Show me the incentive, I’ll show you the outcome, goes the Charlie Munger maxim driving a wave of innovation in impact investing.
To drive outcomes, impact investors are increasingly incorporating impact-linked incentives – that is, mechanisms that financially reward the recipients or managers of capital for achieving impact targets – into impact deals.
At a panel discussion at the annual Conference on Legal Issues in Social Entrepreneurship and Impact Investing at NYU School of Law, a group of leading legal practitioners and experts – Leslie Cornell from Social Finance, Erik Nieuwland from FMO (the Dutch entrepreneurial development bank), Bjoern Struewer from Roots of Impact, and Aaron Bourke from RPCK Rastegar Panchal – discussed key considerations and challenges in structuring effective impact-linked incentive structures.
The discussion compared experiences and insights from a range of transaction structures – in particular, outcomes-based finance, impact-linked carried interest and impact-linked finance – in order to work towards a unified theory of best practice for designing and implementing effective impact-linked incentive structures, which have yet to be adopted at scale.
Here are seven key elements of an effective impact-linked incentive structure:
1. A party (or parties) willing to “pay for impact”
The reason that a transaction may require an impact-linked incentive structure is that the transaction does not sufficiently incentivize the parties to pursue (better) impact in the absence of additional “subsidy.” Thus, in order to create an incentive for an investee or manager to pursue more ambitious impact outcomes, a transaction requires a party willing to “pay for impact.” This could take a variety of forms.
Roots of Impact’s Social Impact Incentive (SIINC) model provides a very “pure” example of an impact payment mechanism. Through this structure, Roots of Impact enters into what amounts to a multi-year services contract for the delivery of impact outcomes with an investee in a transaction. The investor in the transaction is a party other than Roots of Impact. Utilizing catalytic capital raised from donors, Roots of Impact enters into a straightforward arrangement with the investee in the transaction to provide it with a financial incentive to prioritize impact outcomes.
Another form of impact-linked finance is to embed the impact incentive directly into loans. In impact-linked loans, a variable and dynamic interest rate can be reduced according to the achievement of pre-defined impact targets. In such a structure, Roots of Impact is both the investor and the impact payor.
The “impact payor” in a transaction could also be the investor in a fund structure. This is the case in an “impact-linked carried interest” structure, whereby the investors in a fund (limited partners) incentivize the fund’s general partner to prioritize impact outcomes by tying a portion of the general partner’s carried interest to the achievement of impact outcomes.
The mechanism can be a carrot (i.e., increased carried interest if impact outcomes are achieved) and/or a stick (i.e., forfeited carried interest if impact outcomes are not achieved). Since the financial returns from a fund are shared between the fund’s general partner and its limited partners, by offering the general partner additional carried interest in exchange for achieving impact outcomes, the fund’s limited partners are playing the role of “impact payor.”
Nieuwland stressed that alignment amongst limited partners (and with the general partner) is a key success factor in this respect, noting also that the base case scenario for most impact-linked carried interest structures is that the achievement of financial targets (i.e., a positive return on investment for limited partners) is a prerequisite for there to be any carry entitlement for a general partner.
An impact-linked incentive structure could involve a single impact payor (as in the case of Roots of Impact’s SIINC structure) or multiple impact payors (as in the case of an impact-linked carried interest structure). The complexity of the impact-linked incentive structure, as well as the ease of reaching consensus on the structure, may vary widely depending on the number of impact payors.
2. An aligned investor
Every investment requires an investor; however, an effective impact-linked incentive structure requires an investor that is philosophically aligned with the goals of the impact payor and the investee. Social Finance’s outcomes-based finance funds provide a good example of a highly-aligned investor. In the case of Social Finance’s outcomes-based investments, Social Finance is both the investor and the impact payor.
A typical transaction in Social Finance’s “Workforce and Education Investments” portfolio may involve acquiring a student loan portfolio from an organization that provides degree programs or workforce training. The purchase price for the acquisition of the portfolio is typically subject to a deferred payment structure, with a portion of payments “unlocked” when the training provider achieves specified impact outcomes (e.g., successful job placements for graduated students).
Social Finance strongly identifies as an “impact-first” investor, and it markets itself as such to the limited partners in the funds that it manages. The terms of the funds that Social Finance manages prioritize impact over financial returns (which is possible because of the philanthropic nature of founders/investors behind the company). This allows for a high degree of alignment between Social Finance’s roles as investor and impact payor.
Where the investor and the impact payor in a transaction are different parties, there may be a need for communication and coordination between the investor and the impact payor.
