ImpactAlpha, December 8 – Whether and how impact fund managers should tie a portion of their compensation to the achievement of specific impact targets has been a perennially hot and controversial topic in the impact investing industry. The discussion typically revolves around the concept of “impact carry” – that is, the idea that a portion of an impact fund manager’s carried interest should be tied to the achievement of impact targets.
While impact investors and fund managers have long expressed support for the concept of impact carry, real-world examples of impact carry structures are few and far between.
In her recent article “Have we reached the tipping point for impact-linked compensation?” in ImpactAlpha, our friend and colleague Aunnie Patton Power powerfully (no pun intended) presents the philosophical case that the time has come for impact fund managers to put their money where their mouths are: that one should not be able to call themself an “impact” fund manager if they are not willing to incorporate impact carry.
While we agree in principle, as impact fund lawyers who have built impact carry into a variety of fund structures, we can share our own experiences and reflections on the practical challenges that may be preventing wider adoption of impact carry structures. 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.
What is impact carry?
As most readers will probably know, “carried interest” is a compensation structure commonly used in private equity funds whereby fund managers are compensated for making good investment decisions by receiving a percentage of the profits generated by a fund (typically 20%), after investors receive a return on their investments. Carried interest plays a critical function of aligning interests, incentivizing fund managers to make reasoned, well-researched investment decisions by tying compensation to the financial success of a fund’s investments.
Proponents of impact carry argue that traditional carried interest does not properly incentivize impact fund managers to achieve the stated intent of their investments – that is, if impact fund managers represent to investors that they seek to achieve both a financial return and social or environmental impact with their investments, a traditional carried interest structure not only fails to provide fund managers with a financial incentive to pursue the impact component of their investment strategies, it could lead to a perverse incentive causing fund managers to choose investments that sacrifice impact in favor of financial returns.
While impact fund managers have other incentives to pursue the impact goals of their funds (including their own consciences, their reputations, the requirements of their investors, and the regulatory risk inherent in making false representations to investors), proponents of impact carry argue that impact fund managers should also have a financial incentive to pursue impact through their investments.
We agree. But it’s complicated.
We see two key barriers to the implementation of impact carry structures, which are seldom if ever addressed:
Cost and complexity. Private equity funds are expensive to raise. The legal, tax and regulatory expenses of forming a private equity fund alone typically range from several hundred thousand dollars to a million dollars or more. The investors in a fund typically bear the expenses incurred in structuring, raising, and launching the fund, subject to a cap beyond which the fund’s investment manager and/or general partner bear these expenses. Investors often negotiate the cap to a number that they believe is reasonable. Even when not bound by a formal cap on organizational expenses, fund managers typically seek to tightly manage organizational expenses to avoid giving their investors sticker shock.
These challenges are often compounded in the impact fund context where funds are typically far smaller than, for example, the typical buyout fund, and the costs of operation are often higher where, for example, the fund seeks to serve beneficiaries in remote areas of frontier markets. Accordingly, impact fund managers typically manage a fund’s organizational expenses to a fairly tight budget.
The traditional carried interest structure is well-worn, is broadly understood by investors and fund managers alike, and is already reflected in essentially every private equity fund limited partnership agreement in existence. While preparing fund documents is expensive in the aggregate, there is typically very little marginal cost involved in drafting a distribution waterfall that reflects carried interest, because fund counsel will invariably work from template documents that already include carried interest in the distribution waterfall.
One size doesn’t fit all. Impact carry structures give rise to several complexities that require deep thought to resolve and invariably result in bespoke legal drafting, both of which can significantly drive up the organizational costs of a fund.
While traditional carried interest arrangements may seem cookie-cutter because the structure and legal language has been templatized, they are in fact the result of several complex, interrelated provisions in a limited partnership agreement. Changing one element of this structure is like dropping a rock into a pond – it creates ripple effects that must be identified and reckoned with, or else the fund documents will not work.
As Aunnie identified in her article, one of the primary reasons for avoiding impact carry is lack of a uniform framework for measuring impact. While we agree that certain frameworks have become more widely adopted, the application of these frameworks can vary widely depending on the investment strategy of a fund, and even if uniform frameworks were available, a fund manager would still need to navigate their way through significant complexity in order to define how specific impact targets will be measured and the relationship between the achievement of those targeted by the fund manager’s compensation.
Take the example of a fund that starts from a baseline carried interest of 20%, up to 10% of which will be forfeited if the fund fails to achieve its impact targets (the economic incentives of this structure are discussed in greater detail below). How many impact targets is the fund manager seeking to achieve? Are they all measured along the same criteria (e.g. carbon emissions vs health outcomes)? How do the different metrics interact with one another (e.g. poor performance on carbon but good performance on health)?
