The supporters of tying carried interest to achieving impact or ESG targets all agree that they are putting their money where their mouth is. However, designing carry schemes that create the intended incentives is far from straightforward. “It’s a hot topic,” says Amala Ejikeme, partner with the investment funds group at Kirkland & Ellis. “It has the potential to be an emerging trend, although we are only at the start of this conversation and there are a lot of different ways these schemes can be cut.”
Ejikeme points to a number of different issues that GPs and LPs need to consider. “The first of these is whether any link to the carry should operate as a penalty or bonus,” he says. “Carry-at-risk is perhaps not where a GP wants to start out in an ideal world and is a position an impact fund sponsor could find itself negotiated into.”
Advisers say that many firms are currently opting for carry-at-risk – the GP forfeits a percentage of carry if it fails to achieve its predetermined impact or ESG targets. Yet even here, there is plenty to unpick. For a start, not all funds reach their financial hurdle rate, which leaves the question of how incentivised a manager would be to create impact in this situation. And then, separate from the type of impact model adopted, there is the question of whether funds opt for a pass/fail or sliding scale approach (most seem to be going for sliding scale) and how much of the carry is forfeit or subject to uplift in the event that impact or ESG targets are or are not met. “The percentage has to be meaningful – although most proposals we are seeing are less than 25 percent of carry,” says Ejikeme.
“Certainly, in a carry uplift model, the greater the proportion you link, the more pressure there is on the robustness of measurements and other mechanics.”
Target-setting is another area that can throw up issues around alignment. Unless there is a robust process for determining appropriate targets that builds in the opportunity for LPs to challenge them, there is a risk that GPs set themselves easily achievable goals. It’s a point picked up by Rareș Pamfil, contributor to an upcoming report from PFC Social Impact Advisors, who highlights the section that says: “[Where] the process of setting these goals is led by the fund manager, there is no incentive to set ‘stretch’ goals or to ‘go above and beyond’ and exceed the pre-defined impact targets.”
“Impact performance reporting is contextual as well as qualitative and quantitative”
It’s also worth noting that setting targets to link to carry will be easier for some funds than others. With no standard for measuring impact or ESG performance, identifying the correct KPIs for many aspects of environmental and, especially social, outcomes can be a significant challenge. BlueMark CEO Christina Leijonhufvud acknowledges that it is possible to set clear and discrete targets, particularly for climate-associated impact goals, and stresses her belief that there has to be some form of incentive structure around impact realisation. However, she has some concerns about the idea of more widespread adoption of impact carry. “Impact performance reporting is contextual as well as qualitative and quantitative,” she says. “In many areas of impact, it’s really hard to measure outcomes with scientific rigour and I worry about distortions that could be created and misleading conclusions that could be drawn by tying carry to impact at this stage.”
Leijonhufvud also adds that focusing on just the positive impacts could further muddy the picture. “There are negative impacts to nearly every investment you make,” she says. “Yet few managers currently identify, manage and report on these. If you tie carry to impact, there also has to be some consideration of negative impacts and externalities.”
David Gowenlock, a member of the fund advisory team at ClearlySo, agrees. “How you measure impact is really important,” he says. “The issue is that, say you are an impact fund with an electric vehicle investment, very often the metric used will be the amount of carbon saved because there are fewer petrol or diesel vehicles on the road. Yet because they don’t have an eye on net zero targets, many impact funds wouldn’t measure the carbon impact of manufacturing those vehicles. I think this will come, but there needs to be more holistic measurement and reporting of impact.”
It’s clear that the funds currently tying carry to impact are pioneers – and, as with any innovation, there will be wrinkles to iron out. Yet some believe it’s just too early to align impact performance to carried interest. Many are waiting to see what happens, but there are voices that suggest a fundamental rethink of private equity metrics is necessary to make this work.
“As it currently stands, the measurement frameworks are not sophisticated enough and can be easily gamed”
“As it currently stands, the measurement frameworks are not sophisticated enough and can be easily gamed,” says Delilah Rothenberg, co-founder of the Predistribution Initiative and former ESG and impact adviser to funds. “But actually, [all the] while we have metrics like IRRs, which incentivise driving returns over the short term, there is an inherent conflict with trying to achieve long-term sustainability.”
Instead, Rothenberg advocates that GPs, LPs, civil society and academics work together so that potential pitfalls and unintended consequences are avoided. “Most GPs are well-intentioned,” she says. “But we need to act with integrity not urgency when it comes to areas such as compensation. Sometimes when you act quickly, you can do more harm than good.”
The number and size of funds tying carry to impact or ESG is clearly growing – albeit from a low base. BlueMark’s recent report that benchmarks the practices of the GPs it has worked with found that while 47 percent of impact managers align staff incentive systems with impact performance, only 3 percent do so through carry structures. It may well be something we see a lot more – there are certainly plenty of supporters. But GPs opting for these schemes will need to design them with care and diligence, while LPs will need to be mindful of the potential that they may be gaining false comfort around impact incentives and of unintended consequences.
Read the previous instalment of this deep dive: ‘Linking carried interest to impact: The ‘who?’ and the ‘why?’