There is a certain immediate attractiveness associated with the idea of impact investing. The objectives of many impact investors are in some ways similar to those of many critics of capitalist societies: both groups want to contribute to the achievement of various socially worthy objectives that the market does not seem to satisfy by itself, at least not to a sufficient extent. But unlike anti-capitalist political activism, which is based on the beliefs that markets are inherently flawed, impact investing looks like a classic affirmation of the market: by putting his money where his mouth is, an impact investor may be seen as creating demand for socially beneficial corporate actions, and the essence of capitalism is to satisfy such spending-backed demand.
In fact, however, impact investing is nothing of the sort. To be sure, some impact investors may be firm supporters of market capitalism and simply not know how it functions, or they may be acting under various illusions about how their actions will do good at no extra cost. What interests me here, however, is what a rational investor, who is not a philanthropist, might be trying to accomplish by impact investment, rather than what a deluded or misguided social activist may imagine he is doing.
What distinguishes impact investment, as I understand it, is the acceptance of non-financial standards as an integral component of measuring corporate performance. An investor who buys the shares of a company that pursues a certain social policy because he believes that it will at some point increase his financial return, is just an ordinary investor, not an “impact” investor at all. The special feature of an impact investor is that he sees the social impact as an independent factor in evaluating corporate performance, even if as a result the standard financial return ultimately ends up smaller than it would otherwise have been.
The second defining feature of impact investment, as I understand it, is that those engaging in it are not trying to buy on the market the goods they desire from those who produce them. An impact investor who buys the shares of a pharmaceutical company in order to assure that a certain medication is delivered at a low price to indigent people in Africa does not simply intend to contribute a portion of his capital toward paying for the medication in question. At least in part, he is also trying to gain a voice in the company governance structure which can then be used to influence the management to lower all shareholders’ returns and direct a portion of the company’s resources to providing the medication at below market price to the indigent African consumers.
Now my main claim is that insofar as impact investors are not predicting that the market will move in their direction, but rather want to move the fiduciary corporate decision makers in the direction of certain socially conscious decisions, they are in a different kind of business, which I call corporate lobbying, rather than investing. Indeed, an impact investor is trying to force corporate decision makers to use other investors’ money to foster the impact investor’s own preferred social objectives.
But what’s wrong with this, one may ask; aren’t all shareholders entitled to vote in accordance with their preferences? So what if the losers are forced to pay for what the majority decides is the proper use of corporate funds? Isn’t that what majoritarian governance is all about?
The problem is not, of course, with majoritarian governance as such, but with the fact that the objectives pursued by the majority violate the “constitution” of the system within which majority vote is an acceptable decision making procedure. In the same way as using majority vote to, say, institute censorship violates the principles of the American political system, using corporate governance mechanisms to inject objectives unrelated to shareholders’ financial return violates the basic principle of the American economic system. The reason for this is that the American corporate governance system crucially relies on the homogeneity of the interests of corporate investors in order to blunt the edge of the daunting agency problems that could otherwise endanger its viability.
American firms operate in an environment characterized by (1) the separation of ownership and control and (2) dispersed ownership of most firms. Given these two conditions, the corporate governance system of American firms could not function without relying on the ability of the financial markets to lower radically the information costs necessary for the shareholders to monitor corporate performance.
The main purpose of the separation of ownership and control is to match the owners of capital who lack managerial and entrepreneurial skills (or even a proper understanding of what such skills consist of), with the people who have those skills, but are not wealthy enough to provide the capital necessary for deploying them to the optimal effect. The separation of ownership and control thus allows the owners of capital to avail themselves of the upside that may be gained from the special entrepreneurial and managerial skills for which the people who manage businesses are chosen through a specialized managerial labor market.
This matching of capital and managerial skills is perhaps the greatest secret of a successful corporate system. The reason why it is a secret is because managerial skills, especially insofar as they entail what we think of as innovation and entrepreneurship, are quintessentially ineffable. Management, like knowing how to ski or to write a great novel, is an art, not a science that follows a set of prescribed rules. (Indeed, being a good scientist is itself not a science.) To be sure, there are ski schools, writers’ workshops, and business schools. But if all it took to be an Olympic skier was to follow faithfully the rules learned in ski school, the very idea of Olympics would not make sense. The same is true of entrepreneurial management: The essence of entrepreneurial skill is the ability to see that what the standard wisdom prescribes is sometimes not the best way of proceeding, and the ability of an entrepreneur to succeed is the most important (and mysterious) in those cases in which nearly everyone else sees only an excessive risk of failure.
The very nature of entrepreneurial management is what makes it so hard to harness for the benefit of investors. Investors want to benefit from the ineffable skills of the wizards of the industry. But precisely because those skills are ineffable, you cannot limit in advance what the management can do with your money without crippling its ability to do the very innovative things that are likely to appear ex ante unreasonable, but might turn out later to have been the foundation of superior returns. Indeed, even ex post, many good managerial decisions may look wrong just because they did not pan out, although the risk taken had been in fact justified. So managerial discretion is the key if you want to benefit from the skills that the manager has, but you don’t (and don’t even fully understand). Still, if you leave the management too much discretion, then how are you going to prevent not only bad business decisions, but also self-interested behavior that diverts corporate benefits to the managers in control?
This paradox of management-performance monitoring is especially serious in firms with dispersed ownership because small shareholders lack not only the skills, but also the incentives to monitor complex corporate decisions. And it is here that well-functioning financial markets solve the mystery of the modern corporation: They encapsulate the best available knowledge about the quality and honesty of the management in a single piece of data – the stock price –and provide a simple, yet comprehensive and maximally accurate, measure of corporate performance.
But the corporate governance arrangement of this kind crucially presupposes that price is indeed the common denominator of all investors’ objectives, and that return maximization can be seen as the distinctive and unifying aim of all shareholders. This is, of course, a strong assumption, affected with a certain degree of normativity. Shareholders may have all kinds of non-financial preferences with respect to desirable corporate behavior, and markets may not be not be able to satisfy some of them to the extent that various, perhaps even all, shareholders may like. But while some such objectives may be properly pursued through the political system, the very fact that the market does not price them correctly is the reason why their injection into the ordinary mechanisms of corporate governance amounts to not playing by the rules. When the simplicity of the financial-return measure of managerial performance is lost, the objective function of the management contains a number of heterogeneous components that are likely to be very hard, or even impossible, to aggregate. Indeed, once the management’s objective function is too complex, monitoring managerial performance becomes largely a fiction. When a company’s product does not sell, for example, managers can still claim overall success because they caused the company to contribute to saving the environment, maintain a happy labor force, or serve various underprivileged communities. A fall in efficiency and a diversion of corporate assets is likely to follow.
In this respect, impact investors, by advocating a complex managerial objective function, are in the same boat as the proponents of corporatist multi-constituency theories of the corporation, who also contest the idea that shareholder-value maximization, as expressed by the stock price, is the overriding purpose of corporate management. Indeed, state ownership is essentially in the same category as well, in that the struggle over the direction of corporate decisions in firms with a sufficiently large state ownership is no longer decided by the market, but depends at least in part on a contest among various political preferences and considerations. It is a rather widely recognized fact that companies do not perform optimally under such conditions, and neither do economies in which they prevail. Is there any reason to believe that widespread impact investing would have a different effect?
This post comes to us from Andrzej Rapaczynski, the Daniel G. Ross Professor of Law and Joseph Solomon Professor of Wills, Trusts and Estate Planning at Columbia Law School. It is based on his recent article, “Impact Investing as a Form of Lobbying and Its Corporate Governance Effects,” available here.