ImpactAlpha, January 16 – Nearly all of the actual impact in impact investments comes from the ground up.
If it makes sense to incentivize enterprises on the ground to deliver on their impact objectives, it could logically follow that compensation for the fund managers who invest should also be tied to such outcomes.
In search of such alignment, the European Investment Fund, a financing arm of the European Union, requires the private equity and venture capital fund managers it works with to link their carried interest, or share of profits, to impact objectives. Similarly, Netherlands-based Wire Group invests in funds that link their returns to impact – and does the same for its own fund of funds. São Paulo-based Vox Capital ties its returns to the B Corp scores of its portfolio companies.
An increasing number of investors and fund managers are raising the impact stakes with financial incentives that tie their success to the impact of others farther down the investment food chain.
“There needs to be incentives at all levels,” says Bjoern Struewer of Roots of Impact, which structures bonus payments for social enterprises that reach their impact goals. That means understanding how close fund managers are to the impact on the ground through their portfolio companies. At the investor level, it means thinking about human resources and investment strategies as levers for deeper impact, Streuwer explains.
Some kind of impact incentives, including impact-linked carried interest, bonuses or preferential financing terms, are used by at least a significant minority of impact investors. Adoption is accelerating: about half of respondents to the Impact Linked Compensation Project’s fund manager survey have adopted impact incentives in the past two years.
“Our work as a fund of funds exposes us to new innovations that may contribute to a more conscious economy, and challenges us to implement such mechanisms and best practices ourselves,” writes Wire Group’s Ronald Janse in a guest post on ImpactAlpha.
The European Investment Fund, the venture investing arm of the European Investment Bank, was among the first large institutional investors to require fund managers in its portfolio to adopt impact-linked carried interest. Fund managers must structure their compensation terms using the EIF’s impact performance methodology. The process allows EIF to assess “how successful a fund manager is in selecting portfolio companies that are capable of implementing their impact agenda and delivering on their theory of change,” says EIF’s Uli Grabenwarter.
Dutch impact fund of funds manager Wire Group links 100% of its carried interest to impact outcomes from its portfolio. Because it depends on other fund managers successfully achieving impact within their portfolios, Wire Group targets fund managers who also have a financial stake in their impact outcomes. Portfolio fund manager Masawa Ventures, a mental health-focused VC firm, shares its returns with investees. It also doubles down on its strategy by providing mental health support to founders.
“Because many of these models are new, the field has few proof points and best practices,” observes Aunnie Patton Power, who led the research for The ImPact. Guidelines are emerging, however, fueled by impact investors, fund managers and enterprises that are sharing their strategies and early lessons.
For example, just 7% of impact fund managers have adopted impact-linked carried interest, largely because of structuring costs and complexity.
“If impact carry is to move beyond the realm of a widely supported but largely theoretical concept, we must reckon with these practical challenges and devise solutions that fairly allocate risk, reward and cost between investors and impact fund managers,” attorneys Chintan Panchal and Aaron Bourke of RPCK Rastegar Panchal argued in a guest post on ImpactAlpha.
Walking the talk
The push for fund managers to adopt such impact accountability measures often comes from the general partners themselves, rather than their investors.
“It’s about walking the talk,” says Vox Capital’s Gilberto Ribiero. Vox was one of the first impact funds to link its carried interest – the share of a venture fund’s profits that goes to the fund’s managers – to impact objectives. The firm’s first fund pegged half of its carried interest to one impact metric: portfolio companies’ B Corp eligibility. Portfolio companies don’t have to be B Corp certified; the fund measures their eligibility using B Corp’s questionnaire. If its portfolio average tops 80%—the minimum score for a company to seek B Corp certification—Vox is entitled to the portion of its carried interest that is tied to its impact outcomes.
Vox identified this metric as a barometer for companies’ commitment to good governance and social and environmental responsibility.
The fund was successful on its impact goals but missed its financial targets, thus forfeiting Vox’s carry.
“Whatever metric or process you decide to embed within your compensation is not a substitute for proper impact management,” notes Ribeiro. “Sometimes the metrics that are best for designing compensation are not the best for translating the impact you’re having. They’re a proxy.”
Its first experiment with impact-linked compensation helped Vox improve the methodology for its second and now third funds. Not all of the B Corp survey questions were material to portfolio companies’ business models; Vox adapted the questionnaire. It also developed a set of guides and resources to assist companies with implementation of immediate and long-term improvements. And it created a support community of other founders, board members and its broader network.
The firm is now looking at ways to reduce the cost and operational burden and speed up the process for its portfolio companies.
“It’s imperfect,” says Ribeiro. “It’s within the early days, but we need to reform the mindset of doing business in the financial markets. Otherwise, we will only reproduce the kind of externalities, inequality and problems that we are seeking to solve.”
Beyond Capital Ventures, a VC firm that invests in social enterprises in Africa and India, shares its portion of carry with founders in its portfolio.
“Impact-linked carry is good for incentivizing a manager,” says Beyond Capital’s Eva Yazhari, who is based in Dallas, Texas. “But to me it doesn’t hit deep enough at systemic issues,”
As a fund based in the Global North but which invests in the Global South, Beyond Capital wants to ensure that a portion of its profits stay in the markets it supports through its investment activity.
“What we believe drives impact are purpose-driven, conscious leaders who are thinking about all stakeholders,” Yazhari explains. “We want a partnership with our investees where we’re bonded in the success of our fund.”
Paying for success
Large companies like Blackstone and Safaricom and small local businesses alike are benefitting from impact-linked debt, wherein funders pay for impact and ESG achievements. Lenders provide interest rate reductions, set impact conditions for fund disbursement, or forgive a portion of the loan.
Africa-focused mezzanine and debt providers Iungo Capital and Balloon Ventures use similar incentives in their portfolios of small and mid-sized businesses. Iungo will tie repayment terms to conditions like paying employees a living wage or offering health insurance to workers. Balloon, whose impact thesis centers on “good jobs,” disburses its approved loans in two tranches, making the second tranche conditional on companies formalizing worker contracts.
“Often 90% or 95% of businesses’ jobs when we invest are uncontracted, so we give them half of the money, and then help them move their workers to a formal contract before releasing the second half of the funds,” explains Balloon’s Josh Bicknell.
To become a repeat borrower, businesses have to prove that all of their workers are paid a living wage.
“We tried other ways to incentivize good jobs, but found this was the most efficient way,” he adds. “When we raise impact funds that are concessionary, we can provide slightly concessionary terms to businesses, but we ask them to do something for it.”
Balloon also provides internal incentives, pegging a portion of its employees’ bonuses to the number of formalized, fair pay jobs. “It incentivizes employees to find deals that employ a lot of people,” deepening the impact Balloon can have through its lending, says Bicknell.
Another private lender, Beneficial Returns, forgives social enterprises’ final loan payment if they achieve their impact targets. Founder Ted Levinson argues that “if you really care about impact, put your money where your mouth is and reward the folks that are actually delivering the results.”
Roots of Impact has raised philanthropic capital to pay social enterprises like diabetes care provider Clinicas de Azucar, rural lender Root Capital, and dental care provider Novulis to redouble their support for vulnerable populations. After eight years using its social impact incentives, or SIINC, model, the organization is looking at how to support fund managers in incorporating SIINCs in their portfolios.
“Effective compensation is really about being clear on contribution to impact,” says Struewer, “and thinking one level further.”