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Impact funds – social commitment with returns

20 years ago, investors who only wanted to invest their money in assets that would benefit society, or at least do no harm, were ridiculed as do-gooders. At that time, there were only a handful of banks that offered sustainable investments. On top of that, sustainable investments were often less lucrative than conventional investments.

That has changed in the meantime. In recent years, the number of conscious investors has significantly increased. This has also prompted the financial world to rethink and adapt its range of products accordingly.

Selected portfolio examples of an SDG-focused investment strategy of KfW Development Bank
Selected portfolio examples of an SDG-focused investment strategy of KfW Development Bank.

Impact investments are one answer to the increased demand for sustainable investments. With a volume of around US-Dollar 1.164 trillion worldwide in 2022, this is already remarkable, but there is still further potential for growth. For impact investment providers, it is not sufficient to mitigate the negative impacts of economic activities, as sustainable investments do.

They go one step further and only invest their clients’ money in companies that demonstrably add value to society. This can be social or ecological. In addition to a promise of return, investors thus also receive an account of the impacts achieved by the invested money.

Impact funds are a popular form of investment for impact investments. Here, investors leave the money with the fund manager for a certain period of time. The fund manager then invests it in various assets. Unlike conventional funds, however, the investment options are limited to beneficial investments, ideally in developing countries and emerging economies.

This is often a challenge for fund managers because developing countries and emerging economies in most casesare subject to higher risks. Since the funds invest in different countries or industries, they can spread, and thus minimise, their risk accordingly. The impact funds promoted by KfW Development Bank often have a risk capital buffer that absorbs potential initial losses. For example, if a fund’s risk capital buffer is 10%, investors will not bear losses until this threshold is exceeded. KfW assumes such first loss tranches on behalf of the German Federal Government and the EU. KfW is one of the largest investors in first loss tranches worldwide

The range of areas and industries covered by impact investments is very diverse. Below are some examples:

1. Protection against climate risks:

Extreme weather events are increasing as a result of climate change. Developing countries and emerging economies are particularly affected. Floods, storms and droughts are causing damage and endangering livelihoods.

An investment strategy launched by KfW on behalf of the German government is creating and improving climate risk insurance for households and businesses in several developing countries. As of March 2023, around 50 million poor and vulnerable people are covered against climate risks; this figure is expected to rise to between 90 and 140 million by 2025. The InsuResilience Investment Fund, for example, invests in companies that offer and provide insurance, as well as service providers that provide necessary data or information. Via the use of parametric products, an insured person does not have to furnish detailed evidence of a loss after a disaster. Instead, objective external weather data is used to trigger payments – without a loss assessment. This way, customers receive their money promptly and without much administrative effort.

2. Financing start-ups in Africa:

Frau schließt Solarpanel an den Stromkreislauf

In order to turn a good idea into a successful start-up, you need equity, venture or risk capital. Especially in Africa, the market for this is still in its infancy. The total financing gap for small and medium-sized companies in Africa – start-ups included – is estimated at over USD 300 billion. Investors are often only willing to invest in established companies. Start-ups and young companies often fall by the wayside. KfW’s participation on behalf of the German Federal Government in Partech Africa Fund I, a venture capital fund active in Africa, has gone some way towards closing this gap. Launched in 2017, the fund has raised nearly EUR 125 million in funding from public and private investors, providing venture capital to over 15 companies in nine different African countries. The fund’s clients include successful technology companies that make a valuable contribution to the digitalisation process in their countries.

3. Hedging of exchange rate risks:

Public and private borrowers in emerging markets often rely on foreign lenders for financing. However, these lenders usually only issue loans in foreign currencies. This exposes borrowers to exchange rate risk. If their currency depreciates, the repayment of the foreign currency loan becomes more expensive. This can lead to considerable financial burdens.

TCX is an initiative supported by KfW on behalf of the German government to hedge exchange rate risks. TCX provides hedging instruments to hedge borrowers against exchange rate risks. TCX does not compete with commercial banks and only hedges transactions and maturities for which there are no commercial alternatives yet. In 2021 alone, TCX hedged a volume of approximately US-Dollar 1.4 billion in loans in developing and emerging countries against exchange rate risks.

Looking at the societal demand and, above all, the capital requirements for impact investments, the end of the line is far from in sight. There is still a high demand for such investments. Unlike in Switzerland, German private investors cannot currently invest in impact funds. Institutional investors such as insurance companies and pension funds are allowed to do so, however. Fund managers, insurance companies and institutional investors are already working on expanding their range of products. The positive experiences from previous impact fund investments help to establish impact investments more and more.

Interview with Head of Department Stefanie Lindemann-Kohrs on impact investments: "We invest to make an impact"

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