Why impact-linked carry is ‘risky business’

Linking carried interest to impact KPIs, often seen as best practice in impact investing, is not appropriate for all strategies, according to panellists at the Impact Investor Summit: North America in New York last week.

“Impact-linked carry may be one of the things that you use, but aligning incentives with impact is as qualitative as it is quantitative,” said Diane Damskey, head of secretariat at the Operating Principles for Impact Management (OPIM). As a result, there is “not going to be a one size fits all” solution when it comes to incentives, and impact-linked carry is unlikely to become the norm.

Impact-linked carry is still emerging as concept and the approach varies from fund to fund. Typically, a portion of the carried interest (examples range anywhere from 10-100 percent) will only go the general partner if certain impact or ESG targets are met. How those targets are set, and what happens to any “unearned” carry, is an ongoing discussion point. Arguably the highest profile firm to link carried interest to sustainability objectives is EQT, which has done so for its Future fund.

Launched in 2019, OPIM’s nine principles are one of the most widely accepted impact management frameworks. According to its website, 178 firms from 40 countries have signed up, including the likes of BlackRock, Brookfield and KKR.

“I think we’re going to see over time that there are various ways to align incentives with impact. We shouldn’t just focus on carry because it’s not going to work for everybody,” Damskey said.

For the moment, only a small number of managers have implemented the idea, said Bluemark CEO and co-founder Christina Leijonhufvud. Bluemark provides verification, benchmarking and data services to the impact investing industry. Its ‘practice leaderboard’ identifies the fund managers with the strongest alignment with the OPIM. Just 11 firms are currently on the list, including Schroders Capital, Bain Double Impact, Leapfrog Investments and Trill Impact.

Of the 150 impact managers with which Bluemark has worked, “about 31 percent of our clients have adopted some form of impact linked compensation mechanism,” Leijonhufvud said. “That being said, only 7 percent have actual impact-linked carry, which I think points to the fact that it is really hard to do right.

“It is really hard to do in a meaningful way, because impact-linked carry boils down to either cherry-picking a few metrics or trying to quantify impact in a single metric. That is risky business; I think that possibly gets you into the land of false precision and false signalling.”

Leijonhufvud agreed with Damskey that a holistic approach to assessing impact performance is often the best course of action. “Some of the more robust impact-linked compensation mechanisms we’ve seen are based on both quantitative and qualitative data,” she said.

Mixed views from LPs

Among asset allocators, views on impact-linked carry also varied. Speaking as part of wider discussion among allocators at the conference, Jessica Pan, a senior portfolio manager at APG Asset Management, noted that it was a nascent practice, adding: “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. We would say that impact-linked carry is the gold standard.”

In contrast, Kunle Apampa, client solutions head at Capricorn Investment Group, questioned whether financial incentives were the right way to encourage impact improvements.

He said: “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.

“I see the financial incentive as just one of the tools that we should be thinking about. We should also have other ways of motivating people to do the work that they do. Today there are a lot of entrepreneurs that are thinking about solutions in more dynamic, thoughtful, human-centric ways. And I think those should be the things that we incentivise for people to continue to think about more, while we still chase the alpha as well.”