Sponsored | April 3, 2024

Seven red flags institutional investors should avoid when evaluating impact fund managers

Sarah Gelfand

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Guest Author

Sarah Gelfand

As more investment firms launch impact funds, it has become increasingly difficult for institutional allocators to identify the most qualified fund managers to steward their capital. While most allocators know what to look for when evaluating the financial risks and opportunities associated with a firm and its investment strategies, evaluating a manager’s potential to achieve impact results requires a different toolkit.

This knowledge gap is what led BlueMark, an impact verification specialist, and CASE at Duke University to develop a guide that allocators can use to shore up their due diligence and ongoing management of impact fund managers. Building on insights from interviews with more than 50 LPs and GPs, the guide lays out both the best practices and the red flags to look for. Here are seven of the most common red flags.

Pre-investment diligence

  • Weak or vague impact thesis – A strong impact thesis is the foundation of any impact investment strategy, and is typically the basis for how a GP defines the investment opportunity and its linkage to the expected impact. On the other hand, a weak impact thesis can signal a lack of intentionality on the part of the GP, suggesting the impact label is there more for show than for substance. Signs of a weak impact thesis include a lack of a clear problem statement and an inability to describe the connection between the strategy (i.e., target sectors/themes) and the expected results (i.e., target outcomes). Some GPs also make the mistake of attempting to pursue several impact goals simultaneously without developing distinct impact theses for each.
  • Separate investment processes for impact and financial management – Most GPs have a rigorous process for evaluating the financial opportunity associated with an investment, ensuring that all relevant information is carefully vetted. For impact GPs, it’s important that the same rigor is brought to evaluating the impact opportunity. And, further, that the financial and impact information gets evaluated in concert to ensure both are in alignment and fully considered. GPs that approach impact and financial assessments in siloes and/or can’t explain how impact criteria is evaluated when making investment decisions (e.g. the impact team isn’t part of any decision-making body) may be treating impact as an add-on rather than a critical part of the strategy. This increases the likelihood that a deal that’s financially attractive gets inappropriately categorized as an impact deal and decreases understanding of the interrelationship between impact and financial returns.
  • Lack of a structured impact management approach – Just as strong financial management practices are essential for driving financial performance, impact management practices are essential for driving impact performance. Any GP that claims it can deliver strong impact results without the underlying processes to monitor, evaluate and adjust plans based on impact learnings is unlikely to fulfill its pledges to LPs. Some clear signals of lacking impact management include a GPs inability to explain the impact criteria and thresholds it uses when evaluating prospective investments, the types of impact data it routinely monitors, and the dashboards/mechanisms it uses to monitor progress.
  • Lack of relevant expertise and resources – Every GP likes to boast about the investment expertise and experience of its team, and most LPs know how to assess those credentials. But impact expertise – the know-how and experience needed to design, implement, and utilize tools to assess the impact of an investment portfolio – is a wholly different skill set. That’s why LPs should watch out for GP teams that lack dedicated resources with relevant experience or background working in the targeted impact areas. 

Post-investment diligence

  • Relying on marketing over substance when reporting on impact performance – Impact reports are often used by GPs to communicate their impact results to their LPs. Unfortunately, many of these slick-looking reports lack rigor and make it harder for an LP to effectively gauge performance. Common red flags in an impact report that LPs should look out for include: reporting aggregated figures without context or supporting explanations of the data sources and assumptions, including data for only a subset of the investments in the portfolio, and omitting commentary about risks. These approaches can signal an attempt to cherry-pick results that reflect best on the GP’s performance. Even when well-intended, this type of reporting suggests the need for an LP to be more explicit in their reporting requests to ensure they get the information they need.
  • Lack of commitment to impact management – A GP that is dedicated to driving impact can demonstrate engagement with the impact strategy and results, at all levels of the team, from senior managers to analysts. On the other hand, LPs should be concerned if a GPs is not actively involved in the core aspects of impact management, such as impact monitoring and engaging with portfolio companies. Some GPs may outsource some of these functions  – such as portfolio company impact assessments, value creation plans, and/or impact data collection and reporting –  to third parties. While it is fine for a GP to complement internal resources with third party experts, these third parties should not be treated as a replacement for internal expertise.
  • A defensive attitude or fixed mindset – Optimizing a portfolio for impact is complex and dynamic. A commitment to continuous improvement should be a baseline expectation for a GP when it comes to impact. On the flip side, an LP should be concerned when a GP is defensive about or unable to describe the limitations of their current impact management tools and what they’re planning to do to enhance their systems and processes in the future.

While the impact investing industry is still maturing, industry best practices are solidifying. LPs need to be aware of current best practices to ensure they are appropriately evaluating a manager’s approach, can identify gaps or shortcomings, and feel equipped to have direct conversations with managers about the improvements they expect to see.

To read more from the BlueMark and CASE at Duke University Field Guide, please download it for free here: https://bluemark.co/a-field-guide/

Sarah Gelfand is president at BlueMark.