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How are returns and impact correlated?
If you answered, you are wrong.
I meet a lot of impact investors with the presumption that I consider myself an impact investor.
I also meet a lot of staunch non-impact investors with the presumption that I, like the, only consider market rate opportunities.
Funny enough, I tend to identify moment by moment as whichever is the opposite of the group I’m talking to.
Recently, I’ve started to find these labels limiting and my stubborn, untethered counterpositioning as evidence of an underdeveloped philosophy.
At the risk of wading into a conversation much older, more informed, and more opinionated than myself, I would like to try to parse out a more intellectually honest framing for the role of capital in generating returns and impact.
Returns and Impact are Not Inherently Causal
The Milton Friedman doctrine suggests the relationship between returns and impact fit on a spectrum where impact and returns are maximized at the same end.
This assumes all externalities get internalized by the market over time. On a human timescale however, this function has proven too slow. Many issues continue to linger in an untenable state, unsolved, while the market catches up.
Take the hole in our o-zone for example. A pure Friedman view would argue that the free market will note the increase in skin cancer, crop extinction, eye-damage, food loss, and raise the price of using the ozone damaging fluorocarbons. In reality, the feedback loop between these externalities and the price of fluorocarbon-based products broke, or remained incomplete Instead of waiting for those consequences to pile up while price corrected, we passed the Montreal Protocol and regulated away 99% of fluorocarbons, considered one of the most successful environmental regulations ever.
In the investor-seat, Friedman’s view offers a huge shortcut in decision-making. Even the Business Roundtable has abandoned Friedman’s singular responsibility (profit) due to its limited scope. Blindly adopting it is akin to discovering gravity and deciding that is as far as physics needs to go.
Like any meaty subject matter however, there is a polar opposite, yet similarly dangerous view. Let’s call it Anti-Friedman.
This assumes that anything good must be at the expense of profit/return. Business is bad.
No business is perfect, but there are plenty which we are better off for having. Take Sistema Bio, a biodeigester which helps farmers produce fertilizer and renewable energy from waste. Their solution has the potential to reduce emissions and increase yield for 200 million farms, impacting up to one billion people. I’ll take the utilitarian bet that they are a net positive for the universe.
If Sistema Bios reaches this scale, none of their investors will be complaining either. The better off their business is, the better off our climate and food security situations are. Impact is not always at the cost of business. In fact, Friedmans rejoice, their business is impact.
This leaves the Friedman and Anti-Friedman views as both delusionally absolutist. One is a false equivalency and the other a false tradeoff. The real-world proves and disproves both views constantly. Impact and returns are sometimes positively correlated and sometimes negatively correlated. Therefore, they do not have an inherent causal relationship.
When evaluating an investment, risk and impact should be assumed to be uncorrelated until proven otherwise.
While this may sound like a vocabulary tweak, it has big implications for investors.
Friedmanistss and Anti-Friedmanists are rife amongst us.
Anyone who has led a pitch with the wrong narrative has experienced this. You wrap up the elevator pitch and the investor on the other sid eof the table/call/zoom leans back, crosses their arms, and says:
“I heard you mention your UN SDGs. Here at Juniper Creek Partners, we focus on profit. Good luck, but this is not for us.”
“It seems like you are aiming to get very rich from this. Here at Pefect Future Coalition, we invest in impact. Go raise ‘traditional capital’; you don’t need us.”
Weeding out an investment because it comes with returns ALSO, or impact ALSO, seems laughable, but it happens all the time. Investing is hard. Faced with filtering out dealflow at the top of the funnel, investors get mentally overwhelmed and hungry for shortcuts. As Daniel Khaneman would put it, system one thinking takes over to preserve time and energy, when system two is needed to avoid the false equivalency between risk and impact that may discard a deal that fits their own mission and investment criteria.
But is this all just philosophy for the sake of philosophy?
The tempting counterargument is that impact and risk may not have causality, but they have enough correlation that the mental shortcut works.
Both camps can continue to sit on their investment committees and continue to use their dogma as an investment filter. The Friedmans may continue to maximize profit and avoid intentional impact, while the AntiFriedmans may avoid profit so as to maximize impact.
Let’s look at a real business that shows just how faulty the Friedman/Anti-Friedman filters are.
The Toms Shoes Paradigm
When Toms Shoes started, they famously gave a pair of shoes away to those in need for every pair they sold–the 1:1 giving model.
Before this model drove huge consumer adoration and purchasing, it was an idea for corporate philanthropy that on paper would cost the company a lot in COGS. Sure, founder Blake Mycoskie hoped this philanthropy was actually altruistic marketing genius, but what were the odds it was so genius that it could make up for the profit margin he nearly halved with the sale of each pair of shoes?
Any realistic model would show his impact was way too expensive to create globally competitive shoe business.
A Friedman investor would have said, “great business, but you are blatantly not maximizing profit. We invest above the line, where money really gets made.”
I don’t know a single for-profit investor who wouldn’t kick themselves for missing what would become a $625 million exit to Bain Capital.
The Anti-Friedman absolutist would not do any better though.
In walks a wildly optimistic Blake Mycoskie, pitching a humble shoe company that aims to compete with the likes of Crocs, Nike, Vans, you name it. He wants to be the next Shoe Dog, and he will give away some shoes because it is good marketing.
They brush off his giving model due to its devious marketing motivations. From their point of view, this business is really in the top left of the quadrant.
Not much for his capitalistic ambition, the Anti-Friedman investment committee says, “we prioritize impact, and it seems like you just want to make money with a generous marketing ploy. If you really wanted impact, you would donate two pairs of shoes for every one sale. In fact, I’m not actually sure if our organization can invest in profitable businesses.”
Six years later, Toms had donated two million pairs of shoes to children in developing countries. Who knows how many more Toms there could be if the Anti-Friedmans were flexible in their thinking? Or what impact they could have unlocked with investor proceeds from the $625 million dollar sale.
In reality, Toms did not need seed funding, as Mycoskie’s previous venture provided the $500k necessary to start sales. That doesn’t prevent it from being a glorious example of defying and return and impact relationship.
In fact, the story gets even better.
Five years after Bain acquired 50% of Toms, the company was taken over by creditors.
The seed investment would have been lucrative, well above the line, but Bain’s landed in the bottom right - high impact, but bad returns for the for-profit Bain.
Or did it land in the bottom left?
Numerous international aid organizations criticized the company’s 1:1 model, alleging the giving model exploits poverty, is wasteful giving, or even harms the economies where shoe donations are made. Did Toms become a bad investment for Bain and the world at large?
Today, the company has decoupled each sale with a pair donated. Regardless of its efficacy from a philanthropy perspective, the company chose to adopt a more flexible policy of giving to maximize its effectiveness. While owned by creditors, Toms remains a top-tier B-Corp in the Community category and has impacted over 100 million lives according to their most recent impact report.
So which quadrant does Toms reside in?
I suspect the god-view would look upon Toms favorably, but it does not matter. At every stage of its journey, the temptation to draw causality between returns and impact was being proven and disproven. The quadrant is nice, but only useful in hindsight and newsletters.
At the time of investment, there are two different variables, return potential and impact potential, which each have their own risks. They are uncorrelated.
So what is an investor to do?
Like any good existential quandary, the only thing we can do is to prioritize thoughtfully and then do the next right thing.
In Part II we’ll discuss the evolution of profit maximization.
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