(Illustration provided by: iStock / Sesame)
Over the past few years, there have been significant advances in how investors measure social and environmental performance. While frameworks such as the Impact Management Project (IMP) and the International Sustainability Standards Board (ISSB) have allowed investors a more structured approach to impact reporting, the EU’s Sustainable Finance Disclosure Regulation (SFDR) ), regulatory changes require higher levels of disclosure from investors. This is progress.
However, cost remains a significant barrier to widespread implementation of robust impact measurement and reporting. Investment funds have not historically been structured to incorporate rigorous impact measurement, so such activities do not have a natural “place” in the budget. Not only does this limit the resources available to tackle these increasingly important activities, but each general partner, both internally and with limited partners, therefore has to ensure that their funds address this issue. We need to engage in a one-off discussion on how to solve it piece by piece. As a result, there is a significant mismatch between current foundation practices and growing expectations for high-quality social and environmental impact data. Because most funds were established in an environment with low expectations, fund managers have changed their footing, often imposing fund LP agreements midway through their 10-year fund life that did not anticipate today’s situation. It will be done. reality.
Without a clear path forward, investors raising new capital have no strategy for how to approach this issue.
How do investors pay for impact measurement today?
Current approaches typically fall into two broad categories, with funding coming from the fund’s management fees or separately funded technical assistance funds established outside the main fund structure to pay for impact measurement. It will be procured from. Neither is entirely satisfactory.
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In the former case, fund management fees for private investment funds are typically 2 percent per year of committed capital during the investment period and 2 percent per year of invested capital thereafter. Fund managers must cover all general operating expenses of running their business from these management fees. However, in 60dB’s experience of working with hundreds of investment funds as a service provider, in almost all cases (and no matter the size of the fund) this 2% management fee always seems to fall short. I can feel it. Most self-proclaimed impact investing funds are relatively small ($250 million or less), so they don’t have a lot of leeway when it comes to how they spend this money. For most foundations, the amount raised for impact measurement activities often reaches approximately $100,000 annually. If in a typical GP’s portfolio he has 30, 40 or even 50 investments, this is not enough to obtain actionable impact data for each company. Rather, they are likely to provide only basic metrics that are easy to collect, but that provide the insights that investors and companies seek, or that are meaningful to see whether a fund is having an impact on society. It does not provide any solid evidence. It aims to achieve.
A second measure of funding effectiveness, technical assistance (TA) funds are typically provided through grants, but there are specific requirements for how these funds can be used to support portfolio companies. The advantage is that TA funds tend to be more flexible and can therefore often be used to fund the cost of impact measurement. However, TA funds are unpredictable ventures with low success rates and require a significant investment of time and resources to raise and build. As a result, only a small number of impact-first funds (and a much smaller proportion of all funds with environmental or social missions) have TA funds.
new approach
As the saying goes, “you get what you pay for.” For high-quality social and environmental data, structural constraints on allocating appropriate resources within a fund have a predictable impact. The good news is that the framework to address this issue already exists within fund structures and commercial endeavours’ practices.
1. Fund expenditure in LP contract
We have seen more funds treat impact measurement as an allowable fund expense codified in the LP agreement. The rationale is simple. This is because in order for a fund to operate, it must engage in a specific set of activities. Traditionally, these activities have meant things like legal fees and completing annual audits, but more impact funds are now claiming that they need good impact data to run their funds, and therefore , argues that the collection of this data should be an allowable fund expenditure.
Take, for example, the “impact first” funds that pioneered social finance. Central to the Fund’s strategy is a rigorous impact measurement and management (IMM) process that ensures the Fund not only targets but achieves meaningful social and environmental impact. Because of its importance, IMM is an explicitly allowable expense within LP agreements, specifically “costs incurred in connection with assessing, measuring, and monitoring impacts within a portfolio, including associated travel expenses.” may be included).” This approach allows the fund to leverage both internal and external expertise as needed in the impact measurement process. LP has supported the inclusion of measurement costs and enhanced data and reporting opportunities on the financial, social, and environmental impacts of investments.
An additional rationale for treating these expenses as fund expenses under the LP agreement is based on the theory of how expenses are classified. It is generally recognized in the industry that fund expenses cover all expenses specific to that fund, whereas GP expenses covered by management fees are expenses specific to the operation of a fund management business. Following that logic, it would be strange for impact measurement costs specific to a fund’s investments to be covered by management fees, and it would be much more logical for these to be classified as expenses of the fund. Classifying these costs as fund costs under the LP agreement is important because the industry standard 2% management fee allows GPs to “keep the lights on” without taking into account the significant costs of effectiveness. It also acknowledges that it was developed as a substitute for the amount required for. measurement.
