Author’s Note: While this article is written by a registered investment advisor, this article should not be construed in any way to constitute investment advice.—AB
With a third of all public market investments now being screened for SRI (socially responsible investing), or environmental, social, or governance (ESG) criteria, most investors have at least been exposed to the idea of connecting their values with their investment strategy. Impact investing goes beyond ESG investing in that, at least in a robust understanding of the term—definitions vary, and this is part of the challenge!—impact investments seek to use capital to not just obtain a financial return, but to meaningfully boost social outcomes for people and places.
In December, NPQ published an article that highlighted how a rise in popularity of these two forms of investing has not necessarily translated into a narrowing of the economic and racial disparities we see in the US, as evidenced by studies like those coming out of Boston in 2017. After 17 years as a professional in the finance industry, the last 10 of which were spent organizing in the community impact investing movement, the central truth I have come to realize is that community members themselves are best positioned to address inequality. However, current investment rules make it difficult for them to exercise the autonomy they need to make progress.
How Did We Get Here?
To begin, it helps to understand the field’s history. In the 1970s, what is now known as ESG investing started with Michigan State University students demanding their university divest of South African investments to protest against Apartheid; the practice of divestment spread among investors in the 1980s, ultimately contributing to the regime’s demise.
In the 1990s, the Community Development Financial Institutions (CDFI) Act was passed, creating a tool that’s still used today to shift capital into communities. While these were powerful steps forward, they largely left individual investors (commonly called retail investors) and small community-based organizations out of the conversation.
After the Great Recession, a variety of scandals led to widespread public distrust of Wall Street. As retail investors and local businesses (both for-profit and nonprofit) explored their options, they realized they technically did not have the legal freedom to act.
Again, activists pushed for change. This led to the passing of the JOBS Act in 2012 (commonly called Reg CF, for Regulation Crowdfunding), the rules of which finally went into effect in 2016, and a corresponding state-based movement that loosened long-held restrictions on how capital could flow within a community. While there is no solid data on how much capital has shifted using state-based intrastate security exemption laws, there is a robust system of recordkeeping on Reg CF campaigns. In less than five years, nearly $800 million has shifted into the hands of small businesses—$239 million in 2020 alone—as a result of investor activism in the face of COVID.
While expansion has been rapid, it is but a drop in the bucket. All told, US households and nonprofits control over $100 trillion in wealth, making the Reg CF shift less than one-thousandth of one percent of that amount. We have essentially made no progress from what Michael Shuman observed in his book Local Dollars, Local Sense in 2012. This fact is critical to examine because, based on early data, we know that community impact investing leads to more capital being available for women and people of color.
In order to change these numbers, we need to dive into the technical barriers that stand in our way. Structural inequities in America are vast, siloed, and nuanced, requiring observers in each industry to continue surfacing the issues they see. In the finance industry, challenges can be categorized into the following areas: education, risk management, capacity, and reporting.
The Role of Education
In the words of the late Nelson Mandela, “Education is the most powerful weapon which you can use to change the world.” There are four key audiences that need their own tailored education: investors, advisors, entrepreneurs, and technical assistance providers.
The US is tragically behind on including a personal finance curriculum in education at all, so knowledge of how to invest in privately held, community-based enterprises becomes yet another topic to add. Entrepreneurs and the technical assistance professionals that serve them are becoming more aware of tools like Reg CF; however, we still see a big gap in options being presented to entrepreneurs for capital and services to prepare them for those strategies.
Financial advisors, however, are who investors would most expect to be knowledgeable about all forms of investing. Surprisingly though, investing outside of Wall Street is not required education for licensed professionals. The biggest leap forward that has emerged in the marketplace over the last decade has been the Chartered SRI Counselor (CSRIC) designation from US SIF and the College for Financial Planning. While the CSRIC curriculum includes a section on community investing, it only covers CDFIs, not direct community impact investments.
The Local Investing Resource Center recently refreshed content for financial advisors, which included a scan for advisor guidance from financial industry regulators, and again found little education available. This has essentially resulted in advisors providing peer-to-peer education across the sector in learning labs in an attempt to grow the knowledge base together.
The Limits of the Risk Management Approach
Risk management is a critical component of why and how our economic systems function the way they do. Even ESG investing is often justified as more of a risk management signal rather than a conscious investor signal.
For most of the history of the US Security and Exchange Commission (SEC), up until the passing of the JOBS Act, a prevailing accepted principle has been that Wall Street investing is “safer” and “more appropriate” for “unsophisticated” (nonaccredited, retail) investors—and if you have to ask what a nonaccredited investor is, you’re likely one of them. While there are some exceptions, the basic rule remains that to qualify as an investor who’s “accredited,” you must either have a net worth of more than $1 million, excluding the value of your home, or income of at least $200,000 each year for the last two years (or $300,000 of combined income for married investors).
