3.New ways of linking compensation to impact
Despite diverse motivations and profiles, all impact investors are united by a desire to generate measurable social and environmental impact alongside financial returns. Although the sector has professionalized rapidly in recent years, it has to a large extent failed to incorporate impact measurement and the use of non-financial incentives as a mechanism to compensate fund managers. The right incentive schemes that link fund performance to impact can help to ensure that investment choices are not biased in favor of financial returns and that impact outcomes are given proper weight in decision-making.
The compensation structure of the traditional private equity and venture capital funds is highly dependent on the financial success of the fund. In nearly all cases, the general partner GP receives approximately 20% of the net capital gain of the fund, called “carried interest”. Impact-based carried interest is computed using the same mechanism as in traditional funds, yet it is only distributed if certain predefined impact goals are achieved in addition to the financial hurdle. For example, a fund may have an impact objective to provide energy access for 10 million households. If the fund fails to meet this impact hurdle, part of their performance compensation could be forfeited (all-or-nothing method). Alternative impact-based compensation methods may scale the achieved results to the impact objective (pro-rata method). For instance, if the fund provided energy access to three3 million households during the life of the fund, the fund managers would be entitled to 30% of the carried interest. Effectively, funds using such a scheme translate achievement levels across different impact objectives into a numeric score, which allows for a linear increase of the variable pay alongside impact results.
While there is no standardized way for funds to measure the impact of their investments, tools such as the GIIN’s IRIS+ are already being widely used to create comparable criteria, scorecards and frameworks for impact assessment and fund performance. An alternative to an impact -based carry is to provide an impact bonus that can be issued at various points in time throughout the life of the fund.
Although the conversation on how to tie compensation to impact is still in its early stages, proponents are advancing internal fund practices to the top of the agenda. For example, Principle 2 of the International Finance Corporation’s (IFC) Operating Principles for Impact Management states that fund managers should consider aligning compensation to the realization of impact objectives. In 2022, we expect to see more funds consider and experiment with compensation incentives for fund managers that are tied to impact deliverables.