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ESG-linked SCFs are ‘proof’ that financial rewards can be tied to impact

Impact can be quantified and linked to investors financial rewards, says Kirkland & Ellis lawyer Amala Ejikeme, but big questions remain about how it could be tied to carried interest.

“The rise in ESG-linked subscription facilities has to be proof that impact can be quantified and translated into financial impact” for investment professionals, Amala Ejikeme an investment funds partner at law firm Kirkland & Ellis, told delegates at PEI Media’s Impact Investor Forum on Wednesday. “But there’s still some way to go,” he added.

It is still unusual for managers – even impact investing specialists – to tie carried interest to impact performance. However, more are trying to do so. Energy tech fund EV Private Equity introduced this for its sixth fund, launched in April 2021 with a $350 million fundraising target. European fund manager Capza tied its carry to ESG KPIs for a private debt fund launched earlier this month. And placement agent Campbell Lutyens said it had seen somewhere between 15 and 20 GPs linking impact to carried interest. “It’s not pervasive everywhere but some of the bigger impact funds are considering it,” said Campbell Lutyens’s sustainability lead Paula Langton earlier this year.

One question GPs need to consider is whether the link is at the fund level – affecting the share of net profits between LP and GP – or whether it is something that should happen “behind the scenes”, said Kirkland’s Ejikeme, “so that carried interest, bonus and other economic incentives to which the investment professionals are entitled, can be adjusted to reflect how they are doing on an impact basis”.

“We’re sketching frameworks out like this with some clients. Very few have cleared the market at scale”

Amala Ejikeme,
Kirkland & Ellis

Ejikeme continued: “If it’s at fund level, presumably it needs to be connected with financial returns. If you have a scenario where impact performance is being delivered, but there is no financial performance, I think investors would struggle with paying a fee or in some way compensating the relevant sponsor for that.

“And then, how does it operate? Is it a bonus for impact outperformance, which is to say that the baseline carried interest will rise? Or is it penal in nature, where they start at a given threshold, and if they don’t meet the stated objectives, then they essentially suffer a cut on the carried interest?

“I think it’s coming. I think the big questions are ‘how?’, ‘when?’ and ‘who calculates all this?’,” Ejikeme said, “because it has the inherent potential for massive conflicts of interest if the GP is essentially marking its own work and taking economics off the table on the basis of its assessment of its own impact performance.” He said third-party analysts and arbiters to evaluate impact performance would be essential to “lend some sort of impartiality”.

“We’re sketching frameworks out like this with some clients. Very few have cleared the market at scale. I do think it is achievable. Transparency, reporting and that quality of independence will make that possible. But it’s a real challenge and something that we should all watch this space for.”

Beth Houghton, head of private equity firm Palatine’s £100 million ($142 million; €116 million) impact fund, was also on the panel. She said Palatine does not attach any carry to its impact KPIs.

“I just don’t think we know enough about target setting to do that credibly,” said Houghton. “I really want to stretch impact KPIs. So, when I’m setting targets, I really want them to be pushing the boundaries on generating impact.

“I don’t need to be incentivised by carry to generate impact, because if I can’t credibly demonstrate that to investors, I can’t credibly raise impact fund two or three. That in the long term is a much bigger financial incentive for me and my team than attaching a small amount of the impact KPIs to carry. I just think it’s too complicated at the moment.”

But Houghton added that Palatine does give away a percentage of its carry to a foundation, “no strings attached”.