Asking hard questions
How will the fund’s performance relative to those impact targets be measured? And how will a failure to achieve any of those targets correlate to a forfeiture of carried interest? What if a fund manager exceeds certain impact targets but falls short of others? What if a fund manager falls just short of achieving an impact target? Will it forfeit its entire impact carry with respect to that impact target, or will the forfeiture be prorated? Who will audit these results? What if a dispute arises around whether impact has been achieved or how impact has been recorded?
While we have seen fund managers that, with significant effort and at significant expense, have answered these questions in precise detail during the fund marketing process, it is often the case that fund managers kick the can down the road by either stating that impact carry will be determined based on to-be-defined parameters on an investment-by-investment basis, or by tying impact carry to loosely defined standards the measurement of which are subject to significant GP discretion.
Measuring impact performance often falls short. Most often, it is assumed that impact is inherently tied to financial performance. We’ve seen that this is a big assumption. But it’s undeniable that significant impact has been achieved by impact fund managers writ large. While we don’t blame fund managers for taking these approaches for the reasons described above, such approaches run the risk of either:
- failing to fully capture and optimize/maximize impact performance
- failing to properly incentivize fund managers to achieve impact because the impact carry is not precisely tied to the achievement of impact targets
- increasing the risk of disputes when the parties truly reckon with the details of the impact carry and discover that they are not on the same page
Timing mismatches. Impact carry structures can also create timing mismatches that have significant economic ripple effects. In a traditional carried interest structure, carried interest is paid by a fund to its general partner at the time that an investment is sold, when the proceeds of the sale are distributed to investors. However, there may be a significant timing gap between the time that an investment is sold and the time that a particular impact target can reasonably be expected to be achieved or measured.
As a result, impact carry structures often require that a portion of carried interest earned by a fund’s general partner be set aside and held by the fund pending determination of whether the fund has achieved its impact targets. Upon such determination, the earned carried interest amounts are distributed to the general partner, and the unearned carried interest amounts are distributed in accordance with the fund’s limited partnership agreement (i.e., to the limited partners or to a charity). This timing reality can create several challenges for a fund manager.
For example, an investment manager’s investment team often receives a substantial amount of its compensation in the form of carried interest participation (and this portion of an employee’s compensation provides the employee with upside potential based on the success of the fund’s investments). In a traditional, non-impact fund context, investment team members already have to wait a long time – often up to 10 years or longer – to receive this component of their compensation when investments are sold. Requiring impact fund investment professionals to wait even longer to receive carried interest may be untenable and may hinder the ability of impact fund managers to attract top talent.
Accounting and tax nightmares. This timing mismatch can also create accounting and tax headaches for impact fund managers. In limited partnership accounting, general partners must allocate the profits and losses of a partnership to its owners on an annual basis in order to determine how much tax each of them must pay. Profits generated by the limited partnership must be allocated to its owners based on their pro rata ownership even if no corresponding distribution was made to its owners.
If a fund has generated traditional carried interest in a given year, it is possible to calculate how much of that carried interest (if it has not already been distributed) will be distributed to the general partner and the limited partners. However, if a fund retains carried interest pending determination of whether the general partner has actually earned it based on the achievement of impact targets, it isn’t possible for the general partner to determine with reasonable certainty whether and in what proportions to allocate that carried interest to the general partner or the limited partners (if the unearned carried interest is earmarked for the limited partners).
The choices available to the general partner are to either allocate all of the impact carry to the general partner or make a best guess as to how the impact carry will ultimately be distributed and allocated accordingly. In either case, it’s an accounting and tax nightmare where accountants don’t have direction on how to allocate profits, and fund partners may end up with something called “phantom tax”. To avoid such complexities, a fund manager may be incentivized to measure the impact of an investment at the time of its sale, which may not provide a true measure of the impact achieved (and can therefore artificially inflate or diminish the measure of impact performance).
Given these additional complexities that impact carry can create, fund managers typically only try to implement impact carry structures when they know that they have investors with deep impact alignment who are willing to bear some of the additional cost of designing and implementing an impact carry structure.
Not all impact fund managers (many of whom are raising their first or second funds) are lucky enough to have these sorts of relationships. Query whether it’s fair to place the onus on impact fund managers to implement impact carry structures if investors are not willing to bear, or at least share, the additional cost involved – especially given that impact fund managers often operate on very tight margins and face all the same steep obstacles that traditional emerging fund managers face, while taking on the additional level of difficulty (and associated cost) inherent in serving hard-to-reach markets that other fund managers may avoid.
A stick without a carrot?
