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How to bake impact into the paperwork

Professors Jessica Jeffers and Anne Tucker found no evidence of ‘widespread greenwashing’ when they studied 207 contracts struck by impact investors; here’s how impact was written into the deals.

Private markets offer unique opportunities for investors interested in aligning their capital with long-term sustainability goals. Relative to public market ESG strategies, where questions abound about the actual benefits achieved, impact investing funds in private markets can be especially effective because of the outsize influence these investors can have on portfolio companies at an early stage.

Anne Tucker

Many would-be impact investing LPs worry about “greenwashing” funds that may advertise impact but not act any differently in practice than a traditional fund. In an article published in the Journal of Financial Economics, we reviewed 207 contracts struck by impact funds, including limited partner agreements, private placement memoranda, and term sheets. We do not find evidence of widespread greenwashing. In fact, 94 percent of funds had “operational” impact terms in their contracts with LPs: ie, terms that outline specific actions the fund will take to further the impact goal. Funds contract broadly on impact through commitments on due diligence, measurement, and adherence to ESG standards, among other provisions. Moreover, funds contracting more around impact in the LPA, similarly negotiated for more impact contract terms in subsequent investments in portfolio companies. This flow-through of impact provisions demonstrates that contracting on impact matters.

Jessica Jeffers

Still, even with good intentions, it can be hard to balance profit and sustainability goals. Thinking smartly about the contract terms can help. Based on our review of contracts, three tools are particularly effective.

First, as any economist will tell you, thinking about incentives is important. One obvious option to incentivise impact is to tie GP compensation to impact performance. But this approach is tricky. Contracts are multi-dimensional, so adjusting the compensation term on its own is not enough. Moreover, impact-dependent compensation is not always feasible or desirable. It can be hard to specify the right metric for impact: is it the number of people served, gallons of clean water, or jobs created? Getting the right information from underlying portfolio companies is integral to benchmarking success. But doing so without burdening those same companies is a paramount concern, since thriving portfolio companies are how impact is achieved.

Second, provisions that facilitate oversight and dialogue among the parties — what we call “participatory governance” — are important contracting devices. Participatory governance can reconcile the need for flexibility over the life of a fund and accountability to an impact fund’s dual mission. Often, we think of contractual accountability as specifying a narrow set of acceptable outcomes at the outset of the investment. However, rigid obligations like quotas may not always work well in evolving investment sectors with seven to 10-year time horizons, because new information on best practices or priorities can change the desired outcome.

“The right set of tools can prevent impact investing from becoming a box-checking exercise”

The right set of tools can prevent impact investing from becoming a box-checking exercise, while ensuring “good behaviour” in a more holistic sense. For example, advisory committees can provide an opportunity for investors to review the balance the fund is achieving between profit and sustainability goals, and course-correct if needed. Likewise, information rights, annual meetings and other provisions that promote the exchange of information and feedback can ensure investments do not stray from the stated goals while preserving flexibility. We observed many examples of participatory governance in our review and believe it will continue to be an important part of impact investing contracts.

Third, in addition to facilitating strong participatory governance, robust information rights and narrowly tailored confidentiality provisions increase the transparency of deal terms. Like with financial returns, investors need to understand the return on impact. Transparency in impact contracting and the resulting impact benefits will help the sector grow. Transparency will also accelerate emerging best practices in the field. To this last point, in collaborations with the Impact Finance Research Consortium and Eighteen East Capital, we are developing model contract language with impact-tailored information rights and streamlined confidentiality clauses. Contract terms tailored to the field can increase information flows necessary to benchmark impact, facilitate participatory governance and grow the market.

Impact investing in private markets represents an opportunity to fund a more sustainable future. Best practices are emerging to achieve the delicate balance between profit and purpose, including through new contracting approaches. Gathering and sharing information on these and other practices in impact investing is critical to improve the functioning of this sector and fulfill its promise.

Jessica Jeffers is assistant professor of finance at the University of Chicago Booth School of Business. Anne Tucker is professor of law at the College of Law, Georgia State University.