Impact-linked carry: Who’s doing it, how it works and why it divides LP opinion

GPs face a crucial strategic question when bringing impact funds to market: “Should we link our carried interest to our impact performance?”

This is not a new question. The first known instance of a manager linking its carried interest to impact KPIs was in 2014, when the European Investment Fund and Ananda Impact Ventures developed a structure for the impact firm’s third fund.

The concept has seen increased uptake in the past five years. Apollo Global Management, EQT, Apax, L Catterton and Generation Investment Management offshoot Just Climate have all implemented it for their impact funds.

“It’s asset owners that have to start asking for this, because the ripple effect will be enormous,” Just Climate senior partner Clara Barby said at an event hosted by affiliate New Private Markets last year.

But it has also become a hotly debated topic among asset owners. For some, it is the “gold standard” in impact investing – harnessing a well-established incentive mechanism to keep managers aligned to impact objectives as well as financial returns. Other investors have expressed fears that implementing non-financial incentives can prove a distraction or resource drain for GPs; or that it risks pulling GPs away from their fiduciary duty.

“The devil’s in the details in terms of how it’s actually implemented in the context of the investment strategy,” one institution that makes impact fund commitments said of the mechanism at PEI Group’s Responsible Investment Forum in New York in February.

Those details vary from fund to fund. GPs have committed to putting anywhere between 10 percent and 100 percent of their carry on the line for impact, and there is a broad array of different financial mechanisms and KPI-setting frameworks for the practice.

Who’s doing it?

Impact-linked carry is certainly more common among European GPs than American ones. Eimear Palmer, partner and global head of sustainability at Pantheon, estimates that half of the European impact funds she has seen in the past six months are doing it in some form. The most prominent examples are private equity funds, but New Private Markets has seen the mechanism implemented across asset classes, including infrastructure (eg Meridiam, SWEN), agriculture (Gunn Agri Partners) and venture capital (Closed Loop Partners, Revent).

NPM has compiled a full list here:

The practice is not confined to GPs using the ‘impact’ label. Energy transition-focused Tilt Capital has tied 25 percent of its €300 million-target debut fund’s carry to ESG improvements in its portfolio companies. ESG KPIs cover decarbonisation, avoided emissions, gender diversity, health and safety, and financial value creation for employees.

“We would say that impact-linked carry is the gold standard,” APG Asset Management senior portfolio manager Jessica Pan said at NPM’s Impact Investor Summit last year. “We do tell our managers to think about it, as well as other ways of trying to incorporate what you are doing in impact with how your teams are being compensated.”

How are they doing it?

In most cases, GPs self-impose a penalty on their carried interest if they miss impact KPIs. The total carried interest they are eligible for is first calculated on a purely financial basis: for a typical private equity fund, that would be 20 percent of the value appreciation of the assets at exit beyond the hurdle rate. Only after this calculation is the impact performance considered.

The GP claims all of this carry if it has met all its impact targets. If the GP has underperformed against its impact KPIs, it may forfeit all of the impact-linked carry portion (for example, 10 percent of the total carry for funds such as Apollo’s Impact Mission Fund). The alternative is to prorate impact performance with the size of the penalty, so if the GP generated 50 percent of its target impact, it could claim half of the carried interest that is contingent on impact performance.

If carry is forfeited, it may be donated to a cause related to the impact mission (as with L Catterton’s impact fund) or remain part of the total distributions to LPs (as with EQT’s Future fund).

Apollo, L Catterton and Trill have staked 10 percent of their total carry on impact performance. Only a handful of GPs have staked a majority or 100 percent of their carry on impact: Closed Loop Partners has done so for its Circular Plastics fund and Just Climate has for its debut fund.

Setting KPIs

Impact can be assessed across the fund as a whole, but in most cases NPM has come across the KPIs are set on a deal-by-deal basis and each company or asset in the fund is evaluated individually.

A notable exception is EQT, which has set three targets to be applied in the same way across every company in its €3 billion Future fund, the firm’s head of impact Jen Braswell tells NPM. Each company in EQT Future’s portfolio is evaluated individually, contingent on context specific to the company and its sector.

Malaysia-based impact manager Bintang Capital Partners has taken a blanket approach: all portfolio companies in the firm’s second impact fund must achieve B Corp certification within two years of acquisition. Bintang will start forfeiting carry if enough of its portfolio companies have not achieved B Corp certification.

Africa-focused impact firm Investisseurs & Partenaires has set seven total-portfolio targets for its second Afrique Entrepreneurs fund. Carried interest awarded across the entire fund is linked to the proportion of portfolio companies that meet I&P’s seven targets.

The total-fund approach is best-suited to funds focused on a single investment theme, such as low-carbon solutions. Energy-focused firm EV Private Equity put 25 percent of its sixth flagship fund’s carried interest on the line for achieving one million tonnes of avoided CO2 emissions across the entire fund.

