Impact Investing – Fund Mechanisms to Incentivize Impact

A growing number of investors aim to achieve positive social or environmental impacts alongside financial returns.  For such impact investors, there are various legal and structural mechanisms to consider.  In order to incentivize impact in the context of fund formation in particular, certain key concepts should be drafted into the legal documents from the outset.  These include:

  1. Whereas most typical entities are generically set up for “any lawful business or activity,” impact-focused entities will want to embed a more tailored purpose or mission.  In crafting a purpose or mission, it is important to be specific enough to allow for meaningful measurement and reporting, but not so narrow as to restrict the GP’s ability to adapt strategy to meet changing micro and macro market conditions.  It is also critical to have a remedy in the event of “material deviation” from purpose/mission, and an agreed mechanism to make such determination.
  1. Longer Fund Length. Often impact-oriented funds employ a longer term than traditional funds to promote investments that require a longer runway to profitability. Many investments (particularly those involving carbon mitigation) require more than 10 years to yield appropriate returns on capital.  There are a variety of ways to provide for a longer-term investment focus, while also allowing investor flexibility (e.g., allowing investors to opt in or out on an annual basis).
  1. Impact-Oriented Compensation. In order to incentivize impact, investors increasingly seek to connect compensation with impact performance.  For example, in a traditional compensation scenario where the GP earns 20% carry, an impact fund may provide that a portion of the 20% (e.g., 15%), would be earned based on the fund’s financial performance, and the remaining percent (5%) would be earned upon achievement of impact goals.  In such a scenario, having a mechanism for setting impact goals and measuring impact performance is critical.  It is also important to establish a body (e.g., an advisory board) to review and confirm if and when the impact goals have been met.
  1. Mission Protection Provisions. Various protective provisions can work to preserve mission and protect the impact orientation of investments.  For example, funds may create classes of LPs and give special rights to those investors that prioritize impact over financial returns (“impact first” investors).   Additional examples of protective provisions include requiring consent of “impact first” investors or LP board of advisors to deviate materially from mission or change definition of mission, and adding mission concept to powers and obligation of managers so that fiduciary duties include adherence to mission.
  1. Strategic Governance. Investment funds should consider mission and impact orientation when structuring fund governance.  For example, some impact funds may benefit from an advisory board of LPs with the right to oversee investments, review annual mission/impact, and/or evaluate if mission goals are met by GP for purposes of compensation.  Funds may also choose to create classes of LPs and give the “impact-first” investor class a dedicated representative on board of managers.
  1. Impact-Dependent Distributions. There are various ways to structure distributions to further impact.  For example, funds may structure distributions to return money first to impact investors or foundations.  Alternatively, funds may structure distributions to first return money to traditional investors so that the impact investors/charitable funds bear the losses to “de-risk” the investment for traditional investors.  Another option to use distribution mechanics to maximize impact is to require donation of a certain percentage to charity once certain financial goals are met.
  1. Metrics and Monitoring. Finally, all impact investment funds will want to carefully consider impact metrics, measurements, and reporting requirements.  Metrics are usually company-specific but are monitored on a portfolio basis.  A key is to have metrics tailored appropriately with impact—not too broad that it overly captures results or too narrow that it misses significant impacts.  Measuring impact involves identifying some benchmark, either external or internal, to measure success.  For reporting, impact funds will need to determine the best way to communicate with the portfolio company and with LPs on success.  The current trend is toward reporting on environmental, social, and governance (ESG) factors in the same way as financial reporting and integrated reporting (e.g., reporting on ESG factors together with traditional ROI).