This is the first article for ImpactAlpha about the Impact Linked Compensation Project, a research initiative exploring impact-linked compensation mechanisms, metrics and governance.
Robust governance is essential for impact-linked compensation to succeed. Yet the research team at the Impact Linked Compensation Project found, in its survey of more than 200 impact fund managers, investors and intermediaries, that governance is the piece that is often the least discussed.
Effective governance structures are essential to establishing and upholding key decision-making processes aligned with the organization’s strategy and objectives. It’s not merely a regulatory necessity; it’s a strategic imperative aligning financial and impact objectives with organizational strategy. For fund managers, these structures should function as a subset of a fund’s core governance model.
We identified a number of considerations for impact fund managers and investors to design impact-linked compensation governance and assign responsibilities.
Oversight bodies: The decision to establish an oversight body is pivotal. Funds can opt for a separate impact advisory committee or integrate Impact-linked compensation considerations into existing LP advisory committees. Engaging stakeholders sufficiently is crucial, balancing the need for oversight without compromising efficiency. The frequency of meetings and the level of detail covered in these discussions are critical considerations.
Prime Coalition uses a mission alignment committee through its Azolla Fund I to ensure incentives are aligned to its mission as a non-profit.
Level of LP involvement: LPs play a pivotal role in signaling Impact-linked compensation success. However, their level of involvement varies, influenced by factors such as fund size, sector experience, and familiarity with impact management. Development Finance Institutions (DFIs) often take a lead role, contributing to the evolution of industry standards. Fund managers need to carefully assess how LP involvement aligns with their fund’s goals and objectives.
New Forests’ African Forestry Impact Platform was launched with funding from British International Investment, Finnfund, and Norfund. Discussions on wide-ranging fund-related aspects, which included target setting and compensation mechanisms, led to specific carry allocations and how this could be unlocked from an impact perspective.
Use of outside expertise: The need for impact-related expertise can be fulfilled by LPs or independent specialists. Funds leverage outside expertise during the design phase and ongoing governance, enhancing independence and preventing conflicts of interest. Small funds particularly benefit from judicious use of external insight. Careful consideration of when and how to engage external expertise is crucial for maximizing its impact.
Adopters of impact-linked compensation mechanisms also need to assign responsibility for different aspects of their incentives structures.
Chi Impact Capital uses sector specific experts through its impact validation committee to find suitable proxies for impact in its Burning Issues Impact Fund.
Assigning responsibilities
Metrics and targets approval process: A key governance element is the approval of impact metrics and targets. Governance mechanisms should ensure ambitious yet flexible targets. Oversight committees, whether separate or integrated, play a crucial role in this approval process. A well-defined and transparent approval process contributes to the legitimacy of the Impact-linked compensation structure.
Existing investment committees can play a role in the approval process, as is the case with Developing World Markets Displaced Communities fund, which includes a sector specific independent director.
Adjustments to metrics and targets: Acknowledging the dynamic investment landscape, funds must anticipate the need for adjustments to metrics and targets. Governance models may grant discretionary authority to fund managers or involve advisory committees in approving changes. Effective communication and consultation with LPs during adjustments contribute to maintaining trust and alignment.
Ship2B Ventures allows its team to change metrics and targets in its ILC structure, subject to approval by the Advisory Board, which is made up of Ship2B Venture’s main LPs.
Target, data and process verification: Verification, front-end, ongoing and back-end, is instrumental in ensuring the reliability of impact data. Third-party verification can provide independent assurance of relevance and ambition upfront and certify performance data at the back end. The selection of verification partners and the frequency of verification activities are critical considerations for maintaining the integrity of the Impact-linked compensation framework.
Developing World Markets has an external advisor verify the baselines of its targets and metrics (front-end). For the targets themselves, it sets them internally, but selects components of the process to be validated externally. It also secures external verification to determine it has sufficiently met impact hurdles (back-end).
Governance decisions around impact incentives are an essential component for ensuring such incentives’ success. These decisions have far-reaching implications. A comprehensive governance approach both aligns impact-linked compensation with impact goals and works towards transparency, independence and accountability, thereby building credibility and adoption. Funds can pave the way for aligning impact goals with financial goals, while fostering a resilient framework that withstands the evolving dynamics of impact investing.
The Impact Linked Compensation Project is a collection of first-generation data to provide insights and offer fund managers a set of considerations for understanding impact-linked compensation within the context of their fund structures, portfolio compositions and relationships with asset owners. The report aims to contribute to the ongoing evolution of impact-linked compensation in the broader landscape of impact investments.
Aunnie Patton Power is an impact fellow at The ImPact and the lead researcher for the Impact Linked Compensation Project.
