Fund selection in impact investment

Due diligence requires a fundamentally different approach in order to make an impact alongside a financial return, says impact investment expert Julia Balandina Jaquier.

There’s little doubt about the rise of popularity of impact investing. Over $114 billion has been placed with funds that seek to generate social and environmental impact alongside a financial return, according to the latest investor survey from the Global Impact Investing Network.

With private equity the most commonly used instrument in impact investing, deployed by over 75 percent of impact investors, according to the GIIN, and industry giants such as TPG and Bain Capital launching impact funds, this pro- active approach to responsible investing has clearly caught the imagination of both general partners and limited partners alike.

But how do you choose the right fund manager? That’s a question considered by Swiss-based impact investment veteran, Julia Balandina Jaquier, in her recent book Catalyzing Wealth for Change: Guide to Impact Investing. In this extract, she explains the intricacies of fund manager selection and why due diligence takes on a whole new perspective when you are expecting the fund manager to help solve some of the world’s most pressing problems.

CHARACTERISTICS OF IMPACT INVESTMENT

If you decide to invest for impact indirectly, by committing capital to an investment fund, your investment process will differ from a traditional manager due diligence, although the focus will still be on the analysis of the fund strategy and the ability of the team to execute on it.

Broader scope of analysis: In impact investing, manager assessment combines traditional investment analysis with the assessment of the fund impact strategy and the fund manager’s capacity to generate impact. The fund team has to demonstrate both investment acumen and experience in analysing and driving the impact generation within their portfolio companies.

Due diligence methods: The cornerstone of traditional fund due diligence is the analysis of the track record of the fund manager, as it is seen as the best predictor of future performance. However, many of the impact investment funds are first-time funds (meaning they employ a new fund strategy), or even first-time teams (meaning that the team has not worked together before). Further, fewer members of the fund will have even an individual investment track record. This shifts focus from a more quantitative analysis of past performance onto the in-depth assessment of the future capacity of the team to deliver a dual set of returns.

Smaller funds, younger teams

It is not uncommon for the impact investment funds to have as little as $20 million – $30 million in assets. With a fixed management fee, it becomes challenging to cover the fund’s expenses and still have enough budget to attract talent, unless it is subsidised by grants or by a larger firm, to which the fund belongs. Further, unlike in traditional private equity, where carried interest is an undisputed mechanism for aligning the investors’ interests with those of the fund manager, in impact investing, the carried-interest pool is significantly smaller, or even non-existent. While some investors welcome this as a sign of mission alignment, others argue that scrapping the carried interest will prevent impact funds from attracting investment talent, which is key to fund performance.

First-time-team risk (the risk that the partners of the fund will fail to work well with each other and, therefore, that the team will fall apart) is one of the key risks and needs to be carefully assessed. Given the novelty of the strategy, the proportion of first-time funds is substantially higher than in traditional investing. Further, the requirement of a dual skill set makes the recruitment of a staff with more diverse backgrounds more likely, increasing the risk of culture clash between a traditional private equity and a traditional social-sector mentality.

There’s also a difference in fund structures and terms. While most impact investment funds follow the traditional limited partnership structure, some are themselves structured as non-profits or “locked” into the mission in their statutes, which prevents them from developing purely commercial funds. The lives of some impact funds are longer than the usual 10+2 years, and alternative models, such as evergreen funds or holding companies, are used to reduce pressure to exit their investments prematurely. A broader range of instruments is often permitted, and a grant-funded Technical Assistance (TA) facility is frequently used to finance specific interventions for their investees.

IMPACT DUE DILIGENCE

The impact due diligence seeks to assess both the intention and the capacity of the manager to deliver on impact objectives. It is a critical area of manager selection process and typically covers three areas: the analysis of the team/firm, the fund impact strategy and fund governance.

The team/firm analysis focuses on the fund manager’s mission and values. Some impact managers have a non-profit background or are structured as a non-profit themselves, which indicates mission alignment, but may warrant a closer look at their investment experience, which is also crucial to impact delivery. Understand the firm culture, personal motivations, management style and relationship between the head office and the local teams.

