Ommeed Sathe, Vice President, Impact Investments, Prudential Financial
Prudential Financial, Inc. manages one of the largest impact investment portfolios in the world and has long been a pioneer in the field. Since the unit was established in 1976, we have invested more than $2.5 billion across a broad range of impact assets (including more than $1 billion in the last five years alone). This commitment to impact investments is rooted in our founding in 1875 as the Widows and Orphans Friendly Society, a social-purpose enterprise dedicated to bringing an affordable form of burial insurance to the working poor. This was a controversial idea at the time, but our success with that product launched a purpose-driven company dedicated to promoting financial well-being for all.
Prudential’s experience is proof that it is possible to incorporate impact strategies within the norms and constraints faced by institutional investors. However, as we bring ever-larger sums of capital to the impact market, we urge our large institutional peers to avoid the trap of mistaking scale for impact. Ultimately, we believe that the best solutions to the challenges we face today will come from investors who can engage across a spectrum of strategies ranging from concessionary to market-rate and have the commitment to focus on “Impact Value Add,” not just counting impact assets under management (AUM).
What makes something an impact investment?
As we have rapidly grown our impact investing portfolio—currently $800 milllion in AUM—an important internal debate has focused on what constitutes an impact investment versus a traditional investment. This question became more pressing as the portfolio grew and began to generate risk-adjusted returns equal to, or better than, traditional investment portfolios. At the same time, as we analyzed the general account investments of the company, we found sizable allocations to tradtional impact sectors like renewable energy facilities, municipal bonds to support schools and hospitals, support for development finance instituitions (DFIs) and low-income housing tax credits.
Could we describe a meaningful difference between these two portfolios? Is there some higher standard to which we should hold Impact Investments or should we categorize all investments with any social impact as impact investments? In many ways, this struggle harkens back to a seminal article by Paul Brest and Kelly Born about “additionality.” In the article, the authors make the case that in the absence of some form of financial concession there is no additionality to impact investing (and therefore no impact since the investments would have been made anyway).
Directionally, we absolutely agree that additionality is a crucial distinction between impact and traditional investments. However, while financial concessions can be one form of additionality (as we describe further below), we disagree that it is the only form. There are a range of impact management practices that can distinguish impact investments without requiring flexibility on financial returns. The graphic below outlnes some of the core practices that characterize how we manage for impact.
Impact Value-Add is active
As the graphic above depicts, these practices are largely about “how” investments are made rather than “which” investments are made. This broad suite of “Impact Value-Add” practices are fundamentally active management strategies and have analogues among typical financial value-add strategies. Accordingly, we have had to build a senior team with deep experience and an ability to constructively engage with investees. We also inevitably self-select for counterparties willing to engage around impact and eschew channels in which we have limited ability to influence the underlying investee or project. Thus, we will rarely find attractive transactions in the public markets.
Many of these impact strategies can reinforce profitability, but, crucially, we also engage in these practices even when the impact may be independent of the financial drivers.
Asset class flexibility
Another critical aspect of our approach to impact investing is to target an extremely broad and flexible allocation among different asset classes and impact sectors. Presently, the portfolio includes both direct and indirect investments, debt and equity, real assets and operating businesses, mortgages, securtizations, private placements and various other types of alternatives. This freedom gives us the ability to move up and down the capital stack and find opportunities that provide a sensible combination of risk, return and impact. For example, we see strong opportunities in affordable housing equity (but less so in debt), whereas we generally prefer lending opportunities around education and workforce development investments. This asset class flexibility is paralleled by a broad array of impact outcomes that we target, including financial inclusion, affordable housing preservation, educational excellence, workforce development and sustainable agriculture, among others. While not suitable for all investors, this breadth has allowed us to ensure a steady and diversified pipeline even as regulatory, social or investment conditions change.
Three separate portfolios
So, just how do we operationalize these beliefs? Internally, we have divided our work into three portfolios—each of which uses different assets of the firm. Each portfolio has clear and distinct expectations for its risk appetite, return targets and impact goals.
All three portfolios are managed for impact and the largest portfolio, which represents 80% of our impact holdings, seeks market-rate, or better, returns. The other two portfolios have the flexibility to take on additional risk and, in certain cases, make concessionary investments. Notably, we differentiate between a catalytic portfolio—in which the overall portfolio takes on additional risk but indiviudal investments are profit maximizing—from our truly concessionary portfolio in which investments are deliberately below-market and used only for nonprofits. In aggregate, steady outperformance on the 80% of assets in the main portfolio has largely offset the total concessions on the remaining 20%. For different investors, other ratios are possible, but we think having flexible capital sources is crucial to addressing the widest range of impact opportunities. Further details on the three portfolios are provided below.
