Two years ago, Trill Impact’s maiden €900 million fund became one of the largest funds at the time to tie carry to impact targets. Things have moved on quite a bit since then.
“This has been a hotter topic than I would have imagined a year or two ago,” says Christina Leijonhufvud, CEO of impact verification specialist BlueMark. “Impact incentives are a more dominant part of discussions with clients and in the marketplace more generally.”
Of course, Trill was not alone back then. Firms such as EV Private Equity, Norrsken and Revent had also put in place impact-tied carry structures. However, BlueMark’s impact investing practice benchmark for 2021 found that just 3 percent of firms for which it had conducted impact verifications tied carry to impact outcomes.
Among those now tying a proportion of carry to impact targets are some long-standing private markets firms – L Catterton and Morgan Stanley Investment Management both do so for their new impact strategies, for example. Meanwhile, EQT has linked up to 20 percent of its carried interest for its impact-driven Future fund to portfolio-level KPIs.
A few firms have even committed to tying 100 percent of their carry to impact targets – Just Climate is one example. BlueMark’s benchmark for 2023 found that 7 percent of the firms it worked with tied carry to impact (it’s worth noting that this is a percentage of a sample that includes some corporations and public markets investors, where carried interest clearly would not apply).
“We have seen a much greater adoption of carry linked to non-financial metrics over the past two years,” says Ali Floyd, a managing director and co-lead of the sustainability practice at Campbell Lutyens.
“It has become something of a market standard set by some of the largest impact funds. It’s now difficult to claim that these structures don’t work because some large funds have been raised with this structure. The dynamic has shifted.”
It is a shift that David Gowenlock, investment director, sustainable and impact investing at Cambridge Associates, also notes. “Over the past two years, impact-tied carry has become a frequent topic in our due diligence of impact strategies and we are seeing more managers adopting this. We are also seeing the share of carried interest linked to impact increase – it is now typically 20-30 percent of carry.”
This kind of incentive should be table stakes for impact investors, says Vikram Raju, a managing director, head of climate investing for the private credit and equity division of Morgan Stanley Investment Management, and head of the firm’s 1GT climate impact platform.
“We feel that private equity strategies that hold out an impact objective, in addition to financial returns, should use that same mechanism to give real economic meaning to those objectives. There should be a real economic disadvantage associated with the failure of achieving the climate goals, just as there is on the financial side.” Raju adds that carried interest was a “natural choice” because it is a well-established incentive mechanism.
He does, however, point to some of the questions the firm had to answer when devising the scheme, such as how much was meaningful (although he doesn’t disclose the percentage of carry linked to impact targets at 1GT, he does say he would like to see the market move to 50 percent over the next few years); how to ensure financial returns would not be sacrificed in pursuit of the fund’s climate incentive; and whether to donate a portion of carried interest to environmental causes or use it to buy carbon credits.
“Ultimately,” says Raju, “we decided that the cleanest solution was to have a waterfall that prioritised financial returns first and in effect give our LPs a significant discount if we fail to achieve our climate goal.”
There are even moves among firms that are not badging their products as impact funds to tie compensation to non-financial targets. “There is a broad recognition in private markets that safeguarding and improving the ESG performance of a business is part of value creation today – it’s simply good business,” says Tom Alabaster, a partner at Ropes & Gray. “The logical next step is to think about incentives – if the deal team is motivated to make ESG improvements in portfolio companies that will increase the value at exit.”
There is an argument here, though, that if sound ESG improvements increase the value of a business at exit, it follows that traditional carried interest will reward a focus on sustainability without the need for explicit ESG targets. Yet there is a clear rationale among firms implementing ESG-related incentives, says Alabaster: “The direct call-out of these factors is important because it is a clear signal that firms are monitoring individuals’ performance in ESG. This changes the tone of the conversation and underlines the expectation of a more activist approach to achieving better performance in these areas.”
The tricky part
Nevertheless, incentive schemes tied to non-financial measures – and impact carry in particular – are not straightforward. While their adoption has proved such schemes are possible, there is still no consensus on what best practice looks like.
Setting achievable but meaningful targets remains challenging, for example, as does interpreting what impact has genuinely been achieved.
“We hear from people who have been experimenting with impact-linked carry or bonuses that aligning to a discrete set of impact output metrics can lead to a false precision about whether impact has been made,” says BlueMark’s Leijonhufvud. “In climate, for example, it is generally easier to create impact-linked incentive structures because you can be explicit about carbon dioxide emissions avoided or reduced using well-established metrics. However, there may also be unintended impacts and there are assumptions that go into GHG emissions calculations. It’s actually not that straightforward.”
Allied to this is the difficulty of getting a holistic picture – including good and bad. “LPs often tell us they get cherry-picked data. When you are talking about impact-linked carry, that’s often all about cherry picking data,” adds Leijonhufvud. “There are several issues with this approach: it doesn’t necessarily include negative impacts, it’s hard to set reliable, evidence-based targets, we don’t yet have time-series data on the metrics, and there can be perverse incentives to set easily achievable targets.”
