Purpose-Oriented Investing, Part II

Welcome to this week’s edition of Cape May Wealth Weekly. If you’re new here, subscribe to ensure you receive my next piece in your inbox. If you want to read more of my posts, check out my archive!

Last week, we gave you an introduction into what we at Cape May like to call Purpose-Oriented Investing.

We shared with you our outline for purpose-oriented investing, broken down into screened & indexed investments, impact investing, venture philanthropy, and charitable giving, and began our journey with an introduction to screened & indexed investments.

Today, we want to continue our journey by taking closer looks at the other three categories - impact investing, venture philanthropy, and charitable giving.

Let’s get started!

Impact Investing

Impact Investing is the actively managed counterpart to last week’s screened & indexed investments. Instead of removing certain ‘bad’ companies from a given index, impact investing focuses on companies which are most aligned with the investment strategy’s purpose, while also generating a competitive return.

Also worth noting: Out of our four categories, we’d actually see impact investing as the most return-oriented category. Screened investments might increase the amount of capital available to sustainable companies, which at least by capital markets theory might lead to lower returns. Venture philanthropy has financial returns as a secondary objective, while charitable giving has no financial return orientation whatsoever. Impact investing, also hopes to generate a positive non-financial return in regards to our individual purpose, but only if it can also generate competitive returns in doing so.

Unlike screened investments (public markets), and venture philanthropy and charitable giving (private markets and/or not an investment at all), impact investing can take place in public and private markets:

In public markets, impact investing comes as actively managed funds with a well-diversified portfolio of listed companies from which they expect positive purpose-aligned impact over time. They might also be more vocal in realizing this impact, for example through vocal participation at annual meetings of the companies they are invested in. This participation might go as far as outright shareholder activism, with the most notable example probably being activist fund Engine No. 1, which successfully rallied the shareholders of oil & gas giant Exxon Mobil to support a shift towards more renewable energy production.

Impact investing in public markets brings a number of challenges. First of all, Greenwashing is a real issue here - more than one asset manager pivoted an underperforming equity fund to some sort of ESG-oriented, overindexed strategy (see, for example, DWS’ $27M fine). Second, it is quite a balancing act. Take the two examples that we gave in the prior paragraph: In the same portfolio, you might have a more diversified, impact-focused equity funds looking to generate competitive returns that are somewhat akin to its relevant benchmark, but also an extremely concentrated activist fund that might more absolute return-like in its risk profile. Building such a portfolio of fund managers brings the same challenges of a portfolio or ‘regular’ active managers.

In private markets, impact investing is much more differentiated, given the almost unlimited investment options. One relevant investment might be a private equity or venture capital fund with a (sub)focus on a certain type of impact, such as sustainability or societal change. Another might be an infrastructure fund focused on renewable energy sources such as wind or solar. Yet another fund might be focused on taking ‘bad’ assets, like a coal power plant, and putting them on a path towards improving its CO2 footprint. Those examples also highlight how differently investors might view a given opportunity:

• Many private equity or venture capital funds sell themselves as impact investments, but their actual impact might be somewhat limited, if not more akin to outright greenwashing (see my recent post on ‘energy transition’ investments in infrastructure).
  

• Infrastructure funds focused on renewable energy have direct, positive impact towards a climate-related purpose, but they have become so commonplace that many investors don’t see them as impact investments anymore. (In my experience, the most successful renewable energy investors that I know never even thought about branding it as an impact investment.)
  

• Funds that focus on the energy transition of clearly bad assets might have the highest and most differentiated impact, but many impact investors shy away from investing in what at least on Day 1 is uninvestable by their standards.

Investors not only have to assess the merits of an individual fund’s strategy, but also their ability to create positive change in regards to their desired purpose - and balancing both, while clearly possible in some asset classes, might be much more challenging than to just create competitive returns.

Manager selection is an art in itself, which might be hard to address in the relevant depth in this article. But what we can focus on is the question of how we should think about adding impact investments to a broader, purpose-oriented portfolio. And as done many times before, we like to do that by using Aspirational Investor Framework.

Last week, we mentioned that our first category of screened investments typically makes up your Market Bucket, i.e. the long-term-oriented core of your portfolio. Impact investing, given its more volatile nature, might seem like it thus needs to fit into the Aspirational Bucket, meaning the higher-risk allocation of your portfolio which might drive a substantial increase in assets. And that might be true, especially for individual, non-diversified impact investments. However, if you build a diversified portfolio of impact investments, which are appropriately sized relative to one another and your overall portfolio, they might well make up a part of your Market Bucket.

To think about that practically: Assume you are an investor with 10M€ in investable assets. You earmark 2M€ for your Safety Bucket, and require 6M€ allocated to the Market Bucket in the form of a diversified, liquid portfolio of screened investments to achieve your long-term return (and income) target. You could put the 2M€ into risky ‘Aspirational Bucket’ investments, such as Venture Philanthropy or Charitable Giving (which we’ll cover shortly). But you could also allocate them to higher-risk, but still sufficiently diversified impact investments in both public and private markets. If anything, there’s a good chance that they might add some diversified sources of return, both financial and purpose-wise.

