ImpactAlpha – “Why institutional investors are adding independent verification to their impact due diligence”
This piece was originally published in ImpactAlpha.
If efficient capital allocation between asset owners and investees is the main function of investment management, then rigorous due diligence is the lifeblood that allows capital to flow.
Now with institutional demand for impact investing products on the rise, due diligence requirements have expanded to encompass impact and ESG as well as financial performance considerations. While this is a positive trend, the additional requirements can translate into greater analytical complexity, thus slowing down capital allocation decisions. This is why many investors are now looking towards third-party impact verification as a valuable tool for streamlining due diligence and separating the wheat from the chaff.
How due diligence has evolved
Since 2018, there have been more than 2,000 ESG-committed private funds in the market targeting about $1.42 trillion in aggregate capital, according to data from Preqin’s 2020 Impact Report, “The Rise of ESG in Alternative Assets.” An institutional investor can’t be expected to conduct thorough due diligence on every fund that crosses its desk, let alone every impact fund. A well-designed screening process helps reduce the target list to just those funds that meet a certain set of gating criteria, saving time and energy for both the allocator and the fund manager and allowing financial markets to function more smoothly.
In recent years, questions about ESG and climate change have begun appearing on investor due diligence questionnaires (DDQs) with increasing frequency, including questions on everything from a manager’s commitment to diversity, equity and inclusion (DEI) to a manager’s recycling program. For instance, nearly half of asset owners (46%) said they want fund managers to supply information on the greenhouse gas emissions and carbon intensity of their portfolios, according to a survey by Cerulli Associates. The same survey found that 70% of asset owners either already require or will soon require asset managers to report on thematic metrics to show how their investments make measurable social and environmental impacts.
As investors seek greater visibility into ESG and impact policies and processes, there is a commensurate need for independent assurance that these practices are both accurately characterized and on par with industry standards.
The growing adoption of impact verification
As asset owners look to allocate more capital to impact funds, they are looking for reliable ways to identify best-in-class managers. This is where impact verification comes in.
Independent impact verification can make the lives of asset allocators easier by providing a trusted, third-party evaluation of an investment manager’s impact management practices and/or impact performance. An impact assurance provider looks under the hood to determine if the manager’s claims about its impact practices and performance are backed up with evidence, aligned to industry standards (such as the Operating Principles for Impact Management (OPIM) or the forthcoming SDG Impact Standards), and reported in a consistent and reliable way. Just as an institutional investor would hesitate to allocate capital to a fund that lacked a trustworthy auditor or law firm, the same will soon be true of funds missing a reputable impact verifier.
A statement from a third-party impact verifier can provide confidence that a fund’s representations of its impact practices are accurate while also identifying potential areas of impact risk for future monitoring. Given the many different impact investing standards and the dynamic nature of the impact market, this kind of verification statement could help clarify and spotlight the most relevant and differentiated components of a manager’s approach to impact reporting and impact management.
The list of fund managers that have been independently verified is growing at a rapid pace. As of March 2020, 115 impact investors have signed onto the OPIM, which require public disclosure and independent verification of alignment. Nearly half of these signatories have already published their verifier statements, providing essential information for investors looking to allocate to best-in-class impact funds. The SDG Impact Standards are expected to include external assurance and an SDG “seal of approval” for investors seeking to align their investment activities with the SDGs. Other industry standards like the Social Bond Principles also include a mechanism for independent assurance.
A growing number of institutional investors have signaled that they plan to ask fund managers to complete an independent verification as part of their screening and due diligence processes. For example, we have worked closely with one leading development finance institution to verify that prospective fund managers in their pipeline are aligned with best practices in impact investing.
Within the next year or two, we expect impact verification to become commonplace and eventually represent a de facto best practice for impact fund managers seeking to raise capital. As more impact investors enter the market, the insights and benchmarking they receive via an independent verification by a trusted third-party could be what sets managers apart from the competition, especially as prudent asset allocators rely on insights from impact verifications to reduce impact risks and enhance impact results. This market innovation enables not only the efficient allocation of capital, but also ensures that the impact investing industry scales with integrity.
Christina Leijonhufvud is the CEO of BlueMark, Tideline’s new verification business. She manages all aspects of business strategy, new product development, and external relations, and has directly led 30+ impact verification assignments across investor types and asset classes.
This piece was originally published in ImpactAlpha.
The impact investing industry has matured over the past couple of years, especially when it comes to aligning investors around common standards for disciplined impact management practices.
