’s private equity allocations were generally made to funds, but occasionally, when an investment’s impact attributes seemed particularly compelling, KLF made direct investments. Not all investors will be able to achieve adequate diversification through private investments by investing in deals individually or with individual managers. For such investors, multimanager vehicles can provide options for broader exposure.

Asset Allocation

In the context of a complete portfolio approach to impact investing, every potential investment should be evaluated for its contribution to the total portfolio. Position levels should be monitored relative to the investment policy, but to the extent possible, investors should remain flexible and nimble in light of new impact information and when faced with changing conditions. Investors will need to balance the impact desired with the impact available. In many cases and across asset classes, it is possible to achieve a satisfactory balance.

For KLF, once appropriate investments were identified, each investment was matched to the Foundation’s overall asset allocation targets. An effort was made to avoid overexposure to any particular theme, sector, manager or company – sometimes even allocating to cash, cash equivalents or short-term debt when the desired exposures could not be matched with acceptable impact investments. This type of occurrence continues to decrease in frequency as the impact marketplace matures across asset classes.

Next Steps for Investors

For investors seeking to integrate impact across their investment portfolios, the impact investing cycle roadmap can serve as a useful guide for moving from strategy to implementation to results.

• Ask for impact: Asset owners should no longer accept the premise that sacrificing financial performance is necessary to achieve measurable and meaningful impact. Evolution of an Impact Portfolio: From Implementation to Results can serve as a reference. 
• Reclaim ownership of assets: If the service provider is not willing and/or not able to deploy assets to impact, another service provider should be found who is. 
• Become more educated: Growing industry networks and an abundant set of topical resources are available to those interested in learning more.
• Widen options: The industry continues to evolve, and investors today have an increasing number of choices to implement their impact strategies. More high-quality, turnkey solutions are available in the marketplace than ever before.