- Impact Managed Portfolio – This is our largest category, comprising approximately 80% of our assets. This portfolio contains a range of asset classes and has generated market or better levels of financial return. It usually holds larger investments (typically $5-$25 million, depending on asset class) with more-established partners. These investments are used to support the liabilities we take on as an insurance company and receive the same regulatory treatment and scrutiny as all of our traditional assets. A prime example of this portfolio is our charter school lending activity. These loans have produced strong and stable yields and have helped a number of best-in-breed operators rapidly expand to serve more children. When we entered this market, charter schools had limited borrowing options, however, we recognized that strong academic operators could also be strong credits since loan repayments were directly driven by student enrollment. Today, charter schools routinely access the public bond market with oversubscribed offerings that are now at rates much lower than our legacy loans. As these assets have migrated to traditional channels, we have shifted our investment activity into more emerging sectors.
- Catalytic Portfolio – This portfolio is comprised of smaller investments (typically $1-$5 million) in for-profit entities, projects or financial structures that generally lack the data or track record to be included in the prior group. Typically, we are one of the only institutional financial investors supporting these projects, and this portfolio is more heavily weighted toward equity investments. These assets are not used as part of our typical asset-liability matching process, which allows us to take additional risk. Individual investments in this portfolio can perform extremely well, but, over time, we expect the overall portfolio to have a greater volatility of returns, increased risk and, on average, trail the returns of the Impact Managed Portfolio. We also see tremendous R&D value in these investments and when successful they will typically lead to larger future opportunities thatcan be included in the Impact Managed Portfolio. One prime example was working with Naturevest to initiate a local cap-and- trade marketplace to address stormwater runoff in Washington D.C. Our initial investment was high risk since there was not yet an established market price for stormwater credits. After using our capital to initiate the first major stormwater runoff mitigation project, the market for credits has become far more predictable and subsequent investments will be made through our Impact Managed Portfolio.
The performance of the Catalytic Portfolio trends around 150 to 250 basis points lower than that of similar assets in the Impact Managed Portfolio Too often investors hear the term “concessionary” and think a loss of principal—in reality, a “concession” could be anything from strong, slightly lower returns to a total loss of capital, with many points in between those extremes. In this case, we are talking about basis points, despite taking on exclusively investments that would not meet the underwriting standards for our impact managed portfolio. In exchange for this concession, we have received some of the most dramatic examples of social impact and created pipelines for future investments.
- Philantrophic Portfolio – Our final portfolio is managed on behalf of The Prudential Foundation and is used to provide explicitly concessionary capital to nonprofits. Unlike the Catalytic Portfolio, which targets for-profits and has lower average returns on a portfolio basis due to outsized risk, this portfolio is comprised entirely of investments that are below-market from inception. In this portfolio, we largely use low-interest loans to support organizations in which the underlying principal is relatively safe, but where cheaper capital can be directly connected to an end user or beneficiary. For example, many community development finance insitutions (CDFIs) like ROC USA or the Disability Opportunity Fund provide specialized loans to vulnerable populations where the rate on those loans is a direct function of their own cost of capital. These borrowers are also often grantees of the Prudential Foundation and there is signficant value in blending grant and invesment support for the same non-profits.
By any measure, impact assets are rapidly growing alongside a new array of investment approaches. While Prudential’s 80/20 portfolio approach may not be the right ratio for all investors, we see a hybrid approach as crucial to addressing the widest array of impact opportunities. A hybrid approach also explicitly acknowledges that there is continuum of returns and that catalytic investments often set the stage for future market-rate portfolios.
Within our market-facing investments, we also think it is vital to insist on impact management practices and not simply count all of the assets in our portfolio that have social impact or, worse still, engage in a race-to-bottom with ever-more strained definitions of impact in the pursuit of larger “Impact AUM.”
At Prudential, we firmly believe that the key purpose of impact investing is to solve the social and environmental problems that aren’t already being effectively addressed by government, philanthropy or traditional investors. In certain transactions, it is possible to do this while achieving strong, market-rate or better returns. In others, investors with flexible capital will be a necessary and vital part of the ecosystem. As we have grown our portfolio, we have strived to keep these different approaches balanced and unified and see substantial value in that approach for other institutional actors.
About the Author
Prudential Financial, Inc., a financial services leader, helps customers grow and protect their wealth through life insurance, annuities, retirement-related services, mutual funds and investment management. Founded on the belief that financial security should be within everyone’s reach, Prudential has been a pioneer in impact investing and is building a $1 billion portfolio of investments that combines both social and financial return.
*This article was originally posted on The Economist’s digital platform.