Charmaine Tam (left) and Karen Chao (right), Goodwin

There is general support from the impact investor community for impact fund managers to “put their money where their mouth is” with respect to achieving impact and financial return.

One of the ways sponsors can signal their intention is by linking a portion of their remuneration to the achievement of environmental, social and governance metrics. Such fund managers go beyond a promise-driven ESG policy and seek to achieve greater investor alignment by tying profits to impact outcomes that are tracked with objective metrics.

While investors support the accountability of sponsors in this regard, such compensation structures are a difficult endeavour and currently are not the market norm. Even when adopted, the manner in which impact is measured and linked to compensation can vary considerably. This article will look at a few ways fund managers have taken on this challenge.

One way GPs can implement impact-linked compensation is by incorporating the ability to earn additional carried interest beyond the traditional profit structure as a reward for reaching certain impact goals. Take, for example, where a sponsor has a mandate to invest in sustainable building developments. One possibility would be to link additional carry to measures of ESG performance based on financial data, such as, for example, a Global Real Estate Sustainability Benchmark (GRESB) score. The baseline premise is that better the score, the more incremental carried interest the fund manager may gain beyond the base carry percentage.

Such sustainability targets may be evaluated on both a deal-by-deal basis and/or on a fund-wide basis. And not unlike other traditional carry structures, in order to prevent the over-payment of carry, the fund manager may include the ability to re-calculate the final percentages at the final distribution and effect any applicable clawback payments at that point in time. The benefit of this methodology is that it incentivises fund managers in a very direct and financial way to reach their sustainability targets, so long as investors are on board with the payment of an additional performance fee beyond the base carry.

On the other hand, some GPs may choose to tackle impact linked carry with a ‘stick’ based approach, such that a portion of their carry would be unlocked only if they achieve their impact targets. If the GP fails to reach their targets, they may forfeit a percentage of the carried interest as a penalty for underperformance, in some cases by way of donation to charitable organisations, non-governmental organisations or impact projects that are aligned with the mission of the fund. While this may appear to be a more palatable solution for investors, fund managers that do not end up meeting the financial hurdle could be disincentivised to achieve their impact targets.

The methodology of measuring impact goals also varies from fund to fund. Some sponsors measure their impact targets using a third-party benchmark to lessen the ambiguity of whether the desired impact has been reached. For example, linking carry to the amount of CO2 reduction, where the sponsor seeks a targeted level of CO2 reduction and performance is expressed as a multiple of the CO2 reduced over the CO2 reduction target in respect of each investment. This objective standard may go a long way in alleviating LPs’ concerns with goal tracking that is entirely subject to the GP’s discretion.

In contrast, a fund sponsor could elect to determine the impact criteria themselves on an investment by investment basis, with any changes to the methodology down the line requiring investor advisory committee consent. For example, a sponsor could design an impact methodology which enables them to determine the specific impact goals for each investment depending on the particular characteristics of the investment, the value of the impact that can be generated across the lifetime of the investment, and the relative importance of the impact goal to the overall performance of the portfolio company. The GP then submits these metrics to the investor advisory committee for approval shortly after the completion of an investment.

If the GP wants the flexibility to amend the metrics, it can build in mechanisms whereby investor advisory committee consent could be solicited should the purpose or strategy of the portfolio company change substantially or be subject to external forces beyond the control of the portfolio company. The idea is that although the GP is the driving force behind the impact methodology determination, key investors, such as those who are part of the investor advisory committee, would be part of the process and discussion. It is important therefore that the metrics are designed precisely so there is no dispute as to whether impact performance has been achieved.

While both impact fund managers and investors are likely to agree that impact-linked carry can be a powerful way to align interests on impact creation, the importance of designing an impact carry structure that adequately incentivises fund managers to maximise impact performance alongside financial return cannot be overstated.

With impact-linked compensation in its nascency, there are significant complexities in implementing such carry structures in a way that fulfils both impact and financial goals in an equitable manner, many of which are beyond the scope of this article. Fund sponsors should consider carefully how to prioritise achieving financial return and incentivise pursuing impact. What is clear is that there is not a one size fits all solution and fund managers will need to structure thoughtfully the compensation in a way that aligns with their investment mandate.

The authors are Charmaine Tam and Karen Chao of law firm Goodwin.