As Struewer noted, in SIINC transactions that Roots of Impact engages in, investors are typically fairly impact-focused (indeed, they would not seek to invest in the investee companies if they did not care about impact). However, it has occasionally been necessary to communicate with prospective investors to assuage concerns about Social Impact Incentives (SIINC) and help the investors understand that the investee’s attention to impact outcomes is aligned with the long-term value creation of the investment.
3. An investee
Just as every effective impact-linked incentive structure requires a specific type of investor, so does it require a specific type of investee. Cornell provided an example of an aligned investee in Social Finance’s “Workforce and Education Investments” portfolio.
Workforce training providers, by definition, aim to provide students with the skills they need to succeed. However, their economic model, which is typically based on up-front payments of fees and tuition, does not provide them with an explicit economic incentive to maximize the success of their students. By providing these workforce training providers with funding that is unlocked based on the achievement of impact targets, Social Finance aims to address this incentive “gap.” In order for the impact incentive to be effective, an investee must (i) have an inherent commitment to achieving social impact, (ii) be willing to take on risk (“skin in the game”) in order to access capital, and (iii) demonstrate an ability to hit certain performance thresholds.
Similarly, Struewer noted that an effective investee in an impact-linked finance structure should have an inherent commitment to achieving social impact and have a good idea of the impact they want to achieve, but typically lack the resources or the additional stimulus to achieve more ambitious impact targets.
4. Impact metrics / targets that give an accurate picture of the impact achieved by the investment
An impact-linked incentive is meaningless if the metrics / targets that the parties to the transaction identify don’t provide an accurate picture of the impact achieved by the investment. It is therefore critical that the parties spend sufficient time identifying the metrics of success. Nieuwland described FMO’s ongoing effort, along with other development finance institutions, or DFIs, to develop an “impact indicator” framework that will provide a menu of options that can be tailored to each specific deal.
Nieuwland noted that an important debate around this framework relates to attribution – that is, to what extent can we attribute the achievement of impact to the investee (in this case, a fund manager)? When FMO invests in a fund, its goal is to encourage the fund manager to go beyond “business as usual” in terms of focusing resources and effort on driving impactful outcomes. To define what it means to go beyond “business as usual” in a given investment, FMO must be able to identify impact metrics that differentiate between impact that is attributable to the fund manager’s efforts and impact that is attributable to other factors.
In other words, the sole fact that a fund’s strategy aims at greenhouse gas emission (GHG) reduction or renewable energy production is not sufficient by itself. To what extent have the fund manager and, in turn, the fund’s portfolio companies contributed to achieving the impact target(s) at the fund level?
Cornell shared various examples of the impact metrics that Social Finance uses in its talent portfolio, many of which underscore the importance of measuring outcomes against a baseline. For example, Social Finance measures the average earnings of students before and after graduating from workforce training, as well as the percentage of students served who have moved from below the living wage threshold in their geographic region (before training) to above that threshold (after training). Other metrics that Social Finance measures include average graduation rates, placement rates, job satisfaction, lifetime wage expectations, and work hour flexibility.
5. Financial incentives that create enough of a carrot (or stick) to influence behavior
An impact-linked incentive structure will only work effectively if the financial incentive created is sufficiently strong to influence the behavior of the investee. An impact-linked incentive can consist of a combination of carrots (positive incentives) and sticks (negative incentives). Impact-linked carried interest structures in funds provide an interesting case study on this topic. Nieuwland (in his role as Senior Legal Counsel at FMO) and Bourke (in his role as Head of Fund Formation at RPCK Rastegar Panchal) have seen many impact-linked carried interest structures as this concept has become more popular among impact funds.
In many cases, funds that incorporate impact-linked carried interest structures start from the 20% carried interest that is typical among commercial funds, and then ratchet downwards if impact targets are not achieved. It isn’t clear that a structure that incorporates a stick without a carrot provides fund managers with a meaningful incentive to achieve impact targets, especially where (as is the case with many impact funds) the fund may not generate carried interest for a very long time, if at all.
Additionally, forfeiture of carried interest places even more financial pressure on impact fund managers that in many cases are operating on extremely tight budgets. The panelists agreed that if fund managers are penalized for failure to achieve impact targets, it makes sense to also compensate fund managers for achieving impact. This could be achieved by ratcheting the fund’s carried interest percentage upward if impact targets are achieved.