For the deal-by-deal approach, these KPIs can be absolute targets or performance within a scoring system. Ananda gives portfolio companies an impact score related to performance against its targets, and penalties on carried interest are prorated to this score.

Apollo uses both performance scores and absolute targets to determine carried interest for its Impact Mission Fund. The firm identifies between three and five KPIs for positive impact and further KPIs for avoiding or mitigating negative impact for each portfolio company post-acquisition, and sets targets for these KPIs. It also takes into consideration companies’ B Lab scores (a scoring system for companies’ impact on “environment, communities, customers, suppliers, employees and shareholders”, hosted by the non-profit that certifies B Corps).

“It is important that the metrics are designed precisely so there is no dispute as to whether impact performance has been achieved,” say Charmaine Tam and Karen Chao of law firm Goodwin. Managers “need to have robust processes for holistically and accurately assessing impact performance across their portfolio”.

External advice

Many managers lean on external advisers to steer their target-setting and performance measurement. Apollo, for example, has appointed an impact advisory committee and has contracted an external impact consultancy to support the firm with measuring impact and setting impact goals. In some cases, managers involve external auditing or verification of impact performance figures in the same way that financial results are audited.

External verification of impact performance is “a critical component for the creation and implementation of any form of impact-linked compensation”, according to Christina Leijonhufvud, managing partner of impact consultancy Tideline and chief executive of Bluemark, Tideline’s impact verification business. External verification bodies can ensure that the targets and KPIs “are relevant and material to the impact sought, appropriately ambitious and can be accurately measured”, Leijonhufvud, who was named on our list of influencers in sustainable private markets, tells NPM.

Costs and concessions

This, of course, imposes additional costs and resource burdens for the GP – and that is one of the main objections among some LPs. “It takes up too much internal bandwidth,” said one investor. “There are so many third parties involved if you do it on a deal-by-deal basis… I worry that we’re focusing on the wrong thing. [Impact fund managers] should focus on investment selection. Impact should be tied to the investment thesis.”

One of the concerns raised by investors is a simple question of cost: if impact funds are subjected to an additional layer of cost relating to measurement, then this would – all other things being equal – put them at a competitive disadvantage to “non-impact” funds when it comes to net returns.

Another concern is the blurring of the alignment of interests: an impact-linked carry mechanism will in some instances – by design – incentivise the GP to make decisions based on impact targets rather than financial value. The greater the proportion of carried interest at stake, the more pronounced that incentive is.

The GP’s dual priorities could also constrict a company’s growth trajectory and business decisions. The GP may, for example, push the company to remain focused on its original impact mission when the most value-creating or financially sound steps are to drift away from this mission.

That may particularly be the case for venture-stage companies, which frequently need to pivot their growth strategies. It may also be a risk for buyout strategies, which acquire larger or more mature companies with multiple business streams and have various alternatives to organic growth for value creation; how are the targets affected if the company acquires another company and doubles in size, or if it is split in two and half is sold off? Some mechanisms that NPM is aware of allow for impact KPIs to be reviewed and adjusted during the fund life to deal with a pivot in strategy.

GPs fundraising from fiduciary institutions and linking their carry to impact will likely respond that maximising impact and maximising value growth are co-linear. EQT’s Braswell stresses that improving the Future fund portfolio companies’ sustainability performance is a driver of value – and that this was a particular draw for its LPs.

Other LP concerns

Investors have also espoused more philosophical concerns. Speaking at an NPM event in November last year, Kunle Apampa, client solutions head at Capricorn Investment Group, emphasised the importance of instilling authentic, non-financial motivations in the impact investing space rather than tacking financial incentives onto an impact strategy. “I personally hesitate on financial incentives around creating impact more broadly.

“When you think about the traditional space, and what really motivates a lot of fund managers to do what they do, a lot of it is tilted towards the financial. It’s tilted towards the alpha. But with that breeds [what] I would call bad habits. What I don’t want to see is those bad habits get translated into a space that needs to be purpose built from the ground up.”

Getting in line

“You have three stakeholder groups that have to be pretty well aligned in order to really make it work,” says EQT’s Braswell. “LPs have to buy into the fact that these KPIs are going to incentivise the GP in the right way. The GP has to understand that it’s practicable. And companies have to have a willingness and ability to drive [the performance].”

But this is no drawback for Braswell. “Having this incentive structure in place is driving change. It’s keeping focus and it’s really making [sustainability improvement] actions happen.”

While EQT is still “learning about some of the mechanics of implementing the KPIs”, Braswell says, “it’s working. I’m seeing a virtuous circle emerging in the conversations we’re having with our LPs. They’re getting savvier and expecting more from their GPs, and they’re starting to ask us more in-depth questions to understand the mechanics and providing recommendations.”

But while these fund managers work out whether, and how, to build their own mechanism, LPs must decide whether they view impact-linked carry as a fit for their objectives.