When regulators make assertions about what is considered appropriate versus inappropriate, investment advisors take those cues as signals about what they may or may not be sued or disciplined over. While there are legitimate differences between the types of risk in various asset classes, the assertion that people must be protected from investing in community businesses because they’re not listed on the stock market is patronizing.
The result is that investment advice is informed more by risk management than upholding fiduciary duty—that is, advice that corresponds to investors’ goals and values. As long as this is the cultural norm, investors will be driven to make impact investing decisions without professional guidance, limiting the expansion of the movement and possibly leading to more harm than good.
The High Cost of Limited Capacity
As with all new markets, when there are fewer participants and limited resources, the ability to serve in robust ways becomes inhibited by the capacity of the participants. With less than one-thousandth of one percent of capital shifting toward community impact investments, every corner of the movement faces challenging decisions.
The activities required in the impact investing movement include deal sourcing, due diligence, custodian services, tax guidance, affordable legal and valuation services, social capital development, portfolio tracking, and impact reporting—just to name a few. There are effectively three solutions to this limited capacity issue being employed today—1) external subsidization, 2) internal subsidization, or 3) collaboration.
Community investment funds such as the Boston Ujima Project, Seed Commons, or the Fair Food Fund are all excellent examples of great work being done to shift capital into community’s hands for maximum impact, but are still too small to be sustained without external donor capital.
Internal subsidization is what we see happening inside investment firms, platforms, and other service providers, where more profitable lines of business subsidize impact investing activities. Because the sector has not reached an economy of scale, each individual organization has to try its best to make do with what it has. This ongoing tension around time, energy, and capital spent on various business lines leads to the deepest—and most exciting—opportunities not getting the attention they need.
Collaboration, then, becomes the third common workaround to the capacity problem. This is where we see communities of people organizing to open-source their findings, best practices, and deals they are investigating, like at The Next Egg, Angels of Main Street, or Slow Money.
The Need to Measure Impact
For all of this conversation about the structural barriers to investing for impact, we cannot forget what’s arguably the most important part of the story—ensuring the impact is really taking place. As was highlighted in Steve Dubb’s article in December, measuring the impact is its own hairy challenge. In community impact investing, there is no uniform reporting standard or mechanism. Firms work in silos and do not share impact data across the industry. Businesses that raise impact investment capital may or may not have robust investor relations practices, and, if they do, their findings are not shared outside of the investor pool.
If we are not gathering qualitative and quantitative data about how lives are improved, communities are recovering, and social connections are growing, then how can we expect real outcomes that move society toward economic and racial equity?
How We Can Break the Impact Investing Logjam
It is easy to point to all the flaws in a system when confronted with them on a day-to-day basis. The solutions offered so often boil down to a matter of money—if we just move money from here to there, then the problems would disappear. However, more is required. Here are a few places to start:
- State policy. States can leverage tools to help incentivize and organize their ecosystems. Already, some states are taking steps in this direction. Michigan, for example, recently introduced Senate Bill 924 to create a local investment tax credit of up to 50 percent to help offset losses that may be incurred by investors supporting their local businesses. Additionally, a state could create an ombudsman office within their economic development agency to direct inquiries it receives to partner organizations; organize roundtables; and facilitate the flow of information, tools, and market advancements as they occur.
- Federal policy. There are two mechanisms that would reduce risk and costs for communities to organize themselves. The first is that the SEC could allow communities—especially ones including finance industry professionals—to openly discuss investment opportunities, crowdsource due diligence, and let firms share information without reprisal or taking undue compliance risk. Second, the National Coalition for Community Capital (NC3) and several national partners have drafted a letter requesting that the SEC create a new community investment fund structure that would lower the cost, and therefore the breakeven point, for communities to pool their capital for local impact.
- Open call to open source. Professionals from a variety of industries can open-source deal templates, due diligence questionnaires and processes, platforms and servicer ratings and experiences, success stories, and lessons learned. Already, some organizations, like Crowdfund Better, ImpactAlpha, and Locavesting, are providing insights and resources to the public. The more that can be shared outside of paywalls, the wiser the movement will become.
Wanting to invest for community impact first requires an awareness and aspiration toward action, but once that is achieved, it is not as easy as flipping a switch. It is critical to understand why it is not so easy. Otherwise, we may forever be stuck without taking meaningful action toward the future we claim to want.
In examining the infrastructure barriers highlighted here, what can you do? If you lead a nonprofit that has an investment advisor, ask that person to educate your board about community impact investing. If you are in public policy, schedule a meeting with your state regulator to better understand their educational curriculum and what it would take for this impact investing to be included for investment advisors. If you are a financial professional, the next time conference organizers put the call out for topic suggestions, make sure education for advisors gets submitted. If you are a community organizer, connect your constituents with the resources highlighted in this article.
Wherever your power in the economy lies, your contribution toward effecting change is palpable and necessary.