One of the stamps of approval to this framing of important social and environmental issues has come from the investment world, including major institutional investors such as Dutch pension funds now proclaiming that a major portion of their assets will require investment returns as well as a direct link to specific SDGs.

Mainstreaming ESG and impact investing

This endorsement by major global investors is laudable. In our view it represents another clear example of the mainstreaming of ESG (environmental, social and governance factors) and impact investing. However, it also presents a direct risk for cynicism by the beneficiaries of their assets if investors dilute the SDGs too much in their approach in order to link their investments to specific outcomes.

Therefore, we applaud and at the same time remain cautious as we look across asset classes and how to best link them to the specific goals identified by the UN. The most tangible asset classes to achieve demonstrable social and environmental outcomes thus far have been in alternatives as evidenced by green real assets or social impact investing in private equity.

Growing investor demand further driven by the SDGs

While impact investing and SDGs are still new on the horizon, investor demand is quickly growing and moving into larger, more liquid asset classes. For example, green bonds have provided larger tickets and liquidity for the measurement of SDGs such as Clean Water (6), Clean Energy (7) and Climate Action (13). The direction of travel is clear and the next phase of responsible investment evolution is impact investing.

The traditional area for ESG investors has been in public equities. For impact investing, it has been in alternatives. The demand for SDGs in public equities is now starting to emerge and will bridge these two worlds. In order to maintain integrity, products and services should be considered that go beyond a simple analysis of a carbon footprint compared to a benchmark. This will become the standard for client expectations, but will not necessarily meet the needs of sincerity around SDG outcomes.

SDGs create a doorway to impact investing in public equities

Two illustrations come to mind in how to make public equities relevant around SDGs and in line with an impact investing philosophy. If we take quantitative equity, one can imagine a portfolio construction process which focuses on holdings that can demonstrate how they are contributing to a lower carbon future through their products and services and business operations. Metrics such as carbon emissions saved and green share of portfolios can be used for this analysis. These are steps to demonstrate that it’s not just business-as-usual portfolio construction, and not just about following a low carbon index. This is active portfolio management towards an SDG outcome while ensuring financial returns.

Kathryn McDonald, Head of Sustainable Investing at AXA IM Rosenberg Equities, commented:  “We believe that publically traded equity investing can act as complement to traditional impact investing. The breadth of the publically traded market, and the capacity offered by quantitative equity investing in particular, allows asset owners to put significant AUM to work to really move the needle on impact goals.

“Looking carefully at several of the SDGs, we believe that we can build targeted, listed equity portfolios that speak directly to specific investor goals. Importantly, compelling financial returns are a must – without those investors will not stick with ‘listed impact’ approaches for long.”

So too, in a more conviction based approach, we can imagine a portfolio that has high active share and engagement as a key basis. A focus on both environmental and social impact with metrics and information provided by companies around access to improved livelihoods, clean water and improved healthcare allows to build a concentrated portfolio in public equities, particularly with a focus on the underserved and the developing world.

Ian Smith, Portfolio Manager at AXA IM Framlington Equities, added: “At Framlington Equities, we have developed the know-how to be able to adhere to what we believe will be the common requirements of a public equity impact fund in relation to monitoring impact metrics, promoting better disclosures and aligning to the UN SDGs.

“For many companies, there can be a strong symbiotic relationship between generating tangible positive societal change and meaningful long term shareholder value – we are looking to identify the companies that have business models and strategies that extol this. We need to be thoughtful when it comes to the many grey areas in impact investment decision making and this is where our deep understanding of and relationships with businesses are critical. We like to focus on who the end beneficiaries of a company’s impact approach are and how their lives are truly being changed. This framework helps us determine which companies fit into our impact portfolios.”

All of this shows that the arrival of SDGs has created a built-in framework for investors to connect the worlds of responsible investment and traditional investment in a meaningful and measurable way.

In order to ensure SDGs, impact investing and traditional asset management prosper, integrity, care and humility are needed. The ultimate goal is for asset management to bring more colour into the equation of money and done right, SDGs can be a tool across asset classes ranging from illiquid alternatives to highly liquid public equities to truly mainstream impact investing.

By Matt Christensen, Global Head of Responsible Investment at AXA Investment Managers (AXA IM)

This section profiles several sources of potential impact investments suitable for institutional investors. Similar to conventional investment management, these sources include companies (private and public), indices, ETFs, and bonds (or other fixed income instruments). For investors who seek to define what makes an “impact investment,” refer to the Appendix for an explanation of IRIS, a series of metrics that encapsulates many environmental and social themes. It should be noted that the number of new impact investment vehicles continues to grow, and this is by no means an exhaustive catalogue. Whatever the objectives or preferences are, this guide can serve as an introduction to institutional investors who are interested in a broad overview of existing impact investment tools and vehicles.

Companies

Many funds choose to invest in companies individually based on their operations or mission. Some specialized venture capital firms, for example, choose to support only clean technologies. Although this is certainly possible for an institutional investor, investments in larger publicly traded companies may be preferred. Institutional investors can choose companies that value certain ethical guidelines in their business operations or products. To determine whether a company qualifies as an “impact investment,” several frameworks can be used. One popular concept that many companies adopt is “corporate social responsibility,” which is loosely defined as compliance with ethical standards in a business model. CSR frameworks can be used to identify companies or organizations that are ethical or impactful in their business operations. Another more active approach for companies is to make social or environmental impact the core of their mission. It is up to the institutional investor to select companies that best fit their appetite for impact (i.e. in operations or in mission) and preferences (e.g. investment horizon, company performance, and company size).