What does the cost of impact measurement look like? Imagine a fund that aims to obtain best-in-class social impact data. Its costs range from 25 to 50 basis points (0.25 to 0.5 percent of committed capital) annually at the fund level. Considering this cost as part of a 200 basis point annual management fee, it represents 12 to 25 percent of the total available resources, which is impractical in most cases.
Conversely, if the expense is charged to a financially successful fund (imagine an equity fund with an IRR of 20%), then given this exceptional financial success, it would be better for both LPs and GPs. , the impact management costs seem suitably small. Additionally, on a more technical note, a fund’s waterfall can be arranged to have some adjusted cost sharing between the GP and the fund’s LPs (e.g., by offering preferred returns to the LPs) .
We have spoken to many legal and fund advisors about this practice and there is widespread agreement that it makes sense. Leslie Cornell, Vice President and Deputy General Counsel, Social Finance, said, There is precedent.” “This fundamentally improves investment decision-making, and integrating the costs of these high-yield activities into the structure of a fund shows forward-thinking in impact investing.”
Deciding how to allocate a fund’s impact measurement costs does not have to be a zero-sum game or an adversarial exercise. The best her GP/LP relationships are built on a foundation of trust and common purpose. To that end, he believes rising expectations around impact measurement provide an opportunity for GPs and LPs to talk and align expectations before the first closing. In other words, GPs and LPs need to have a strong discussion about the scope of impact measurement, what they are trying to achieve, and how they will implement it (e.g., the language used in the LPA, how it will be budgeted, its content, etc.) there is. activity) and how much does it cost? As mentioned above, cost-sharing mechanisms can be built into a fund’s distribution waterfall.
Having this robust discussion, rather than simply adding new items to a long list of funding expenditures, ensures alignment from the beginning and avoids difficult discussions if the cost of impact measurement exceeds expectations. It also helps.
2. Due diligence costs
Including company-level impact assessments as part of due diligence is another way for funds to obtain higher quality data.
The logic is relatively simple. A company’s social and environmental impact is one of the core drivers of its investment thesis, so it’s important to put appropriate diligent resources behind these activities, with either a value creation or risk mitigation mindset. It makes sense to invest. Additionally, for investments with customer-level impact theory, understanding customer experiences with products and services becomes similar to traditional market research, which is a very common activity in the investment due diligence process. Indeed, paying for diligent customer research is an expected activity in consumer-facing private equity deals, so why is this not common for assessing the social performance of impact-focused deals? That’s amazing.
On a practical level, this is very attractive to investors. Private equity investors typically hire multiple third-party vendors to conduct due diligence. These typically include commercial diligence providers, human resources professionals, legal advisors, accountants, risk advisory firms, management consultants, and insurance companies. It’s also common for both B2B and B2C companies to hire companies to talk to a representative sample of customers to understand the customer’s perspective on the company.
Similarly, some of the most innovative efforts in social impact measurement, including 60 Decibels’ work, focus on talking directly to customers and supply chain stakeholders about their experiences with companies and their products and services. I am. By incorporating these activities as part of their due diligence, investors will have the insight they need at the most critical moments: deciding whether to commit capital and enter into a 10-year relationship with a potential investee. You can get it. Above all, this type of activity creates direct value for the investee. Insights about customer experience are immediately actionable by businesses.
Additionally, these costs are paid upfront by the investor but are typically capitalized as part of the transaction. This means that some or all of the costs are ultimately borne by the investee in the form of equity to the investor. Given that this is standard practice for other diligence costs, customer and impact diligence should be included in this combination for all transactions where social or environmental impact is an important part of the investment’s core theme. It seems logical to be part of it.
Changes to terms and conditions
Broader socialization of these approaches involves honest conversations between limited partners and general partners about the purpose of the fund and what data they need to see if the fund is on track. It starts with that. Additionally, we propose structural changes to the way LP agreements are written for broadly defined “impact” funds. By default, you will be allowed to collect and report data on social and environmental performance so that you can begin to trust these data from your fund in the same way you trust the financial data your auditors share. , must be specified as the expected fund expenditure.
Beyond this, we should ask what it means for a fund to “guarantee impact” and dedicate resources during the due diligence process to help investors meaningfully understand their impact theory. It should be freely allocated. Whether it’s the environmental impact, whether it’s the core of the deal. To influence people, you need to hear their perspective directly.
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Read more stories by Sasha Dichter and Aaron Burke.
