Can Social Impact Investments deliver VC-grade returns?

ESG-themed Venture Capital funds tend to focus, often exclusively, on the Enviromental “E” part, which covers different verticals of Cleantech, such as energy, mobility and new materials. A few days back at the MWC 4YFN event in Barcelona, I was met with skepticism when signaling that the SFDR Article 9 fund AYOSV tried to build would only invest in the Social “S” part, which covers verticals such as health, education and social inclusion. I would have reacted the same hadn’t I been exposed to great social impact-focused funds as part of my previous Fund of Funds journey.

So let’s break down the stereotype haunting social impact investing.

First, it is essential to define Social+“Impact Investment” and clarify its position within the impact and sustainability spectrum shown below.

In short, we are looking for a combination of:

• 🫱🏻‍🫲🏾 Social Return. This could be measured through Impact KPIs related to some of The 17 Goals (“SDGs”), such as the number of people who got access to education or to a new vaccine thanks to the investment.
• 💸 Financial Return. In terms of MOIC (individual investments) or DPI (fund investments) and IRR.

To illustrate with examples:

• 🚸 Traditional Philantropy: “free” grants for development (EIC accelerator), “free consulting hours” of an NGO or accelerator (AYO Emprende). No financial return.
• 🔬 Venture Philantropy: subsidized high-risk loans for startups (Enisa), grants with royalty schemes for early phases of drug development (Champalimaud Foundation). Focus is on social return.
• ⚖️ Social Investing: some VC funds looking for an annual return of 6%-12%, less than the VC-grade target of 20%+. Alternatively, co-investments (CDTI Innvierte) or LP fund investments (BBB Enterprise Capital Funds programme) where the public sector-backed investor takes a profit cut to favor other parties, prioritizing social return indirectly canalized through empowering the VC and startup ecosystem over financial return.
• 🛴 Impact Investment: looking for a social return, but prioritizing (close-to-)VC-grade financial returns. For instance, aiming at a 2.5x-3x DPI for the fund or 15%-20% cash IRR is not top-tier for a Venture Capital fund, but considering the high social return the investment or fund should generate, some investors would be willing to compromise. A way to consolidate or “hedge” the social return target would be to vest a portion of the carried interest to the fulfillment of impact KPIs by the aggregate fund portfolio. For example, a part of the carried would be “donated” if such KPIs are not met.
• 🙋 Sustainable and Responsible Investing: VC funds signatories of PRI and/or with an established ESG policy. Focus on financial return.
• 🛢️ Fully commercial: I don’t think any established manager would fall into the category. For a non-VC example, think of the company behind the Panama copper mine saga.

Second, let’s discuss some ways a Social Impact Venture Capital can generate market-grade financial returns.

• 🔥Investment themes: for generalist VCs, many of the topics that cover Social Impact, such as ageing population (crunchbase report) or social inclusion -promoting ones like remote work and payroll HRtech companies (unicorns like Deel), have gained the hot topic label over the previous years. Regarding health-focused and life sciences VCs, medtech and/or biotech have long been their core investment themes, and, from a portfolio construction perspective of a social impact fund, those sectors tend to be countercyclical compared to productivity SaaS and high growth startups also part of the portfolio, hence enriching portfolio diversification.
• 👧🏽Minorities founders. You have probably noticed or heard it several times on 20VC, many of the greatest once-startups companies had a (co)founder who experienced a tough childhood (poor family, immigrant story, women sometimes…). From one side, most of those founders tend to have a social impact purpose driving their startup, and on the other, they tend to be more “careful” spending money, thus shoul be better qualifed in finding the path to profitability, which is necessary to build a robust and sustainable business. Bonus: I talked about funds that focus on minorities in this previous post.
• 👯‍♀️Co-investing with top funds. It is simple there, if you primarily adopt a follower or co-lead role and co-invest with a top fund, you are seeking the same financial return. Nowadays, impact startups tend to appreciate the presence of an impact fund on the cap table, particularly if they assist them in defining and monitoring impact KPIs.
• 🎯Tangible Impact KPIs, no greenwashing. Think that we would be counting the people postively and directly impacted by the investment in an objective way. The observable aspect of social impact KPIs characterises them compared to enviromental impact KPIs, such as the “subjective” computing of carbon footprints spared and the hypothetical quantity of litres of water saved, sometimes misused by corporates and funds to demonstrate their ESG commitment. Owing it to their high credibility, in my opinion, social impact KPIs could be a key driver in the fundraising “equity story” of the startup as well as of the exit strategy of the fund. On one hand, those KPIs could attract “social investment” (below market financial return) investors in future financing rounds since the social return is demonstrated. On the other hand, social impact KPIs could be a key liquidity provider for fund managers willing to sell secondaries (single company positions, batch sale of positions, LP secondary…) to impact-focused investors such as late stage or secondary impact funds that should emerge in the coming years (after the recent booming of secondaries) or impact-focused Family Offices or Private Equity firms.