Impact investing, which aims to achieve both financial returns and tangible social or environmental outcomes, is significantly different from traditional venture capital.
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| Impact Investing: The Future of Venture Capital? |
The growing interest in impact investing has led an increasing number of individuals, family offices, and financial institutions to align their investments with broader social and environmental goals.
While impact investing might come with lower financial return expectations compared to traditional venture capital, both approaches are essential in supporting exceptional projects and teams shaping the future of the economy. In both cases, liquidity challenges are prevalent.
What do companies like Tesla, Beyond Meat, Zoom Video Communications, Moderna, and Impossible Foods have in common? Besides their technical and commercial prowess, these former startups are also success stories in impact, having generated value for their investors while positively contributing to real social or environmental challenges.
Even though these companies combine impact with financial returns, the investment logic isn't always the same when comparing venture capital with impact investing. Venture capital involves investing in startups with high growth potential and return on investment, focusing on innovative products or services.
On the other hand, impact investing aims to generate positive social or environmental impact in addition to financial returns. These investments are geared towards supporting companies or projects with clear goals in sustainable development, social responsibility, and/or environmental stewardship.
In recent years, there has been a significant increase in interest in impact investing. A growing number of individuals, family offices, and financial institutions are now seeking to align their investments with broader social and environmental objectives. Global issues such as climate change, poverty, access to education and healthcare are key themes in impact investing.
Reduced Profit Expectations in Impact Investing?
A venture capital fund selects projects likely to multiply the initial investment by 3 or more within 5 years, to offset capital losses from inherently risky companies.
Although the average performance of most venture capital funds falls short of this 25% annual return rate (hovering around 15% according to research firm Preqin), this financial goal reflects the stakes and ambition of the profession.
Impact investment fund managers may reduce their financial return expectations as long as the societal or environmental impact is significant, aligning with the investment thesis "sold" to their individual or institutional subscribers.
The idea is to select projects likely to double the initial investment in 5 years, which still corresponds to an internal rate of return close to 15%, significantly higher than what the stock market delivers in the long term.
Again, reality falls short of this goal, with average impact investment returns in the private sector at 10.5%, according to the 2023 Global Impact Investing Trends report by Preqin. The average return discount compared to generalist venture capital is therefore 4.5%.
The Low Liquidity of Impact Investments
A Major Constraint Given that these are unlisted investments, each carrying considerable risks of failure and equally significant liquidity challenges, it is clear that both generalist venture capital and impact investments in the unlisted sector can only apply to exceptional projects led by top-tier teams.
The median exit (sale or other liquidity event) time for a startup financed by venture capital funds is now 9 years, according to investment bank Avolta.
This liquidity constraint is a major issue for unlisted investments. The quest for liquidity in impact investments is even more challenging, as an impact company cannot simply be sold to the highest bidder without ensuring a strong compatibility between the values and corporate cultures of the buyer and the target.
The Irrepressible Growth of Impact Startups
Clean energy, MedTech, EdTech, Agritech, FinTech for inclusion, circular economy, social impact platforms, sustainable fashion, clean water and sanitation, mental health, and well-being: the list of fields ripe for disruptive innovation is long.
Whether it's seed funding, venture capital, or growth capital, investors will naturally seek to systematically support startups that integrate sustainable or socially responsible solutions into their business models. As a result, impact investing will gain importance in the venture capital space.
However, while impact investing is gaining popularity and is set to play an increasingly important role in venture capital, it would be presumptuous to claim it represents the exclusive future of this form of investment.
The combination of both approaches could pave the way for a future where financial goals and social and environmental impact complement each other.
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