The challenges of impact investment facing PE investors

By Vandana Pai and Ayush Jain, Bharucha & Partners

Globally, private equity investors have been a driving force for economic growth, and have recently been adding responsible investments to their portfolios. This is driven by factors such as climate change, regulatory developments, and the impact of covid-19. Responsible investing is usually achieved either by environmental, social and governance (ESG)-focused investments or impact investments.

While private equity investors in the past were concerned solely with return on investment, increasing social consciousness has led to many private equity investors restricting investments in products such as tobacco and weapons, irrespective of returns. The focus has shifted further to ESG investments and, now, to impact investments.

Vandana Pai, Bharucha & Partners
Vandana Pai
Partner and Head of the Investment Funds Practice
Bharucha & Partners

ESG-focused investments are the foundation for impact investments. The main difference being that in ESG-focused investments, the target shows its commitment to mitigating negative outcomes by considering ESG, whereas an impact investment target also has a roadmap for creating a measurable social or environmental impact. ESG-focused investments consider past and present practices whereas impact investments look at future prospects. All impact investments are ESG-focused, but not all ESG-focused investments are impact investments.

Companies making impact investments are not always not-for-profit organisations. Many private equity investors believe that impact investments and financial returns need not be mutually exclusive, and impact investments by private equity investors are usually profit-driven.

With the increasing popularity of responsible investments, regulators are looking at ways to remove barriers and incentivise impact investments. The Securities Exchange Board of India (SEBI) has introduced a number of regulatory changes to attract impact investments.

The SEBI (Alternative Investment Funds) Regulations, 2012 (AIF regulations) have now substituted social impact funds for social venture funds. These are funds permitted to invest in social enterprises, including for-profit organisations satisfying certain criteria.

The SEBI (Issue of Capital and Disclosure Requirements) Regulations, 2018, the SEBI (Listing Obligations and Disclosure Requirements) Regulations, 2015 and the AIF regulations have been amended to provide a regulatory framework for social stock exchanges.

The SEBI (Issue and Listing of Non-Convertible Securities) Regulations, 2021 have been amended to bring the existing framework for green debt securities into line with the updated Green Bond Principles recognised by the International Organisation of Securities Commissions.

In its vision for 2019-2024, the Ministry of Corporate Affairs discussed how a social impact company, when introduced, would be a hybrid of a commercial enterprise and a charitable entity. While a committee of experts was to be constituted by 2022 to make recommendations for a new legislative framework for social impact companies, no concrete steps have so far been taken.

Such regulatory changes increase the need for comprehensive due diligence. Due diligence differs for an ESG-focused company and for an impact investment. ESG-related due diligence is easier as metrics often apply, including SEBI’s business responsibility and sustainability reporting requirements. Ratings are also available that enable investors to assess the target’s ESG compliance and commitment. Internal compliance systems and policies developed by the target company and its governance models are also important factors. Due diligence for impact investments, on the other hand, requires both ESG-related due diligence and also a review of additional data to measure the positive impact created by the target company in accordance with its stated goals and objectives.

Responsible investments are no longer driven just by risk management but have become a way of creating value. Private equity investors want to become the leaders in impact creation and have either already developed or are developing, specific impact funds or teams for this purpose. The challenge is to determine the parameters for measuring impact and it is unclear whether these will be standardised. Given that the regulatory framework for impact investing is new and still evolving, it remains to be seen how the framework will impact value creation and address concerns over greenwashing.

Vandana Pai is a partner and head of the investment funds practice and Ayush Jain is a senior associate at Bharucha & Partners.

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