By Rachel F. Wang, Fellow, Bretton Wood’s Initiative.

Download her report at: https://na-production.s3.amazonaws.com/documents/Impact-Investing-for-Institutional-Investors.pdf

A major reason for this expected growth is the impending transfer of wealth from parents to their children. Millennials and Generation Xers stand to inherit between $30 and $40 trillion dollars from the baby boomer generation. The magnitude of this wealth transfer is unmatched by previous generations. Beyond simply the size of the inheritance, Millennials have different priorities than the generations before them. Younger investors seek investments that yield a social return, as well as a financial one.

When asked about the primary purpose of business, 36% of Millennials selected “Improve Society” as their answer. Other answers included “Enable Progress,” which was chosen by 25% of participants, and “Create Wealth,” which was picked only 15% of the time (Deloitte Survey, 2014).

In the past, investments in emerging or non-traditional markets were viewed as exceedingly risky. A lack of transparency and available information discouraged investors from exploring opportunities abroad. The digital age has changed that. Enhanced connectivity now makes it possible for investors to act wisely when investing in emerging markets. Moreover, the credit ratings in many developing nations—such as Mexico and Brazil—have improved as governments exercise greater fiscal responsibility. This development creates more opportunity for impact investing.

Investing for gender equality is rapidly becoming one of the most popular forms of impact investing. The goal is to promote gender parity and personal empowerment through debt and equity investments. There are three basic types of gender equality investments: supporting female-owned enterprises, funding companies that offer products and services for women, or expanding employment opportunities for women.

Organizations like the Calvert Foundation and Root Capital have launched initiatives to promote gender-focused investments. To quote Jackie VanderBrug, a former managing director of Criterion Ventures and now SVP at U.S. Trust: “Women are key assets in combating poverty, building their communities, and creating new pathways to a more just and sustainable world. Investing in women’s education, economic welfare, health, and overall well-being produces powerful results that benefit families, communities, and entire societies. When women become economic agents and leaders, social change accelerates and returns multiply.”

Foreign investment in developing countries dropped 16% in 2014. This has resulted in a $2.5 trillion funding gap, which has made it nearly impossible for these countries to cope with lingering problems like food and water shortages, limited healthcare access, and failing infrastructure.

Similarly, the clean energy sector is experiencing a major shortfall. The International Energy Agency calculates that an additional $36 trillion will be needed over the next 35 years to curb the most extreme effects of climate change. Since philanthropic activity alone cannot bridge the gap, advisors must educate themselves and their clients on impact investing. Our globalized economy has made it possible to engender social change and produce a healthy return on investment. Whether we can find solutions to the most pressing global challenges will depend on the commitment and foresight of investors.

By Marguerita M. Cheng is the Chief Executive Officer at Blue Ocean Global Wealth and Blue Ocean Global Technology.

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A recent study by the EY Global Family Business Centre of Excellence that surveyed 525 family business owners and managers across 21 countries found that nearly half (44%) of those surveyed make investment decisions targeting specific social objectives along with a financial return.

The report, entitled Family business philanthropy – creating lasting impact through values and legacy, found that family businesses globally invest, on average, 3.1% of their wealth in social impact investing, with the Middle East (investing 3.5%), Europe and Asia (both investing 3.4%) leading this trend.

Meanwhile, the majority of family business owners and managers perceive governmental support for social impact investing to be better than (28%) or similar to (62%) the support for traditional philanthropy, even though in reality, only the UK has specifically legislated to accommodate and encourage it.

Survey respondents see government incentives and regulation as key enablers of family business philanthropy. In most countries, taxation seems to be viewed as a key factor for both philanthropy and social impact investing. In countries with laws that promote tax benefits for giving, family businesses are more likely to engage in philanthropy.

Mr. Englisch opines that as companies grow in size, their commitment to philanthropy rises in tandem, emphasising that it is therefore, crucial that governments “harness this desire of family businesses to give back [to society] and make a difference”.

Delegation to external managers

When it comes to organising their philanthropic activities, up to 70% of family business owners were found to be operating via a family-specific vehicle, with 40% having a family foundation or trust, and a mere 30% operating through a family office.

In terms of the success of philanthropic activities carried out, more than half (56%) of all family business owners personally oversee the progress and effectiveness of their philanthropic projects, with very small and very large family businesses tending to exert more family control over the projects compared to mid-sized family businesses.

The recently published World Wealth Report 2016 by Capgemini reported that Asia Pacific (APAC) is now home to the biggest pool of capital after overtaking North America for the first time, holding US$17.4 trillion in wealth from high-net-worth individuals (HNWIs) and boasting a HNWI population of 5.1 million.

Within APAC, however, the degree of control varies according to country, which is likely to impact how family businesses manage their wealth and subsequently, their philanthropic activities. In Hong Kong and China – where the third generation is seen to be taking over the family’s inherited wealth and business – Enrico Mattoli, head of global family office, Greater China at UBS Wealth Management, observes an institutionalisation of family offices taking place, with management layers hired to manage family office affairs, governance measures implemented and traders or portfolio managers hired to focus on different specialisations.

Meanwhile, in other parts of Asia such as in Singapore where wealth is still largely concentrated in the hands of the first generation, Mandeep Nalwa, chief executive officer and founder of Singapore-based Taurus Family Office, says the delegation of investment responsibility does not come easy, which subsequently impacts the outsourcing of money management to funds.

“While the perceived value – in terms of the removal of the conflict of interest [element] – is well understood, oftentimes the firm belief by the family patriarch in his own ability to have checks and balances [in place] on private banks enables – mistakenly, in my opinion – high-net-worth families to dispense with hiring the services of a family office [manager], or a fund manager,” he explains.

