Impact Funds Offer a Lower-Risk Proposition for Private Markets

by Alli Romano

Impact investing can be a valuable financial tool for private-market investors seeking to manage risk. New research by Cornell SC Johnson College of Business assistant professor Kelly Posenau and her co-authors indicates that private market impact funds—vehicles that direct capital to companies that generate impact environmental and social benefits—can help investors reduce market risk exposure and diversify portfolios.

While impact funds are typically known for their environmental and social goals, “adding impact to a portfolio may lower market risk exposure,” Posenau said. “And they don’t necessarily require the financial trade-off most people assume.”

Posenau and co-authors HEC Paris associate professor Jessica Jeffers and Yale School of Management doctoral student Tianshu Lyu recently published their findings, “The Risk and Return of Impact Investing Funds,” in the Journal of Financial Economics.

According to the study, impact investing funds have lower returns than public equity markets but perform comparably to non-impact private-market funds on a risk-adjusted basis. Impact funds, as a result, offer lower-risk investment opportunities at similar costs as non-impact funds, they found, making impact funds an attractive option for private-market investors with social and environmental goals in venture capital, growth equity, or private equity generally.

While other researchers have focused on the returns—or lack of—from impact investing, Posenau and her co-authors opted for a different lens: Concentrate on the risk exposure and performance of private-market impact funds.

“We wanted to add more nuance to the debate about impact investing, specifically how it could fit into investor portfolios from a risk perspective,” she explained.

The findings reveal positive outcomes. Impact funds are less sensitive to market movements, contributing to a lower-risk investment strategy for private market investors. While they underperform public equities, impact funds perform comparably to non-impact funds.

Posenau said impact funds invest in companies typically in their early stages and deliver financial results comparable to those of non-impact funds. Thus, they can be used as a tool to balance more high-risk, high-return investments.

Media and investors focus more on environmental, social, and governance (ESG) investing in public equity markets Many ESG investments are made in publicly traded firms—often larger, more established companies with regularly observed returns. Private market impact funds, on the other hand, typically invest in smaller, early-stage or growth firms and disclose limited—if any—information on their holdings and performance.

Studying private market funds has been challenging due to a lack of information, but that didn’t deter Posenau and her co-authors. From these sources, the researchers constructed a final database of fund cash flows from 94 funds of different asset classes, vintage, and sizes, covering activity from 1999 to 2021. They built a benchmark for non-impact funds that matched impact funds based on asset class, vintage, and size, enabling comparisons between impact funds and non-impact assets.

As they analyzed the data, Posenau said she was struck by the heterogeneity of firms receiving impact investment; they ranged from firms specializing in climate technology to education and regional development.

“We saw companies targeting a wide range of goals at different stages,” she said, adding, “Many impact funds were balanced across different-stage companies.”

Another key finding from the literature is that, as private capital providers, impact funds, being have opportunities to influence the strategy and governance of companies more directly than investors in large public companies, who typically have limited input.

“These funds tend to invest in early-stage or growth companies towards the beginning of their life cycle, and capital becomes important for survival,” she said. “Investors can generate a lot of impact; their voice makes a difference.”

Posenau became interested in impact investing in graduate school at the University of Chicago’s Booth School of Business when she observed environmentally and socially conscious investments gaining traction. At the same time, Posenau and coauthors noticed a lack of solid evidence on returns and portfolio risk contributions, which inspired her to research impact funds and private markets.

Risk analysis is a common thread in Posenau’s work. At SC Johnson College of Business, Posenau teaches managerial finance to graduate students. While she doesn’t cover private markets as part of the class, she shares her findings anecdotally to illustrate portfolio theory and systematic risk management.