Impact-linked carry faces a fundamental challenge; let’s hope it prevails

It’s a private fund innovation that could be a force for good, and one that some investors may struggle with.

The idea of linking carried interest to sustainable investing – whether that’s good ESG practice or positive impact outcomes – has major appeal.

It takes arguably the most powerful incentive in the private markets investment framework and tilts it towards positive external outcomes.

There is no set formula for how it works, but typically a portion of the manager’s carried interest pot – anything from 10 to 50 percent of it – only goes to them if certain “extra-financial” goals are meet. Those goals can be singular and thematic, like total emissions avoided, or they can be tailored to each portfolio company, as with Trill Impact’s debut fund. Or they can have more of a portfolio-wide ESG flavour, as EQT has introduced. While it started in Europe, it is now being adopted by US managers, like The Drawdown Fund, as affiliate title New Private Markets reported this week.

There are challenges when linking sustainability to carry. The choice of relevant metric is not straightforward. And LPs must be satisfied that the data is accurate (“no marking your own homework!”). And how much carry should be at risk?

These challenges are surmountable. The number of third-party organisations able to provide assurance services around impact and ESG data is on the rise. And while we are still far from a market standard, each iteration gives LPs another data point to reference and takes us a step closer.

But while these teething problems can be overcome, a potentially more fundamental problem exists; how do these incentives sit with an interpretation of fiduciary duty that allows no room for ESG?

Take, for example, Florida SBA, which – as we explored two weeks ago – reiterated its desire for investment decisions to be based on pecuniary factors, which do not include “social, political or ideological interests”.

As we said at the time, this makes little difference to its existing private markets portfolio, which includes some sustainability-focused funds alongside more conventional ones. None of them claims to sacrifice financial returns for other goals; on the contrary, these are funds that pursue outperformance by harnessing sustainability.

It would be a different pitch if one of those funds introduced an impact-linked carry component. It would create a slight kink in what is normally a quite straightforward “I win, you win” financial alignment of manager and investor. To be specific: there could be a situation in which a GP is incentivised to sacrifice some of the fund’s financial returns in order to hit an ESG or impact target and unlock an additional tranche of carry.

To put it another way: sustainability-linked carry could be seen as undermining the argument that sustainability is naturally, inextricably linked to enterprise value.

I personally do not subscribe to this argument. When it comes to alignment of interests in private markets, the overall system is sound, but conflicts of interest inevitably pop up that require management. These marginal situations should fall into that category; they just need managing.

Impact- and ESG-linked carry has the potential to be a powerful force for good in financial markets. I hope it proliferates.

Toby Mitchenall is senior editor of affiliate title New Private Markets. Email him at toby.m@peimedia.com