GPs should handle philanthropy with care

Ares Management last week committed to donating 10 percent of the carried interest from its second Pathfinder fund – which is targeting $5 billion – to philanthropic initiatives. This is a continuation of an arrangement that so far has raised “approximately $10 million for potential charitable donations… based on performance to date”, said chief executive Michael Arougheti.

Philanthropic initiatives linked to fund performance are unusual, but not unheard of. European private equity firm Inflexion, for example, launched a foundation in 2018 with a commitment to donate “distributions equal to 1 percent of [its two recently closed] funds’ profits”.

What is more common – as one might expect – is general philanthropic activity among private markets firms and individuals. Indeed, KKR’s head of corporate citizenship Pamela Alexander – hired last year – is tasked with overseeing KKR’s philanthropic efforts as well as supporting philanthropy efforts of its portfolio companies.

Managers should be mindful, however, about how they present their philanthropic activity: in particular how it is linked to its sustainability or ESG credentials. As Hanna Ideström, senior portfolio manager at Swedish pension fund AP4, told us last year, she considers generous charitable programmes not as evidence of a culture of sustainability, but as an indication of “excess profitability, probably at the management fee level”.

Given that management fees remain one of the biggest negotiation flashpoints in GP-LP negotiations – 38 percent of LPs describe it as “causing the most disagreement” during due diligence, according to PEI Group’s LP Perspectives survey – this is worth thinking about.

This is not to say that philanthropy is always viewed dimly. LPs may take a more positive view if GPs are donating to an area related to where LPs’ impact objectives lie, notes Nick Rees, managing director at investment consultant Cambridge Associates’ private client group. If the area of choice is unrelated to LPs’ interests, then at worst, the investor is “likely to be agnostic”, he says.

One area where charitable donations and sustainable investing intersect is in mechanisms linking financial incentives to impact or ESG performance. In both impact-linked carry and sustainability-linked loans we have heard of examples where – if the GP is “penalised” for poor ESG or impact performance – then the spoils (the “unearned” carry or the additional interest payment) are diverted to charities. This helps ensure no party’s economic interests align with a sustainability failure.

Even this must be carefully handled, though; a fund lawyer recently described a situation to us in which their GP client was linking part of the carried interest pot to impact KPIs; the GP wanted any forgone carried interest to be diverted to their own foundation. The lawyer was understandably concerned about the optics of the arrangement.

Like so many things in sustainability, the role of philanthropy is complicated. It needs to be handled with care.