It’s an article of faith in the investing world that to drive performance, fund managers need a performance-based compensation package. Should we assume otherwise in impact investing? It’s time we introduce “impact carry” – an incentive to deliver social-return that would be used to generate further return.
In a traditional investment fund structure, limited partners or investors, the LPs, incentivize general partners or fund managers, the GPs, by granting them “carried interest.”
Carried interest is paid to the fund manager as a percentage of the returns generated by the fund. The structure is meant to align the financial objectives of LPs and GPs.
Impact investment funds add a complication by introducing social return, alongside financial. At most impact funds, the social impact is not yet directly incentivized by LPs.
If carried interest for financial returns is provided as a financial incentive – cash for cash, what would work as an incentive for social returns?
Here’s an idea: the incentives for creating social returns should be structured to generate further social impact – not purely a monetary benefit to the general partner.
One incentive to generate social impact is the use of Technical Assistance, often shortened to simply TA. TA is a widely used grant-funding structure in the sector. LPs provide grant funding into a TA pool that is then used for specific projects in the GP’s portfolio that could contribute to higher social returns, for example, an impact survey or consulting on ethical pricing.
A carried interest for social returns then could be structured as a contribution by LPs into the GP’s TA pool. This would ensure that the end-use contributes to the overall social impact and isn’t merely a financial benefit to the GP.
LPs can further ensure their contribution is used for generating social returns, and not for projects geared towards financial returns, by ensuring a larger participation in the investment committee of the TA pool.
Here’s how that would work. Usually LPs occupy just a few spots on the investment committee of a fund to allow the GP to make investment decisions independently. In the case of a TA pool’s investment committee, it would make sense for LPs to participate even more in order to mitigate the conflicts of interest a GP would face in selecting projects that predominantly generate social returns over those generating purely financial returns.
Determining impact carry
Measuring financial returns is pure math, with limited scope for subjectivity. How can we objectively measure social returns in order to decide the carried interest?
In recent years, the impact investment sector has evolved to become more proactive in its approach to measuring impact. Alongside an LP-driven agenda to ensure that GPs are sticking to their stated “double bottom line” objectives of generating social and financial returns, there is an increased awareness of the UN’s Sustainable Development Goals as a framework for pursuing impact.
Impact measurement is also becoming increasingly objective and standardized. Some impact funds hire reputable third parties, including the Big Four audit firms, to objectively measure impact. But these methodologies are not standardized across the industry. GIIRS, what has become somewhat of a gold standard in impact measurement, provides a standardized measurement framework and a platform that compares data across 30,000+ companies and close to 100 funds.
Once there is an agreement on the methodology to measure the social returns, the next question that emerges is – when do you incentivize the GP?
A carried interest for financial returns is paid to the GP during the exit period of the fund. Such a timeline would be ineffective for a social return-based carried interest because it doesn’t leave much time for the GP and their portfolio to utilize the monies.
For a social return-based carry, it makes sense to structure annual objectives at the time of each investment by the GP. The carry should then accrue through the investment period, annually, based on the achievement of these objectives. The GP can then, with the approval of the investment committee, decide on the distribution of the TA pool to the portfolio companies.
A social return-based investment carry that is paid annually as a contribution by LPs into a TA pool managed by GPs, on achievement of mutually decided social objectives, can ensure strong alignment of the stakeholders towards the impact objectives of the fund.
There could be many such carry structures that can be devised once the LPs and GPs put the best of their minds together. These structures need to stand the tests of efficacy in enabling impact and ability to self-regulate any conflicts of interest.
The industry needs to acknowledge that incentivizing a social-based return will help to further the overall impact of each investment. For impact investment fund managers, more carrot and less stick, will help drive social returns to greater heights.