It is often the case in the law (as in many other areas of life) that innovation results not from a single “a-ha!” moment, but rather from a series of iterations and adjustments to the traditional way of doing things. In defining the new way of doing things, we start from the old way and then identify changes or improvements that eventually result in the new way. In our experience, this has been the case with impact carry.
The typical approach to impact carry is to start from a traditional baseline carried interest of 20% – i.e., the limited partners give up 20% of the fund’s profit – and then set aside a portion of that carried interest (typically half of the carried interest, or 10% of the fund’s profit) pending determination of whether and to what extent the impact targets were achieved. If the impact targets are not achieved, the carry ratchets downward, and a portion of it is forfeited by the general partner (typically for distribution to the limited partners, but the forfeited carry could also be donated to a charity). In other words, the best that an impact fund manager can hope to do is to match the market standard of 20% for non-impact fund managers.
In our view, this is a stick without a carrot, and it would only disincentivize fund managers from seeking to pursue impactful outcomes. It makes it that much harder for an impact fund manager to successfully scale its business because it now has a higher hurdle to reach in order to receive the market-standard 20% carried interest than a traditional, non-impact fund manager enjoys.
Towards an equitable approach
A fairer approach may be one where an impact fund manager is asked to achieve an additional threshold and is financially punished for underperformance, while at the same time investors are prepared to pay for overperformance. We don’t disagree in principle that if an impact fund manager generates carried interest from a fund but underperforms against its impact targets, that it should forfeit a portion of the 20% carried interest that it would otherwise receive. This seems to us a fair outcome because the impact fund manager has represented to its investors that it seeks to achieve social or environmental impact in addition to a financial return and has failed to perform along one of those parameters.
It also helps to solve the “incentive” problem described above because this structure disincentivizes impact fund managers from sacrificing impact in order to generate a higher financial return that would otherwise generate more carried interest. However, if a fund manager both generates a profit for investors and outperforms its impact targets, it should have the possibility of receiving a higher-than-traditional carried interest.
After all, by achieving this double-bottom line, the impact fund manager is providing more value (financial and social/environmental) than a traditional fund manager and has worked hard to do so. Of course, the “right” numbers that would be fair to both fund managers and investors are specific to the context, but this concept should help allocate risk and reward more fairly.
A trickier question is whether a fund manager should be entitled to receive carried interest if, for example, a fund slightly underperforms financially (i.e., investors don’t receive a full return of their capital or a preferred return, as the case may be) but significantly overperforms its impact targets. Should the fund manager be entitled to carried interest in that scenario? This would more directly test the primacy of interests in the impact fund context – is it more important that investors receive a full return of capital or full preferred return, or that the fund manager be appropriately incentivized to pursue impact?
Finally, given that carried interest is paid out of cash profits generated by the fund, in this case (where such cash profits don’t exist but impact performance does) where would the cash to pay the manager come from? There are answers to all of these questions, but we don’t attempt to dive into that level of complexity here.
An impact carry solution?
The debate over impact carry has been robust and will only continue to grow as the impact investing industry continues to mature. We’re excited to see where the discussion goes. We strongly support the idea of truly aligning incentives across bottom lines, and we think the fact that the impact investing industry is grappling so intensely with this topic demonstrates the sincerity of purpose that defines the industry and makes us so proud to be a part of it. However, the discussion around impact carry has been mostly surface-level and principles-based. Too often, the topic is debated without sufficient consideration of the complexities, costs and challenges that implementing an impact carry structure entails.
We believe that this complexity helps to explain why, when faced with the realities of implementing an impact carry structure, most impact fund managers have either shied away or have used relatively blunt tools as a proxy for the achievement of impact targets. Combine this with the relative lack of pressure from limited partners that Aunnie noted in her article, and it’s easy to see why we continue to talk, over a decade later, about the stark contrast between the enthusiasm for impact carry often expressed in the industry and the paucity of real-world examples.
Simply stated, doing impact carry is hard. It requires significant time and effort. If now is the time to move from theory to reality, then impact fund managers cannot be saddled with the full burden of its implementation. Such an outcome would add to the already formidable challenge of launching and scaling a successful impact fund management business, and it would create the wrong incentives.
On the other hand, if LPs want to move the impact investing industry forward and make impact carry a reality, they should look to truly partner with GPs by both sharing in the cost of doing so and compensating impact fund managers for achieving impact rather than only punishing impact shortfalls.
We know that there are many investors and fund managers out there willing to play their part in making impact carry a reality, but that cannot happen until the industry has an open and detailed conversation about the challenges, risks and rewards and moves forward with shared purpose.
Chintan Panchal is a founding partner of law firm RPCK Rastegar Panchal LLP. Aaron Bourke is senior counsel in the firm’s fund formation practice.