By Asia Asset Management

As valuations flounder for Silicon Valley startups once worth billions of dollars, investor interest is on the rise in startups with both financial and social benefits, such as healthcare software for poor communities or low cost solar panels for homes.

So-called “impact investing” rose to $15.2 billion globally last year from $10.6 billion in 2014, according to a recent report by the Global Impact Investing Network. The figure includes several types of investment, from funds to foundations, which intend to generate social and financial returns.

The group expects a 16% rise in 2016. The change reflects investor concern with current valuations of more mainstream technology startups, a desire to help by some investors and a broadening definition of social-good startups. There is also growing sentiment that the rise of mobile technology will allow for profitable upstarts in parts of the world relatively untouched by Silicon Valley.

Earlier this year Union Square Ventures Partner Fred Wilson called the developing world “the next whitespace” for venture capital, pointing to 2.5 billion people poised to adopt smartphones.

Altruism and Profits for Kickstarter the Public Benefit Corporation

Big financial institutions such as Bank of America  BAC -7.34%  and JPMorgan Chase  JPM -6.95%  are investing, seeing rural communities and emerging markets as potential customers for financial services.

The drop in valuations for tech industry darlings that do “things my mom used to do for me” was a “pivotal wake up” for investors, said Doug Galen, chief executive of RippleWorks, which provides advisers for entrepreneurs in the developing world.

Speaking on the sidelines of the Global Entrepreneurship Summit, put on by the U.S. State Department this week at Stanford University for entrepreneurs from around the world, he and others poked fun at businesses made by and for well-off Americans.

“Uber for pets or overnight underwear delivery—those things definitely aren’t getting the same traction they were six months ago,” Andrew Beebe, managing director at Obvious Ventures, a venture firm for ‘world-positive’ investing, said in an interview with Reuters. “But take water (shortages) —on the other side of that solution is a massive pot of gold,” he said.

How Companies Can Enrich Shareholders—and the Planet

The case for investing in social impact startups is the sheer size of the market; millions of people lack access to clean water, for instance. But, with companies serving customers living on $2 a day, profits can at times be slim.

“Maybe 2% is a fabulous return in some cases,” said Matthew Bannick, managing partner at Omidyar Network.

By comparison, traditional venture capitalists might seek a return 10 times their investment.

Some impact investors such as DBL Partners have had strong returns by using a broader definition of ‘social impact.’ DBL considers its investments in electric car company Tesla Motors and Juicero, a juice company that raised $70 million in March, as having both financial gain and social impact.

“You can walk and chew gum at the same time,” said Nancy Pfund, founder of DBL, which raised a $400 million fund last year.

Still, many of the high-profile Silicon Valley venture firms have steered clear of investing outside their comfort zone.

“Your impact could be bigger. Stop looking at the 60 mile (area)” of Silicon Valley, Youssef Chaqor, founder and general manager of Kilimanjaro Environment, which recycles used cooking oil into biodiesel, told an audience of investors and entrepreneurs.

Some venture capitalists are worried about emerging market risks, such as fluctuating currencies, military coups, disease and corruption. Others don’t see enough profit.

Andrea Carafa, founder and CEO of art and music event coordinator ArtsUp, says he does not bother to tell Silicon Valley venture capitalists about the societal benefits of his startup.

“They don’t care if you’re a social impact company,” he said. “They care about your profitability.”

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Institutional investors face a moment of truth about their commitment to environmental, social, and governance (ESG) factors. Many have long realized that these issues—including climate change, workplace diversity, and long-standing corporate concerns such as executive compensation—can drive risks and returns. In fact, many large institutional investors have publicly committed themselves to integrate ESG factors into their investing. The UN-backed Principles for Responsible Investment (PRI) have been signed by more than 1,500 investors and managers, representing nearly $60 trillion in assets under management.

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Yet look a little deeper, and it’s clear that many investors have struggled to convert their commitment into practice. For example, less than 1 percent of the total capital of the 15 largest US public pension funds is allocated to ESG-specific strategies, such as ESG-screened passive indexes, active management using ESG insights, or private-market management with a fully integrated ESG strategy. Moreover, many institutional investors continue to treat ESG as a sideshow rather than an integral part of their investing. While ESG and corporate-governance teams are commonplace, they are often held at arm’s length from core investment activities. Even the most successful funds have integrated ESG unevenly. While sustainable-equities strategies (such as low-carbon indexes) are no longer oddities, most funds haven’t expanded ESG integration to other asset classes. Members of the PRI agree that more is required. Its board is considering a change that would allow it to remove signatories that haven’t made sufficient practical progress.

This is not to say that the industry has been standing still. In fact, three big problems have recently been cracked, setting the stage for continued growth. First, investors have struggled for some time to determine which ESG concerns are relevant to particular investments. In response, some leading institutions have embraced the idea of “materiality,” derived from the concept of material information in accounting. Much as knowledge that could influence investors’ decisions is deemed material, so too are ESG factors that will have a measurable effect on an investment’s financial performance. According to a recent study using the materiality framework of the Sustainability Accounting Standards Board (SASB), companies that address material ESG issues and ignore immaterial ones outperform those that address both material and immaterial issues by 4 percent and outperform companies that address neither by nearly 9 percent (exhibit). Generation Investment Management, a sustainable-investing specialist founded by David Blood and Al Gore, put ESG materiality at the heart of its global equity strategy and has reportedly exceeded its benchmark by an annualized 500 basis points for over a decade.