Nieuwland also suggested that there may be alternative approaches to providing a carrot to fund managers for achieving impact targets. For example, his team has conducted modeling that shows that, in most cases, a manager of a fund with a hurdle rate will have a better economic outcome if the achievement of impact targets results in a reduction of the hurdle rate (i.e., the general partner begins to receive carried interest earlier) rather than an increase in the carried interest percentage.
Nieuwland pointed to the example of a fund that aims at reducing inequalities (SDG 8) and promoting economic growth (SDG 10) in Sub-Saharan Africa, whereby a set hurdle rate of, e.g., 8% would be reduced by 0.5-1% depending on, e.g., the number of the fund’s portfolio companies that are women-owned and/or on the percentage of the fund’s invested capital in portfolio companies that meet the fund’s definition of “small or medium-sized enterprise”.
6. Accurate data
It doesn’t matter how well-defined the impact targets are for an investment if the parties to the transaction are not able to collect accurate data to demonstrate with certainty whether the impact targets have been achieved. There has been a recent proliferation in the impact investing industry of data collection methods, technology and service providers. The question that often comes up when implementing impact-linked incentive structures is: Who is going to pay for the collection of impact data? Struewer noted that in its impact-linked finance structures, Roots of Impact pays for the collection of impact data so that the investor and the investee do not need to worry about covering this cost.
The question of who pays for impact data collection has become a hot topic in the impact fund community. Many existing funds were set up at a time of lower expectations with respect to impact measurement and management, or IMM, and their limited partnership agreements, or LPAs, accordingly do not address who will pay for IMM. Many fund managers to date have paid for IMM out of the management fee. However, the traditional 2% management fee was designed to cover the costs of running a fund without taking account of a potential significant expense for IMM. Accordingly, requiring IMM to be paid for out of a fund’s management fee places significant strain on the budgets of fund managers.
Bourke and Cornell recently contributed to an article in the Stanford Social Innovation Review (co-authored by 60 Decibels’ Co-Founder and CEO, Sasha Dichter) that argued that the cost of IMM naturally falls within the category of “operating expenses” that are typically defined in a fund’s limited partner agreement and are covered by the fund’s limited partners because, among other things, IMM fundamentally helps improve investment-decision making for the fund.
However, by adding a single line to the typical lengthy laundry list of “fund expenses” in an LPA, or even taking the position that IMM expenses are “operating expenses” without explicitly mentioning it in the fund’s LPA, fund managers run the risk of placing a significant expense on the fund’s limited partners without providing them with sufficient notice (which regulators including the SEC disfavor). Nieuwland also noted that as a matter of normal market practice, DFIs have required robust reporting across multiple impact indicators for several decades already (without typically adding IMM as a separate fund expense).
Based on the considerations described above, the panelists agreed that it is fair to ask limited partners to cover the cost of IMM as a fund operating expense (not out of the management fee), but this should be the result of open discussion with the limited partners and a good faith effort should be made to quantify the likely cost and place a cap on the amount that must be borne by limited partners (including the general partner through its stake as limited partner) as an operating expense.
7. Simplicity
As if it wasn’t challenging enough to capture all of the other elements described above in a single transaction, an effective impact-linked incentive structure needs to be simple enough that the transaction remains economically viable (i.e., the complexity and cost of setting up the transaction can’t overwhelm the economics of the transaction). That is the key to achieving scale.
Social impact bonds, or SIBs, while a great success story in many ways, also provide a cautionary tale about the importance of achieving simplicity in impact-linked incentive structures. SIBs were initially met with much fanfare, but they have failed to achieve their initial promise because of an inability to scale. A big reason for this inability to scale is that many SIB transactions are so complex and bespoke that they become unviable economically. A significant piece of this challenge is the unpredictability of working with government actors that are subject to complex appropriations processes and frequent changes in political priorities. As a result, it can be very challenging to create the right conditions for a SIB to provide financial outcomes that would attract commercially-oriented investors. Cornell explained that, in part for this reason, Social Finance has expanded its work over time to include more efficient outcomes-based finance structures.
The panelists also agreed that the further proliferation of impact-linked incentive structures will depend not only on the development of simple structures, but on a continuing evolution in the mindset of market participants. That is, this proliferation requires a sustained commitment on the part of both investors and investees to implement effective impact-linked incentive structures, and a willingness to experiment and invest resources to design and implement such structures effectively.
This ongoing “mindset shift” will be vital to the long-term success of impact-linked incentive structures. Participants in development finance could be crucial in moving the needle globally, especially impact investors (including DFIs) with a catalytic mindset and investees that are committed to using the power of business to create positive social and environmental change.
Aaron Bourke is a partner at RPCK and leads the firm’s fund formation practice.