The Operating Principles for Impact Management (OPIM) and the forthcoming SDG Impact Standards from UNDP, in particular, have created both clarity around the practices required to authentically integrate impact into each stage of the investment process and accountability for those practices through the encouragement or requirement of independent verification.
And yet with each advancement, another missing building block in the impact investment market is revealed. Attention has shifted to the imperative of impact performance reporting standards and, as with impact management practices, both clear standards and a mechanism for accountability are needed. Recent publications by leading sustainability and integrated reporting organizations like CDP, CDSB, GRI, IIRC and SASB; the IFRS Foundation; and the Global Impact Investing Network (GIIN) reflect efforts to define and harmonize both corporate and investor reporting standards.
Impact performance reports today come in all sizes and flavors, reflecting a lack of clarity and consensus on what constitutes quality impact reporting as well as efforts by individual investors to convey their own “secret sauce.” The state of play makes it difficult for asset owners and allocators to interpret the impact performance of their investments, much less to compare one impact fund to another.
Investors are in search of a better approach to impact reporting that incorporates relevant impact goals and metrics along with the qualitative information needed to communicate a holistic, yet digestible, portrayal of the impact of their portfolios.
While we collectively strive for more consistency and standardization, it’s important to keep in mind that robust reporting—whether on impact or financial performance—is both an art and a science, a balance of both qualitative and quantitative information. Impact reporting will always involve a degree of subjectivity, which makes the role of expert, third-party evaluation and verification critical to ensuring accountability, discipline, and comparability, three core pillars of BlueMark’s approach.
Introducing a way to verify impact reporting
In the absence of a universal or harmonized set of impact reporting standards, BlueMark has stepped up to introduce an impact reporting verification service to respond to market demand. We welcome feedback and comments from market practitioners as we seek to continue to refine our methodology to best meet the market’s needs.
Our approach draws on several leading foundational frameworks, including the GRI’s Sustainability Reporting Standards, OPIM, Impact Management Project, IRIS+, and the SDGs, and encompasses both quantitative and qualitative information necessary for a complete and insightful picture of impact performance.
BlueMark’s approach is organized around five key characteristics of high-quality impact reporting. We can think about these elements as divided between two categories: the reporting framework, on the one hand, and the impact performance report, on the other. While an investor’s actual impact report may focus most heavily on the latter, both levels of information are needed for completeness.
- Context – Impact reporting should be supported by robust and clearly articulated portfolio-level and investment-level impact theories of change, including an analysis of the evidence base for the linkages between stated impact goals, assumptions, target outputs, and outcomes. The investor’s particular contribution to achieving impact should also be clearly developed.
- Relevance – The relevance of impact goals to the SDGs and underlying SDG Targets should be clearly established, drawing on industry frameworks such as the Impact Management Project’s A, B, C classification scheme. In addition, the reporting should take care to identify the stakeholders – including customers, the environment, local communities, and workers – who experience the positive and negative impacts of the investment strategy.
- Comparability – An impact report should use objective and transparent impact indicators, drawn wherever possible from industry standards, that allow for the analysis of impact performance over time, relative to expectations, and relative to other organizations. The proportionality of reported impact results to the scale of the investment should also be considered.
- Balance – An impact report should feature a discussion of both positive and negative impacts as well as impact and ESG risks. To achieve true balance, the report should also discuss instances of impact underperformance and unintended impacts and what lessons were learned as a result.
- Reliability – Impact data, which may come from both primary and secondary sources, should be collected and tracked in a way that drives data quality. Quality control practices should help to ensure that reported impact data is free of manipulation or errors and consistently defined and calculated.
We believe that impact reporting that incorporates these elements is worthy of a high mark, and we look forward to sharing specific examples in future articles.
Given the lack of common standards and dearth of historical impact performance reporting, even the most experienced impact investors are likely to have gaps or shortcomings in their reporting processes. Independent verification of these reports and the underlying systems can help spotlight areas of strength and where there is room for improvement, thereby providing LPs and other stakeholders with the assurance they need while also encouraging investors’ continued advancement towards best practices.
We see the future of impact reporting evolving in much the same way as financial reporting, with third-party verifiers such as BlueMark playing an important role in bringing greater accountability, discipline, and comparability to the market. As impact investors become more comfortable with reporting on a variety of both quantitative and qualitative inputs, the bar of ‘performance’ and best practices will rise across the industry.
Christina Leijonhufvud is the CEO of BlueMark, Tideline’s new verification business. She manages all aspects of business strategy, new product development, and external relations, and has directly led over 20 impact verification assignments across investor types and asset classes.