Venture Philanthropy

To us, Venture Philanthropy (“VP”) is best seen as a category between Impact Investing and Charitable Giving. Venture Philanthropy wants to achieve a return on purpose, and ideally also a a return on investment - but while the former is mandatory, the latter isn’t, or at best limited to a desired return of capital.

In my experience, VP stems from the desire of investors to have an allocation within their portfolio to purpose-oriented assets rather than opting for charitable giving outright. The motivations for that are meaningful: It might be a negative view of charitable giving as a way of tackling certain issues. It might be driven by the desire for systemic change through market-based solutions to problems in the scape of their purpose. Or it might be a desire to give to positive causes while still having the chance to generate some kind of positive return.

Also these three motivations can be used to give examples of relevant investments:

• If an investor is critical of how a charitable cause might tackle a certain problem in the world, they might instead opt to invest in a company - profit-oriented or not - that they thinks can alleviate that problem. (There might be overlap with the aforementioned Impact Investing.)

• If an investor wants to drive systemic change through market-based solutions, one potential area of interest might be so-called steward ownership, in which for-profit companies look to use its earnings to drive positive change. Popular examples include apparel company Patagonia or Danish pharmaceuticals giant Novo Nordisk.
  

• If an investor wants to support positive causes while also having a chance at positive returns, they might invest in areas such as social housing or microloans to underserved groups. Or they might lend money to purpose-oriented companies at below-market rates to help them achieve positive impact while still holding them to some degree of financial return requirement.

How should one go about venture philanthropy? In the end, it depends on the underlying asset class: An actual venture investment, semi-philanthropic or not, should be looked at through the critical lense of a venture investor - after all, they can’t generate positive impact if their business plan doesn’t make sense, or if they run out of money earlier than expected. In the case of debt investments, investors should be mindful that there is at least a chance of getting their money back - if you think that the receiving company, impact-oriented or not, will likely default before their first debt payment, perhaps another company or charitable cause might be a better recipient of your capital.

Lastly, the question of where to fit venture philanthropy within your portfolio. Once again using the Aspirational Investor Framework, Venture Philanthropy is clearly an asset for the Aspirational Bucket. As there is no expectation of providing benefit towards your financial goals, and high risk of losing some or all of your invested capital, investors should only allocate capital that they are willing and able to lose.

Charitable Giving

Even for a highly purpose-oriented portfolio, charitable giving is likely not a building block than investors typically think about. However, there are a number of ways that we’ve seen charitable giving being built into investing frameworks, that we wanted to share with you to round out our little excursion into purpose-oriented investing.

What do we mean with charitable giving? To us, it’s a one-time or recurring donation to a non-profit charitable organization, such as an NGO or a foundation. The receiving organization is almost always not-for-profit, financing itself through such donations, with the funds then being used to generate positive results towards the giving investor’s purpose. There’s no financial instrument or contract - it can be as little as a wire transfer or a donation of your spare change.

So with that in mind - how can charitable giving be reflected in an investor’s portfolio? There’s three ways that we encounter:

First, donating a defined percentage of your (excess) returns/earnings to charitable purposes. Remember last week’s example of so-called effective altruism: If you have a very specific purpose in mind that might be hard to cover through the prior three categories, it might be easier to not steer your portfolio towards a given purpose, and instead just donate a part of these earnings. Even with a purpose-oriented portfolio, you could also chose to returns in excess of your required, long-term return to (additional) good causes - we helped one of our clients at Cape May design their portfolio accordingly. 

Second, potential tax benefits from charitable giving. Most jurisdictions that we’ve encountered encourage charitable giving to registered non-profit organizations through a (partial) tax credit. Of course, that means you can only give to good causes if you actually have income you can give away. But if you are looking at a holistic approach to purpose-driven investing, that might mean that charitable giving could be a cheaper, more efficient option to support your causes, especially as the tax credit is typically (almost) immediate.

That tax benefit also should motivate investors to review their charitable giving at the end of the year. Perhaps they want to donate the same amount of money every year, but have significantly higher income in one of two years - in that case, donating more money in the year with higher income might provide them with a higher tax refund, which can then be used for other donations or purpose-driven investments.

Third, charitable giving as a pillar of your tax structure. Perhaps an extension of the second point - depending on your jurisdiction, you might have the tax benefit of giving to a charitable foundation even if that is a charitable foundation set up by yourself. There are numerous challenges here - despite the legal complexities of setting up and running a foundation, one is example that you typically don’t receive the benefits of a charitable foundation if the funds are used for non-charitable purposes, such as family’s lifestyle. However, there might be cases where some of the funds can be used for family-adjacent purposes, such as funding your children’s or children’s children’s education. If you own operating businesses, there’s also considerations in regards to the aforementioned steward ownership.

Final Remarks

In our view, purpose-oriented investing is something that can be done in just one part of your portfolio, but makes the most sense to tackle holistically. Asset allocation is a topic that has nuances on its own, and adding the complexity of purpose to it just further enhances the number of those complexities.

My co-founders at Cape May and I like to see that more and more of our clients are thinking about purposeful investing - and would love to help even more investors in finding their purpose. So if you are looking for assistance in the matter, or simply would like to speak to likeminded individuals, please don’t hesitate to reach out to us: We’d be happy to support the good cause, and search for purpose.