The news that former EQT executive Jan Ståhlberg’s maiden €900 million vehicle under the Trill Impact brand will forfeit 10 percent of its carried interest if the fund does not meet certain impact targets has certainly got the industry talking.

Trill is not the only GP tying its carried interest to ESG or impact metrics, but it is one of the few examples of a large fund doing so. EV Private Equity is starting a similar scheme for its sixth fund. Capza will also forfeit some carried interest if it fails to reach its target of implementing ESG schemes for the portfolio companies in its sixth private debt fund. And a handful of venture firms, including Norrsken and Revent, are tying carry to impact. Swen Capital Partners is linking 50 percent of the carry on an ocean-focused impact fund it is currently raising.

“We’ve been talking about impact carry for a number of years now,” says Ali Floyd, senior vice-president at Campbell Lutyens. “Yet most of those doing this were fairly established, specialist impact-focused GPs that operated predominantly in the lower mid-market and that tended to attract capital from mainly domestic investors. We’ve now seen an undeniably significant entrant to the market setting a precedent for other new players.”

So, is this the beginning of a new trend in impact investing? Some believe it may be, with emerging managers leading the way. “New managers are starting with a clean sheet of paper,” says David Gowenlock, a member of the fund advisory team at ClearlySo. “They tend to be smaller and partner-led with small teams, and so they can design their offerings with more freedom than, say, a more established and larger firm where it would take longer to get approval from all partners and staff, and they may not get buy-in from the whole team.”

The more established managers newly implementing these arrangements believe it is a natural evolution, as Capza CEO Laurent Bénard explains. “We’ve been working on ESG since 2015, but it has become increasingly evident how urgent the need is for improvement in areas such as climate change and social equality,” he says. “This is a long-term necessity and to make it really work and to ensure effort is really directed towards improvement, we believe linking carry to that is important – it strengthens your purpose. I see a time when LPs will be looking for an ESG hurdle rate as well as a financial one because it demonstrates a commitment to positive change.”

Investor demand

An influential proponent of this approach is the European Investment Fund, which manages impact funds of funds targeting both climate and social impact funds, predominantly in the venture space. When raising its first vehicle in 2013, the organisation created “a framework to quantify, measure and verify impact to be used as an alignment-of-interest tool, as opposed to a reporting tool”, says Cyril Gouiffès, head of social impact investments at the EIF.

Using this framework, firms calculate an impact multiple for each portfolio company that is weighted by investment size; this feeds into a single impact multiple for the fund. If a vehicle reaches its hurdle rate, the level of carried interest the managers then receive is dependent on this multiple (which is equivalent to its impact performance).

However, there is flexibility built into agreements to ensure all LPs are comfortable with the arrangement and corresponding financial incentives. “We devised this approach because we believe there has to be a positive correlation between financial and impact performance,” says Gouiffès.

The EIF is applying this model to its impact venture funds currently, but there may be further moves in this direction elsewhere in its portfolio. “We are looking to implement our impact methodology in our private equity activity,” says Adelaide Cracco, head of climate and environmental impact at the EIF. “It may be easier to achieve this in private equity because we’re dealing with larger, consolidated companies with established revenue-generating businesses and, as such, know where to focus their efforts and what impact they can achieve.”

While the EIF is, by its nature, an impact investor itself – its mission is to foster risk financing, entrepreneurship and innovation in Europe – other investors are clearly encouraging this approach. “LPs are really important in shaping this dynamic,” says Floyd. “Not all are on board, because it’s a relatively recent phenomenon, but we are seeing a few very influential LPs that want this to happen.”

UBS is one investor supportive of the idea. “I sat on the advisory board for the IFC’s Operating Principles for Impact Management,” says Andrew Lee, head of sustainable and impact investing at UBS. “Principle two states that managers should consider aligning compensation to the realisation of impact. It’s an evolving field, but those aiming to deliver measurable impact should align incentives – after all, if impact is being measured, you should be able to tie it to carry.”

The supporters of tying carried interest to achieving impact or ESG targets all agree that they are putting their money where their mouths are.

However, designing carry schemes that create the intended incentives is far from straightforward. “It’s a hot topic,” says Amala Ejikeme, a partner with the investment funds group at Kirkland & Ellis. “It has the potential to be an emerging trend, although we are only at the start of this conversation and there are a lot of different ways these schemes can be cut.”

Penalty or bonus

Ejikeme points to a number of different issues that GPs and LPs need to consider. “The first of these is whether any link to the carry should operate as a penalty or bonus,” he says. “Carry-at-risk is perhaps not where a GP wants to start out in an ideal world and is a position an impact fund sponsor could find itself negotiated into.”

Advisers say many firms are currently opting for carry-at-risk – whereby the GP forfeits a percentage of carry if it fails to achieve its predetermined impact or ESG targets. Yet, even here, there is plenty to unpick. For a start, not all funds reach their financial hurdle rate, which leaves the question of how incentivised a manager would be to create impact in this situation. And then, separate from the type of impact model adopted, there is the question of whether funds opt for a pass/fail or sliding scale approach (most seem to be going for sliding scale) and how much of the carry is forfeit or subject to uplift in the event that impact or ESG targets are or are not met.

