Impact Voices | November 3, 2022

Have we reached the tipping point for impact-linked compensation?

Aunnie Patton Power
Guest Author

Aunnie Patton Power

ImpactAlpha, November 3 – On a panel I recently moderated at the GIIN Investor Forum, I baited the participants with a statement that I thought was controversial: I said I didn’t believe that fund managers should be able to say they’re impact investors unless their fund compensation is linked directly to their impact. 

To my surprise, all of the panelists, whose firms collectively represented nearly $1.7 trillion in assets under management, all nodded in agreement. 

Stephen Morency of Fondaction CSN went on to say that so-called impact carry was “table stakes” for impact fund managers.

Have we finally reached the tipping point on the link between impact performance and general partners’ financial compensation? If so, it would represent a monumental shift for the sector. 

Origins of impact carry

Let’s back up for a moment. Historically, in private equity, GPs’ earn a share of their funds’ profits as a compensation  for their investment savvy and management. This carried interest rewards risk-taking—or more specifically, it rewards risk taking that pays off in the long-term. 

Many ESG investment managers are going a step further, linking their remuneration to environmental, social and governance metrics—a concept called “responsible reward.” Impact investors, however, have been slower to follow suit by linking impact outcomes to carry calculation. 

BlueMark’s 2021 report “The Benchmark for Impact Investing Practice” found that 43% of all investors surveyed align staff incentives with impact performance, but only 3% embedded impact-linked carry into their remuneration structures. 

The concept has nevertheless been circulating in the impact investing field for more than a decade. The GIIN issued a brief on impact-based incentive structures back in 2011, and the Stanford Social Innovation Review published a piece by Daniel Izzo about linking compensation to impact in 2013. 

Aureos Capital was one of the first firms to adopt the idea in some form. The firm established a base rate of carry for its 2009 Africa Health Fund at 15% for achieving financial hurdles, and the rate would increase if the fund also achieved its impact targets.

Brazilian impact fund manager Vox Capital went a step further. Its model required the fund to achieve both financial and social targets to receive the full amount of carry, otherwise, the team’s take of profits would be halved.  

Private equity firms Apollo and EQT Future have also adopted impact-linked incentives for their managed funds. 

Slow adoption

If it seems obvious that impact fund managers should be accountable to their impact missions, fund managers often cite two main reasons for not embracing impact-linked carry: 

First, they say they don’t have standardized metrics at the portfolio level. Second, they note that their limited partners don’t ask them to tie their profits to impact.

To the first point, it’s true that we’re a ways away from complete standardization of impact measurement and management, particularly at the portfolio level. But we as a field are coalescing around standards. A growing number of gender lens funds, for example, are integrating the 2X Collaborative’s criteria into their carry targets. Also, as the GIIN’s recent benchmark project announcement attests, we are moving towards benchmarking impact performance within sectors.

To the second point, it is somewhat baffling that more limited partners aren’t demanding impact-linked compensation, given that the perception of greenwashing is the predominant challenge for the impact investing community. Limited partners that invest in impact funds whose compensation is purely linked to financial performance risk seeing the impact be sidelined. 

The need for greater impact-compensation alignment was reiterated again and again by limited partners I spoke to at the GIIN forum. Clearly there is a communication disconnect between GPs and LPs. If institutional LPs start to communicate that impact-linked carry is a must have, not a nice to have, the entire compensation structure of impact investment funds will change.

Impact-linked compensations structures incentivise managers to clearly define their impact and establish systems for rigorous management, measurement and monitoring from the outset. A GP who truly believes in their impact thesis should be willing to put their money on the table. It’s possible some will have good reasons not to do this. But LPs should at the very least make compensation a key part of their due diligence processes.

More research is needed to gather learnings and identify best practices for impact-linked compensation models—something I am planning to do in the coming months. Nonetheless, managers wanting to be at the forefront of the impact investing field should pay heed to this turning tide. It’s a development that is long overdue.

Aunnie Patton Power is a lecturer at the University of Oxford, the London School of Economics and the University of Cape Town, as well as an advisor and angel investor. Her book, Adventure Finance, aims to help founders and funders navigate the spectrum of funding options that blend profit and purpose.

Riannah Burns, Research Assistant to Aunnie Patton Power and Social Finance Analyst at White Box Finance assisted with research for this piece.