Second, many institutions have found it hard to measure external managers’ regard for ESG issues; they need a kind of “greenwashing” detector to see through the obfuscation that plagues some managers’ activities. A number of institutions are now successfully deploying new mechanisms to increase accountability. The New York Common Retirement Fund, for example, recently developed a comprehensive scoring system based on the best available benchmarks. Managers that don’t disclose information receive poor marks, hammering home the idea that transparency is paramount when someone else’s capital is on the line.

Third, some board members and trustees of institutional investors have worried about whether, as part of meeting their fiduciary duties, they are considering ESG factors. Recently, the US Department of Labor revised its ERISA1guidance to say explicitly that consideration of ESG concerns is a part of the pension plans’ fiduciary duty. The department also specified that when a fiduciary considers two investments that are similar from a financial perspective, it should select the one that’s better from the standpoint of ESG. Such cases come up frequently. In France, the Ministry of Finance recently announced new rules that require investors to measure their portfolios’ exposure to carbon, among other ESG considerations. With the regulatory drumbeat picking up tempo, investors will probably soon adopt sound practices to determine materiality and evaluate managers.

Accelerating progress

Materiality, scorecards, and clearer definitions of fiduciary duty are only a launchpad. A commitment to ESG integration will remain merely symbolic unless institutions change their investment and capital-allocation processes in the ways required for this kind of investing to lift off. Investors should consider six steps to broaden and enhance their ESG impact.

Require uniform corporate ESG-reporting standards based on the principle of materiality

Considerations of materiality ought to be a two-way street: publicly traded companies as well as investment managers should disclose material ESG information. Some institutional investors have already been working with groups such as the Carbon Disclosure Project to push companies to report their ESG metrics (for instance, their carbon footprint or water usage), but more must be done.

Requiring companies to share all material information in a standardized, comparable way is necessary if institutional investors and their external managers are to assess the meaningful ESG-related risks and opportunities companies face. Institutional investors can work with the groups that have sprung up to advance the cause. The Sustainability Accounting Standards Board, for example, has rigorously defined materiality factors at sector and industry levels and is pushing for disclosure of material ESG factors in IPO and 10-K filings. Institutional investors should also collaborate with the Financial Stability Board’s task force on climate-related financial disclosures (led by Bank of England governor Mark Carney and Michael Bloomberg) and support the efforts of the International Integrated Reporting Council to encourage more comprehensive corporate reporting, including reporting on material ESG factors. They may also wish to comment on the US Securities and Exchange Commission’s recent consultation about whether investors would like to see more formal disclosure requirements for companies’ sustainability measures.

Build a shared ESG-rating system for external managers

Institutional investors usually have a rigorous due-diligence process for evaluating their external managers, yet too many treat their assessment of the managers’ approach to ESG as merely an exercise in box ticking. Farsighted institutions are already building systems to rate external managers more thoroughly, but a shared system would multiply the benefits considerably. Rather than duplicating one another’s work, funds could both cut the effort needed to make informed decisions and hold managers to a high standard for their ESG performance across the board.

A shared rating system should consider the sources of a manager’s ESG insights and the ways it seeks to engage with the companies in which it invests. The system will need to reflect the nuances of different asset classes and investment styles; ESG factors will be less material for many hedge-fund strategies than for managers investing in real assets or global equities, for example. Over time, a shared rating system should help prime the market for ESG-informed investment strategies. Many of them have historically struggled to gain allocations because of their short investment histories or skepticism about whether the alpha they generate will endure. That’s why institutional investors should invest in building a shared, open standard that their investment professionals will understand rather than simply outsourcing this task to investment consultants.

Work together to engage with corporations

Most investors recognize that as patient capital, engagement is for them both a social responsibility and a source of long-term returns. Yet most have small corporate-engagement teams that can work with only a few companies each year. Leaders such as the Canada Pension Plan Investment Board, the Ontario Teachers’ Pension Plan, and Calpers have built relationship-investing strategies—they back engagement with dedicated capital and sometimes board seats. Large external asset managers such as BlackRock and Vanguard have strengthened their engagement teams and are working with their investors on this front.2But even these efforts have limits to what they can achieve.

Too many investors fritter away their best chance at engagement by relying blindly on third-party proxy-voting guidance. Investors have a real opportunity to move beyond ad-hoc collaboration; instead, they could agree on a specific and narrow set of principles, back these with capital, and commit their votes. From this platform, they could demand that laggards disclose material ESG factors. For example, they might join Fidelity in calling for the pay of all CEOs to be based on incentive plans that are at least five years long—or go further and call for such plans to be based on a mix of operational, free-cash-flow, and material ESG metrics.

Investors should also request better disclosure and ask companies to lay out long-term strategies showing how ESG factors may affect their ability to generate value. Businesses that depend on a “social license to operate” to maintain their pricing power or that need to invest heavily in training to expand a peer-to-peer sales force should reveal these ESG-related dependencies. Investors might slap proxy motions on companies slow to respond.

Stress-test portfolios for ESG risk factors

Since 2008, many institutional investors have strengthened their risk management—for example, by adding tools and skills needed to run scenario analyses on how their portfolios might behave in times of stress. Yet most focus narrowly on “tail” value-at-risk scenarios driven by broad macroeconomic volatility. They ought to complement this approach with considerations of unpredictable shocks, such as regional water shortages, avian-flu pandemics, and increases in (or the introduction of) externality pricing.

Other institutions are embracing risk-factor investing: they evaluate their exposure to root sources of risk, such as currencies and interest rates, and then set limits for them. In both stress-test and risk-factor investing, material ESG considerations are not always taken into account, but they should be. A risk-informed decision-making process allows institutional investors to fulfill their fiduciary duty as stewards of university and foundation assets or of the retirement savings of public-sector employees.