Understand the firm culture, personal motivations, management style and relationship between the head office and the local teams

Look also at the impact-related skills and qualifications of the team. Have they invested for impact before, or undergone specific training on ESG or impact assessment? Is impact expertise present on the ground, and not only in head office? Do they understand the cultural specificities of their target markets and target investees? Check whether the fund is a member of (impact) investment networks, associations, and working groups (ANDE, GIIN, EVPA, toniic, etc).

Fund strategy should be thoroughly assessed, including the rigour and viability of its theory of change. Discuss what impact the fund intends to generate and how. Ask how they have come up with the strategy – was it an intellectual exercise or the fruit of investment experience? Also, critically evaluate the degree of tension between impact and financial objectives inherent in the strategy by examining which business models will be funded, and which populations and sectors will be targeted. Discuss with the manager how they plan to address this tension. This will help judge the risk of a mission drift (the risk of deviating from the stated impact strategy).

GOVERNANCE CHECK

Scrutinise the governance of the firm/ fund for confirmation of mission-alignment, including the following:

  • Mission lock: Some impact investment fund managers lock their mission into their statutes, similarly to impact-driven enterprises. Maintenance of impact ratings (such as GIIRs) or certification (such as B Corp), are further signs of mission commitment.
  • Policies: This analysis will focus not only on the compulsory good-governance policies (anti-corruption, anti-money laundering, exclusion list, etc.), but will check for environmentally sustainable practices (carbon offsets, waste management, etc.), fair employment, and gender-diversity policies. Some impact investors will only invest in gender-diverse fund manager teams.
  • Investment Committee (IC)/Advisory Board: Check the composition of the IC for (independent) members with impact expertise and their ability to veto the deal. If available, check the IC memos and minutes to see how evenly distributed the discussions have been between the impact and financial merits of the deal. Review the (likely) composition, the role and values-alignment of the LP Committee and the Advisory Board.
  • Impact measurement and reporting: Does the fund have thorough impact reporting in place? How does it measure, or intend to measure, impact? While impact measurement is a complex and challenging undertaking, a lack of commitment to evaluate and manage the impact generation by its investees may indicate that the fund is not serious about impact.

INCENTIVES

Given smaller sizes and difference in terms, it is important to analyse the fund’s financial sustainability, study its budget, and ensure the sufficiency and fair distribution of financial incentives. If incentives are not linked to impact objectives, introduce the subject but be aware of the challenges of this approach and the industry debate about the ‘proper’ incentives structures of impact investment fund managers.

THE INVESTMENT PROCESS

Analyse the investment process, including the integration of impact assessment at every stage from screening to exit. Look both for the robustness of the process and its pragmatism. Check the strength of the deal sourcing and value added to investees – they are critical in impact investment. Analyse how the team goes about impact assessment; whether they use such tools, as screening checklists, due diligence questionnaires, or 100-days plans; and, if so, how impact analysis is integrated into them.

THE INVESTMENTS

The best way to check on impact commitment and investment acumen is to look at past and current investments of the fund manager. Check their impact profiles and understand what drove their decision to invest and how the manager monitors impact performance and adds value to the investee. By having a detailed discussion of individual investments, checking the related documentation and making reference calls, you will be able to test most of the statements made by the fund manager. Also check whether the investment pipeline matches the stated investment strategy and impact profile.

Taken from Catalyzing Wealth for Change: Guide to Impact Investing, which is available from www.guidetoimpactinvesting.net. The author, Julia Balandina Jaquier, is an advisor to institutional, private and sovereign investors, with over 20 years of impact investment and private equity experience. She lectures at the St.-Gallen University, IMD, Harvard and CEIBS. She started her career at McKinsey and went on to manage the European direct private equity business at AIG Global Investment Group prior to pioneering an impact fund in 2004.