## Visual Introduction to Impact Returns

[Warning - new, experimental content!]

Consider the example investment universe illustrated in the chart below.

Each opportunity has a Profitability, Company Impact, Crowdedness and Scalability score. The Crowdedness score is shown as the color (red = crowded) and the Scalability score is shown as the size of each opportunity. More profitable companies tend to be more crowded.

It's not obvious, looking at this chart, which opportunities are best because profitability is not the same as financial returns.

Suppose you estimate the expected (risk-adjusted) financial return of each opportunity. This return will be higher for higher profitabilities, but lower for more crowded opportunities (which will attract a higher price).

Based on your financial returns estimates and the company impact scores, you work out the 'Impact Frontier': the portfolios that offer the greatest level of impact for a given financial return. The frontier will always, by definition, be downward sloping.

The key question becomes: how do you choose where on this frontier you want to be?

Trying to pick a spot on the frontier brings up the issue of what the impact scores 'really mean'. Suppose you examine the 'company impact scores' and decide that they don't properly reflect the magnitude of the impact of each underlying enterprise. In particular, on the dimensions of 'How much?' and 'Enterprise Contribution'.

So, you estimate the 'Enterprise Impact' of each opportunity in a way that reflects its magnitude and you find a new impact frontier (orange). This is Impact Return Key 1.

The old portfolios based on 'Company Impact Score' (black) are not very efficient from the perspective of 'Enterprise Impact'.

Then, if you're trying to capture the magnitude of each enterprise's impact, what about the magnitude of your contribution as an investor?

So, you adjust 'Enterprise Impact' to get an estimate of the 'Investor Impact' you can generate with each opportunity. And, again you find a new impact frontier (blue). This is Impact Return Key 2.

The old portfolios based on 'Company Impact Score' and 'Enterprise Impact' (black, orange) are not very efficient from the perspective of 'Investor Impact'.

Now, you're finally happy with 'Investor Impact' as your impact metric. But, you still have the problem of which point on the 'impact frontier' to target with your portfolio. One potential choice is illustrated on the chart below as a star (yellow). This choice of position on the frontier is Impact Return Key 3.

This may not be obvious at first, but choosing a spot on the impact frontier defines the rate at which you are willing to trade financial returns for impact. This is because to optimize your portfolio choice, you walk along the frontier from the top left until the slope of the frontier equals this rate. This rate, or 'price of impact', is the slope of the yellow line in the chart. A lower price of impact is equivalent to choosing a point up on the flat part of the frontier on the left. A high price of impact will get you a point on the steep part of the frontier on the far right.

This is a subjective choice - there is no right or wrong answer. However, there are more or less 'coherent' ways to make this choice. The meaning of this will be explained with the following charts.

Note that, while the choice is subjective, not making a choice is not an option. Every investor who is trying to hold the best possible portfolio, in one way or another, will end up trying to hold a portfolio somewhere on the frontier. And every point on the frontier has a corresponding price of impact. If you choose to ignore this choice, then you're likely to end up with a portfolio that is suboptimal for your actual preferences. Either with a lower or higher price of impact than you would choose if you thought about it. That would be a recipe for leaving either financial returns or impact on the table.

The tangent line to the impact frontier defines how you are willing to translate between investor impact and financial returns. When applied to opportunities it defines the 'Security Impact Line' (SIL). This line separates opportunities that are in your chosen impact frontier portfolio (above the SIL) from those that aren't (below the SIL).

The SIL will be straight as long as you have defined investor impact in a way that you are comfortable represents its magnitude across the entire range of possible values.

It could be that complexity of impact means that it's not possible to define the impact frontier or investor impact in a way that can be compared across all opportunities (e.g. different types of investment, different geographies, different forms of impact). For portfolios that span such incomparable areas, a natural solution is to define the impact frontier and the SIL separately for each area.

The SIL also visually defines how to translate investor impact into an 'impact return'. The impact return is the difference in financial returns between the level of the SIL at a given investor impact and the level at zero investor impact.

The slope of the Security Impact Line is the 'price of impact': it tells you how to convert any amount of investor impact into an impact return. Once you have impact returns you can combine them with financial returns to get: Impact-adjusted returns = Financial returns + Impact returns.

When expressed in terms of impact-adjusted returns, the impact frontier wraps around and has a clear optimum point. This optimum point is exactly your chosen spot on the frontier.

Note that the portfolios you would get by optimizing with company impact scores or enterprise impact don't come close to the optimal total return (as defined by the price of impact your choice implies).

Considering impact-adjusted returns, we can draw a simple line that separates the opportunities in the optimal portfolio from the rest. All the optimal opportunities have impact-adjusted returns around 20% or higher. If you miss any of these opportunities, then you are leaving either financial or impact returns 'on the table'.

When expressed in terms of impact returns, the 'simple line' in the chart above becomes the 'security impact line' (SIL) in the chart below. In this case, with 'impact returns' on the horizontal axis, the SIL has a slope of -45 degrees.

Whereas, when investor impact is on the horizontal axis, the slope is the 'price of impact' that defines how to translate between impact and financial returns.

Points on the line all have the same impact-adjusted return. It goes through the opportunity with the lowest impact-adjusted return that is still in your optimal 'star' portfolio. It is similar to the 'security market line' of the traditional CAPM model.

This is where 'coherence' comes into play. If you were to choose this point on the frontier, but only make the investments with a financial return >20%, then you wouldn't actually be coherent with your chosen target. Equally, if you were to only make the investments with impact returns >40%, this would not be coherent with the chosen frontier point.

Of course, if your investment mandate restricts you from pursuing certain opportunities then it may be your role to only focus on part of the 'optimal portfolio'. But for the ultimate asset owner, not being coherent with the chosen frontier point is likely to leave substantial financial or impact returns on the table.

Compare the plot of opportunities on an impact-financial return chart (above) to a chart that uses company impact scores (below). Remember, the company impact scores don't account for the magnitude of impact (Key 1) nor investor contribution (Key 2). This makes the points in the chart below so jumbled up that we can't cleanly separate out the best investments (Key 3)!

It is much easier to pick the best opportunities (in the top right) with the impact-financial return chart (or the impact-adjusted return chart). This is because, as investors, what we ultimately care about are returns (financial and impact), not profitability or company impact.

This illustrates the power of using impact returns instead of intermediate metrics like company impact scores.

What does this mean in practice?

The chart about shows the impact-financial return chart with the opportunities divided into four quadrants. The point of this chart is that with this choice of 'security impact line' you should consider a selective mix of 'Traditional', 'Most promising' and 'Concessionary' investments.

The divisions are just illustrative, please don't read too much into the specific values. Roughly speaking it seems fair to think of 'traditional' investors as being willing to considered any opportunity in the Traditional and Most Promising categories. Sure, they might try to only get the highest financial return options, but this is a competitive business and they need to consider the whole set of opportunities to be sure of being fully invested. Similarly, we can think of relatively 'impact-first' or philanthropic investors as considering any of the Concessionary opportunities. The chart then shows that if you are optimizing for impact-adjusted returns then you will be relatively picky in each category compared to other investors. The blue, orange and green opportunities in your 'optimal' portfolio are all subsets of their respective categories.