Public concern over climate change is a particularly acute risk factor and source of value at risk. Many institutional investors are considering whether to reduce the carbon exposure in their portfolios or even to divest out of fossil fuels entirely. We realize that some fiduciaries view this as a moral decision. Nonetheless, it is important for institutional investors to have a nuanced understanding of the actual ESG risks they are exposed to, so that they can choose whether and how to respond. Some institutional investors have decided against divestment in the short term but plan to test their portfolios continually for climate risk. They are setting clear limits that, when triggered, will require them to reduce their exposure, to encourage companies to return cash rather than invest in exploration, or ultimately to divest fully.

Use a long-term ESG outlook to unlock new investment opportunities

All investors ought to consider material ESG factors. But the long time horizons and broad market exposure of institutional investors mean that they are particularly vulnerable to the good or bad ESG decisions of the companies in which they invest. Some institutions have developed innovative investment strategies to deal with this issue. For example, several have created indexes that either screen out worst-in-class ESG companies or weight toward best-in-class companies. Since 2012, the Swedish pension plan AP4 has been running a low-carbon fund that excludes the 150 worst polluters in the S&P 500, thereby producing an index whose carbon footprint is about 50 percent lower than that of the broader index.

While differing liability profiles may make custom indexes the optimal solution for institutions, they should consider the scale benefits of collaborating with others. A good example is the $2 billion committed by six big institutions to the Long-Term Value Creation Global Index, designed for them by S&P. Investors should also think beyond passive equities and consider how they can use ESG factors to reduce risk or identify alpha across a range of asset classes. An obvious possibility is direct investments in companies and real assets where institutional investors have enough influence or control to upgrade the ESG management.

Finally, only a handful of ESG managers have ten-year track records. Institutional investors shouldn’t wait passively for such track records to turn up—they ought to use their emerging-manager programs to seed and support innovative ESG-informed strategies. Several managers are pushing the boundaries of ESG-informed investing (see sidebar, “Innovative approaches to integrating ESG”).

Confront the skepticism and misunderstanding that surround ESG head-on

Successful investment organizations have strong cultures, but strengthening a culture takes time. At many institutions, ESG investing is caught in a cultural trap. For decades, conventional wisdom has held that ESG and its forebears, such as socially responsible investing, are merely a sideline, something to be worked on separately from the true business of investing. Changing this mind-set requires concrete action.

Chief investment officers must direct a cultural change within their investment teams. For a start, they can model the right behavior by leading the integration of ESG into the investment committee’s risk/return discussions. Institutional investors should also consider whether training and certifications may advertise the value they place on ESG fluency. Just as the CFA Institute’s Claritas certificate gives investment professionals a measure of credibility after only 100 hours of study, an industry-wide ESG certification could become a signal of qualification to institutional investors as they hire and invest. Bloomberg, the CFA Institute, the SASB, and many universities already offer ESG courses, and some consolidation around a clear industry qualification would benefit everyone.

Turning a symbolic commitment to ESG into daily practice will not be easy. But faced with rising stakeholder demand for meaningful action, there is little choice. Institutions that get out in front of the growing wave will be the first to reap the benefits of sound ESG investing: better returns, lower risk, and—should these ideas be widely adopted—a more sustainable world.

The Finnish arm of Sweden’s Nordea Bank will be the first Nordic bank to offer businesses access to the crowdfunding market by launching a technology platform in the summer of 2016.

The technology will enable investors to provide capital for growing businesses through automated processes – a major change for a bank as it will not be providing the capital but enabling other organisations or individuals to do so.

Startup businesses are increasingly turning to crowds for financing – the European crowdfunding market topped €6bn in 2015.

“Digitisation is transforming the banking industry and we want to be part of that transformation,” Topi Manner, CEO of Nordea Bank Finland, told Computer Weekly. “We will offer startups and growth companies the chance to find funding through a digital platform and bring together investors and companies in need of financing.”

It’s no secret impact investing is mainstreaming quickly, with large, commercial investors like Zurich, Blackrock, and UBS taking significant strides. Yet the question remains: just how rapidly is the market changing, and what are the implications?

The venture capital industry creates value that far outweighs the dollars allocated to it. But ten year returns to investors haven’t reflected that fact.

Innovation presents opportunities to solve customer problems more effectively and efficiently. But creating solutions that don’t yet exist involves a high degree of uncertainty. Usually, you need to spend a considerable amount of time and money before you know your efforts are going to pan out. That’s where risk capital comes into play; private investors invest money with the hopes of earning outsized returns to account for the level of risk they’re taking

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Source: PricewaterhouseCoopers/National Venture Capital Association

Venture Capital is one of the most important sources of risk capital around. Limited Partners (LPs) commit money to venture capital funds managed by General Partners (GPs). In aggregate, US GPs put roughly $25 billion to work every year. That might sound like a lot of money, but it’s less than 0.2% of US GDP.

Yet that 0.2% has been key in creating companies that account for 21% of the US GDP, and over 11% of private sector jobs (read the report). A tiny fraction of GDP invested by venture firms every year has been instrumental in creating more than one-fifth of the value in our economy.

Of course, venture financing isn’t the only funding source most of these successful companies have used to get where they are. After getting their venture dollars, many have taken in money from banks, mezzanine funds, and public offerings. But for most of these companies, it was venture financing that made them big; by the time they qualify for later-stage funding events, their valuations are often huge.

Clearly, venture capital investing results in tremendous asset value creation, particularly when compared to the dollar inputs.

But where is the payback for investors?