The hurdle is another area for discussion. “There can be a distortion created by the hurdle,” explains Cambridge Associates’ Gowenlock. “Once the impact carry hurdle has been reached, there may be no further incentive for the manager to strive for better performance. Some, however, get around this using a sliding scale to reward impact outperformance.”
While many LPs welcome the adoption of impact-tied incentives – and in some cases, they are driving the development – they are scrutinising schemes to guard against some of these pitfalls.
“Many of our clients deploying capital to impact strategies like to see managers putting their money where their mouth is when it comes to impact goals,” says Gowenlock.
“When evaluating managers, we want to know if impact incentives are in place across the whole team – not just for fund partners; why the targets are ambitious; how the firm performs lifecycle analysis; and if their performance is self-reported or audited. Some managers are leading the way in ensuring their approach is both robust and transparent.”
Yet both LPs and GPs need to guard against the potential for making impact incentives carry too much weight. As Floyd says: “Impact carry can be a bit of a red herring. There is a risk that a lot of time and attention are spent on what is often a relatively small quantum of compensation that may or may not be paid in future. If impact carry becomes central to a firm’s marketing or positioning of their investment strategy, the manager may not focus enough on the really important areas such as fiduciary duty, robust impact measurement and where capital is being deployed.”
Most agree that, while impact incentives can be an important mechanism for focusing minds on improvement, they are only one element of what needs to be a comprehensive strategy and framework for generating intended outcomes. Acknowledging both the potential power and shortcomings of impact incentive schemes is vital.
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“The adoption of impact carry is positive,” says Leijonhufvud. “But we do need to have a healthy degree of scepticism. Otherwise, there is a temptation to believe it’s a silver bullet. Impact carry should be one component in an all-encompassing approach to managing impact and aligning incentives.”
Getting third-party verification for targets tied to impact, the measures a firm is using to assess performance, and for LP reporting are all considered good practice. “There is a definite sense that firms don’t want to be seen to be marking their own homework,” says Campbell Lutyens’ Floyd.
The 1GT fund is using a third party to measure and verify companies’ impact, and LPs are also permitted to change the third party during the life of the fund “to ensure complete independence”, says Morgan Stanley Investment Management’s Raju. He also says the fund has built in “measurement optionality for LPs in the future” because of the current plethora of impact frameworks, metrics and scoring systems in the market, a situation that he expects will mature and settle over time.
Yet Raju is clear that impact incentives are the way forward for funds with an impact objective. Describing the current adoption in the industry as “timid”, he says: “People are concerned that adding an impact link to carry will create perverse incentives. We need to be clear that we’re taking a standard two and 20 fee structure and effectively creating a potential discount for investors if we fail to achieve our climate goal. We should also be clear that, in our view, a strategy that fails in financial objectives should get zero carried interest, no matter how well they have done on the climate impact side.”
Raju is far from alone in believing that what we are seeing is only the start. “It’s a constantly evolving area and we expect more firms will adopt this,” says Gowenlock. “The concept appears to have taken hold – it wasn’t certain that it would be widely adopted just a couple of years ago. We expect it will become more common and LPs will expect GPs to put more money on the line, take a more robust approach to setting ambitious targets and a more standardised approach to measuring outcomes, aligned with the emerging industry standards.”
Towards better practice
Impact incentives are a relatively new trend, so it is hardly surprising that ambitions of best practice are a work in progress
As impact investing continues to mature, and subsectors arise with their own specific impact objectives, establishing a widely accepted framework for incentives remains a complicated endeavour. Yet there are some initiatives that could help the industry get there. One of these is a research project led by Aunnie Patton Power, an academic and a fellow at non-profit organisation The ImPact.
The study, Impact Linked Compensation, due out in late 2023, has received responses from 200 funds and features in-depth interviews with 40 LPs and GPs. The aim is to understand how widespread these schemes are, share knowledge and ideas, and help the industry develop and improve practices. “We have heard from around 80 funds that currently don’t tie incentives to impact,” says Patton Power. “That’s because they feel it is too complex and they can’t get to portfolio-company-level metrics.”
However, she adds that it is possible to design schemes well even if it is complicated. “Our research has cemented the idea that everyone responds to incentives. What we heard time and again was that the discipline created using impact-linked compensation focuses minds at every stage of an investment.”
Patton Power also points to a willingness to learn, share experience and to evolve processes among the firms responding to the research. “Even those that have been doing this for some time see the need to be iterative.”
The European Investment Fund has been a major driver of impact-tied incentives in the venture capital space for a decade – and yet it also believes in continuing to develop its implementation. Having created an impact multiple methodology as an alignment of interest tool back in 2013, the EIF now has 100 impact VC funds in its portfolio representing commitments of €1.5 billion.
“Our mechanisms are not set in stone,” says Cyril Gouiffès, head of social impact investments at the EIF. “We are currently adapting our target setting. As the impact market has grown, it has become more specialised on specific sectors, so it is harder for us and the LPAC alone to understand which targets are relevant and meaningful.
“While we still want a voice in the process, we think that KPIs and targets need to be set or verified by an independent committee that includes experts from the sector.”