The problem is that LPs are capturing very little of the value created. Over the past ten years, the average venture LP would have generated better returns investing in an index fund such as the S&P 500. Ten year returnsfor early stage venture were 3.9% as of 2013, while returns for the S&P 500 for the same period were 8%. And that’s before adjusting for risk, which makes venture returns appear even more lackluster.

I have heard two common objections to this line of reasoning, and they go something like this (followed by my rebuttals):

“If you look at the past 25 years, the numbers look much better for venture. This has just been a bad 10 years.”

Ten years is a pretty long time. And we’re talking about how venture tracks against a broad market index; it’s not like we’re expecting absolute returns to be awesome. Going back 25 years lumps in the dot-com boom, and I’m not convinced there’s any real likelihood we’re going to see another valuation and liquidity explosion like that again. Rather, I see evidence of fundamental structural changes in the venture industry that are causing these poor returns.

“It’s all about the top performing firms; you need to focus on the incredible returns they make.”

If we’re talking about what a typical LP should expect, averages are what matter. Perhaps if you’re an existing investor in one of the old-school top-tier venture firms, this argument is meaningful for you. Frankly, it’s probably the opposite for most LPs; they don’t have a snowball’s chance in hell of getting into one of those top funds. Even then, you might want to think twice; it’s not clear historical performance for those funds is a good predictor of future outcomes.

The Kauffman Foundation (a non-profit dedicated to education and entrepreneurship) wrote a scathing report in 2012 entitled, “We have met the enemy… and he is us.” The foundation is a large and experienced venture investor, with (at the time) $249 million of their total $1.83 billion investments allocated to 100 different venture firms. Here are a few choice things they had to say:

• 62 of 100 firms failed to exceed returns available from the public markets, after accounting for fees and carry
• 69 out of 100 did not achieve sufficient returns to justify investment
• venture fund GPs have little actual money at risk in their own funds: an average of 1%
• the “2 and 20” model means that GPs are assured of high levels of personal income, regardless of the performance of their investments
• venture funds were taking on average far more than 10 years to return liquidity (when they did)

In summary, they said: “Returns data is very clear: it doesn’t make sense to invest in anything but a tiny group of ten or twenty top-performing VC funds.”

Market forces impacting venture

A combination of structural factors, historical trends, and market dynamics are creating tremendous pressure on the venture capital industry.

The “2 and 20” structure

The vast majority of venture firms work on some (minor) variation of the 2 and 20 structure whereby the fund managers get 2% per year of the committed funds for salaries and operating expenses (“management fee”), as well as 20% of the net value created (“carry”). Since most funds last ten years, that means 20% of investment dollars (2% times 10 years) never even reach the portfolio companies. Sometimes the annual percentage amount drops after the active investing period. Still, net of higher annual percentages (2.5% is fairly common) and long investing periods, the reality is that somewhere around 20% of investor dollars are taken off the top.

There is nothing intrinsically wrong, or even irrational, about the 2 and 20 model; it’s fairly common in other segments of the finance industry such as hedge funds and traditional private equity (although read here and here to see how those industries may be changing). There’s also nothing wrong with investors making multi-million dollar salaries. But in the face of such poor venture returns, it is hard to justify the current economic structure.

Ironically, it’s the 2 and 20 structure that is in part responsible for a chain of events that have contributed to the decline in venture returns over the years. As time goes on, it seems that the fundamental economics of the venture model are putting the entire industry at risk.

A rising tide

The dot-com era was an extraordinary period of value creation, and many savvy venture capitalists made the most of it. As the IPO market exploded, so did the returns for the venture funds who were smart enough to be in the right deals at the right time.

During the five-year period between 1996 and 2000, the US markets saw 1,227 venture backed IPOs. And the VCs were cleaning up, with a median ownership stake of 40%. Perhaps more importantly, IPO returns averaged a stunning 88% during 1999 and 2000 (read the study).

Opening the floodgates

With venture funds practically minting money, the financing floodgates opened. Billions of dollars poured into venture capital funds, and many new funds formed. By the peak of the bubble in the year 2000, there were1,022 active US venture capital firms.

And it wasn’t just the number of firms that ballooned; the average size also grew rapidly. And the size of the firms grew much faster than the number of GPs. According to data from the NCVA, average capital per principal rose from about $3 million in 1980 to roughly $30 million by the late 2000s–roughly 10x growth.

Why did dollars managed per partner grow so much? It’s almost certainly due to the incentives associated with the 2 and 20 structure. The more dollars per partner, the more management fee, and potentially, the more carry. Increasing the size of a fund pro rata with the number of partners wouldn’t be in their interests. And if the LPs were willing to invest more money on those terms, it’s only natural that the GPs were happy to oblige.

The requirement for massive exits

Deborah Gage wrote in her 2012 Wall Street Journal article that the common rule of thumb for venture outcomes is 30-40% completely fail, another 30-40% return the original investment, and 10-20% produce substantial returns. However, her article then points out that research into over 2,000 venture backed companies by Shikhar Ghosh suggest numbers that are somewhat more stark:

• 30-40% return nothing to investors
• 75% don’t return investor capital
• 95% don’t achieve a specific growth rate or break even date

That suggests that it’s closer to 1 deal in 20 that returns a meaningful amount of money, and another 3 in 20 that return capital.

Let’s do a little bit of venture math

What sort of return would the one big winner require to make the fund? First, the fund and it’s goals:

• $125 million fund that makes 20 investments
• Typical 2 and 20 structure, with 2% average over 10 year fund lifespan
• Due to follow-on investments in the good deals that, each accounts for 10% of fund, rather than the expected 5%
• The fund needs to return at least 2x overall to investors to ensure they can raise another fund
• With 20% carry, they need to return 2.5x, or $312.5 million to hit their goal

Investment dollars, and expected outcomes:

• They’re investing $100 million net of 20% management fee
• 3 so-so deals return an average of 2x each
• 8 deals return an average of 1x each
• 8 deals are a total wipeout

Here’s how the math works out:

• The goal is 2.5 times $125 million, or $312.5 million
• $40 million into 8 deals generates $0
• $40 million into 8 deals generates $40 million
• $20 million into 3 deals generates $40 million

Without the big winner, they’ve returned $80 million out of a target of $312.5 million, which is $232 million short.

So, what return does their “fund-making” investment need to achieve? With $10 million invested in the big winner, they need a $232 million (23x) return to make their target minimum. More likely, they’re actually targeting a 3x overall fund return, which would imply that they need more than a 43x return in that one deal to make their numbers.

Wow. And to put that in perspective, those returns imply much higher enterprise valuations. Assuming the VCs own a third of the company at the time of liquidity (and ignoring a presumed 1x liquidation preference), we’re talking about an enterprise valuation of $696 million for that one company to achieve the overall 2x return on their fund.

That’s the sort of math that forces most venture capitalists to seek massive exits to make their fund economics make sense.

A weak IPO market

During the massive growth of the venture industry in the 1990s, funds relied in large part on the booming IPO market to achieve these extraordinary liquidity multiples. The returns for some funds of that era are truly astonishing. But the turn of the century brought a whole new economic reality to the venture market. The IPO market dried up extremely quickly, and has only slowly begun to recover over the past few years.

Even with recent improvements, however, the IPO market is nothing like what it was during the boom times, and likely never will be again. The number of issuances is down, and the economics for the investors are far different than they were previously. No more 40% stakes in the companies at IPO, or reasonable expectations for 88% returns from the IPO.

Rather suddenly, venture capitalists had all but lost their most important liquidity generation tool.

Venture’s new reality

The result is larger funds, higher valuations, and later stage investments, which in turn require even bigger liquidity multiples. Without a highly active IPO market, that’s a significant challenge.

More capital per partner means bigger investments

When a fund grows at a rate three times faster than partner growth, it’s not as if each partner can source three time as many quality deals, and perform diligence three times as efficiently. An obvious solution is to put more money to work in each deal, rather than simply increasing the overall number of deals.

That probably explains the trend towards larger deal sizes, and in particular more “loading up” on existing investments in the form of follow-on financings. Peter Delevett’s article in the San Jose Mercury Newsquotes entrepreneur Tony Jamous, who says, “There’s so much money right now in the market that it’s my challenge to actually keep it a small round.”

Revenue generating is the new seed stage

Just because GPs are investing more dollars in each deal doesn’t necessarily mean that they’re acquiring more of the company. Venture investing is not about making control investments; it’s about backing a team. Given the prospect of follow-on rounds, it simply doesn’t make sense to take too much of a company in early venture rounds; otherwise, you’re setting yourself up for a recapitalization when the entrepreneurs find themselves squeezed into a small corner of the cap table.

The obvious way to put more money into a company, while maintaining a suitable portion of the cap table, is to invest in companies that are worth more. That, in turn, implies investing in companies that have reduced risk by making more progress.

That’s why so many venture firms are investing later stage, where risk is lower, and valuations are justifiably higher. Later stage investments are also easier to diligence because there’s more of a track record. Ernst and Young’s Turning the Corner report from 2013 said it pretty succinctly: “VC funds are adjusting their investing strategies, preferring to invest in companies that are generating revenue and focusing less on product development, pre-revenue businesses.”

And Paul Graham, founder of Y Combinator, is clearly seeing it in the market, too, referring to “…what used to be the series A stage before series As turned into de facto series B rounds.”

Venture investors are investing later in the risk curve, meaning they have mostly vacated what used to be seed stage, and seed stage investments now are more similar to what Series A investments used to be. That in turn pushes Series B and later rounds further along the risk continuum.

Bigger investments often mean higher valuations

As traditional venture capitalists move away from true seed stage investing, they’re beginning to clump at the later stages, with more investment dollars targeting a relatively stable supply of viable startup investments. That stable supply and increased demand tend to push valuations higher.

That’s further exacerbated by the generally high levels of LP investments over the past decade. Despite relatively poor returns, Limited Partners continue to pour money into the industry, albeit with what appears to be an increasing emphasis on a smaller set of funds with the best track records. The excess capital active in the later stages of the venture market have resulted in a war for tech companies with demonstrable traction, resulting in even further valuation inflation.

The venture valuation bubble

For a number of years, I’ve struggled to reconcile the evidence of frothy venture valuations with the inability of amazing entrepreneurs to acquire funding. I suspect the best explanation is that both are true; seed stage investments are irrationally hard to achieve, while mid-stage deals are overly competitive.

Revisiting Paul Graham’s June 2013 essay on Startup Investing Trends (referenced earlier):

“Right now, VCs often knowingly invest too much money at the series A stage. They do it because they feel they need to get a big chunk of each series A company to compensate for the opportunity cost of the board seat it consumes. Which means when there is a lot of competition for a deal, the number that moves is the valuation (and thus amount invested) rather than the percentage of the company being sold. Which means, especially in the case of more promising startups, that series A investors often make companies take more money than they want.”

There is tremendous pressure in the venture industry to invest more money, at higher valuations, in more mature companies.

Higher investment valuations require higher exit valuations

We have already discussed the economic imperative for venture firms to seek massive exits. What happens when those already lofty multiples are rebased on a significantly higher initial investment valuation? It simply means that the size of the liquidity events required to achieve success are all that much larger.

The entrepreneurs are feeling it, too. Peter Delevett’s article in the San Jose Mercury News goes on to quote venture investor Craig Hanson: “In other words, too much money now makes it harder for the VC firms and entrepreneurs to strike it rich later.”

Swinging for the fences

IPOs are typically the best way for venture funds to achieve massive liquidity, but they remain elusive targets. Even when the IPO markets are working, there is a finite supply of companies that are suited to an IPO. Bruce Booth wrote a 2012 piece about venture capital, saying “… it’s not the lower frequency of winners in general, but the lower frequency of outsized winners, that has dampened returns in the asset class.”

This is creating a dilemma for venture capitalists. Their strongest economic imperative is to maximize the capital under management per partner. Success for most is more about raising and layering funds than generating income through carry. That’s not to say that they don’t hope for massive payouts from carry, but the changes in the market have made it increasingly difficult to achieve that.

Here’s a colorful way to think of it: the home run king is under pressure to beat a field of top-notch batters. But this season, they moved the fence out 100 yards farther than before. A miss is as good as a mile; the only thing he can do is swing with all of his heart.

For many venture funds, their singular goal is to invest in those very few mega deals that deliver crushing returns. Anything less simply won’t move the needle.

The future of venture capital

While venture capital is certainly here to stay, it’s clearly an industry in flux. Investors and fund managers are beginning to adapt. Meanwhile, exciting new models are beginning to emerge.

Venture capital is here to stay

Venture capital is by no means going away. It’s an important, multi-billion dollar industry, filled with talented, intelligent, and often charismatic people. Many of them are experienced entrepreneurs accustomed to dealing with change and uncertainty. The likelihood is that they’ll figure out a way to thrive, and that in turn implies that they will be able to continue to make money for their investors.

There are also some trends that will likely change some of the industry dynamics for the better. Those include:

• While the past 10 years have been bitter for many venture capitalists, there is recent evidence of an upward trend.
• The overhang in LP capital commitments is mostly worked out, and there is some evidence capital inflows are moderating to a more sustainable pace.
• The NVCA estimates there were 462 active US venture firms, down from 1,022 in the bubble of 2000; that is likely a reduction to quality, and a more appropriate overall market size.
• There is evidence that the IPO markets are reviving, improving potential liquidity opportunities.
• The underlying value created by many venture investments is real in a way that probably wasn’t true to the same extent during the dot-com era.
• There is evidence that LPs are focusing more on track records of the actual investing partners, which is probably a more efficient rubric for selection.
• There is some evidence that GPs are willing and interested to engage in a dialog about how to evolve the economics and structure of their funds.

But it is an industry in flux

I think Wade Brooks sums it up nicely in his TechCrunch article when he says, “early stage venture investing does not occur in an efficient market.” Returns to investors over the past ten years have been inadequate, and the Limited Partners are beginning to change their behavior. And the fundamental economics will not be tenable for many funds; I expect continued fallout, and further winnowing of funds.

New models emerging

Perhaps most importantly, there are new investment models emerging. These may be hybrid models where venture capitalists add value in new ways, such as Andreessen Horowitz. Or, in the case of 500 Startups, revolutions in the ways that professional investors select and invest in companies. In some cases, it may be fundamentally different approaches to investing, such as crowdfunding. Meanwhile, we can’t forget Angel investing, which offers the chance to capture enormous value, albeit with certain caveats.

And, of course, there’s the new approach that we’re taking here at Founder Equity, which we believe offers the chance to create more value, more quickly, and with reduced risk. We look forward to sharing more with you as we continue our journey.

By Joe Dwyer

The LSE made Syndicate Room Ltd. a member of the exchange on Monday, allowing the startup’s customers to invest in IPOs and private share placements.

The move, the first of its kind in the U.K, aims to democratize the process of investing in companies coming to market in a response to criticism from smaller investors that they are often frozen out of these deals in which shares are often sold at a discount.

Depending on the IPO, Syndicate Room could allow investors to put sums of a few hundred dollars into listings via its website.

Other exchanges are already in on the act. In Australia On-Market Bookbuilds flags upcoming IPOs to members who can participate. Last year J.P. Morgan Chase & Co. and Motif Investing Inc., an online brokerage, joined a program to allow individuals to invest as little as $250 in IPOs.

The battle to open up the U.K. IPO market could prove long. Currently only a few initial public offerings include a tranche reserved for retail investors. Previous efforts to draw in a wider community of investors during the dot-com boom floundered as smaller investors lost money on sinking stock prices.

The U.K.’s Conservative government is trying to rekindle former Prime Minister Margaret Thatcher’s vision of a shareholder democracy. Thousands of retail investors bought shares when the government privatized various U.K. public companies in the 1980s.

That enthusiasm for IPOs hasn’t lasted. Some 12 million people in the U.K. population are estimated to own shares, but more than three quarters of those didn’t take part in initial offerings of stock last year, according to Syndicate Room. The U.K. government hoped to sell shares this year in Lloyds Banking Group PLC, one of the U.K. lenders bailed out in the financial crisis, but it has postponed the plan given volatile markets.

Some British executives and academics have called for better use of new technology to widen access to IPOs.

The traditional IPO process is “preindustrial,” Paul Myners, the former financial services secretary to the U.K. Treasury said last April.

There hadn’t been much technological innovation in IPOs because “entrenched interests” were resisting change to a business model that suited them, Mr. Myners said. “Too many people’s rice bowls are at risk,” he said.

By Max Colchester and Simon Clark of WSJ