“The percentage has to be meaningful – although most proposals we are seeing are less than 25 percent of carry,” says Ejikeme. “Certainly, in a carry uplift model, the greater the proportion you link, the more pressure there is on the robustness of measurements and other mechanics.”

Easy target

Target-setting is another area that can throw up issues around alignment. Unless there is a robust process for determining appropriate targets that builds in the opportunity for LPs to challenge them, there is a risk that GPs set themselves easily achievable goals.

It is a point picked up by Rareș Pamfil, contributor to an upcoming report from PFC Social Impact Advisors, who highlights the section that says: “[Where] the process of setting these goals is led by the fund manager, there is no incentive to set ‘stretch’ goals or to ‘go above and beyond’ and exceed the pre-defined impact targets.”

It is also worth noting that setting targets to link to carry will be easier for some funds than others. With no standard for measuring impact or ESG performance, identifying the correct KPIs for many aspects of environmental and, especially, social outcomes can be a significant challenge. BlueMark CEO Christina Leijonhufvud acknowledges that it is possible to set clear and discrete targets, particularly for climate-associated
impact goals, and stresses her belief that there has to be some form of incentive structure around impact realisation.

However, she has some concerns about the idea of more widespread adoption of impact carry. “Impact performance reporting is contextual as well as qualitative and quantitative,” she says. “In many areas of impact, it’s really hard to measure outcomes with scientific rigour and I worry about distortions that could be created and misleading conclusions that could be drawn by tying carry to impact at this stage.”

Leijonhufvud adds that focusing on just the positive impacts could further muddy the picture. “There are negative impacts to nearly every investment you make,” she says. “Yet few managers currently identify, manage and report on these. If you tie carry to impact, there also has to be some consideration of negative impacts and externalities.”

Gowenlock agrees: “How you measure impact is really important. The issue is that, say you are an impact fund with an electric vehicle investment, very often the metric used will be the amount of carbon saved because there are fewer petrol or diesel vehicles on the road. Yet because they don’t have an eye on net-zero targets, many impact funds wouldn’t measure the carbon impact of manufacturing those vehicles. I think this will come, but there needs to be more holistic measurement and reporting of impact.”

Early days

It is clear that the funds currently tying carry to impact are pioneers – and, as with any innovation, there will be wrinkles to iron out. Yet some believe it is just too early to align impact performance to carried interest. Many are waiting to see what happens, but there are voices that suggest a fundamental rethink of private equity metrics is necessary to make this work.

“As it currently stands, the measurement frameworks are not sophisticated enough and can be easily gamed,” says Delilah Rothenberg, co-founder of the Predistribution Initiative and former ESG and impact adviser to funds. “But actually, while we have metrics like IRRs, which incentivise driving returns over the short term, there is an inherent conflict with trying to achieve long-term sustainability.”

Instead, Rothenberg advocates that GPs, LPs, civil society and academics work together so that potential pitfalls and unintended consequences are avoided. “Most GPs are well-intentioned,” she says. “But we need to act with integrity not urgency when it comes to areas such as compensation. Sometimes when you act quickly, you can do more harm than good.”

The number and size of funds tying carry to impact or ESG is clearly growing – albeit from a low base. BlueMark’s recent report that benchmarks the practices of the GPs it has worked with found that while 47 percent of impact managers align staff incentive systems with impact performance, only 3 percent do so through carry structures. It may well be something we see a lot more – there are certainly plenty of supporters. But GPs opting for these schemes will need to design them with care and diligence, and LPs will need to be mindful of the potential for gaining false comfort around impact incentives and for unintended consequences.

Impact carry at work

Helge Tveit, managing partner at EV Private Equity, has been considering for some time how best to tie impact performance to carry.

“It creates alignment and demonstrates your intentionality around creating impact,” he says. “It goes far beyond just saying you are working towards an impact goal – that is very fungible.”

Yet devising a set of metrics that is both credible and quantifiable is not an easy task, even for a firm focusing on technology that reduces greenhouse gas emissions. “Initially, we wanted to include pollution and we looked at whether we could design a matrix that included both pollution and CO2 reduction,” Tveit says. “But we concluded that we needed clarity and specificity around what we were seeking to achieve. There is a straightforward scientific basis for measuring CO2; there isn’t for pollution.”

The firm has opted for a carry-at-risk structure with targets that consider CO2 avoided but also how much portfolio companies contribute to greenhouse gases. It has also opted to buy carbon credits with carry forfeited in the event the fund does not achieve its target. “We wanted to defuse the difference in incentives between LPs and GPs if we can’t achieve our targets,” explains Tveit. “This way, LPs still get the same financially, while also achieving an impact on their net-zero goals.”

Alternative view

Palatine Private Equity has opted for a different route for its impact fund. It donates 10 percent of carry earned from the fund to a charitable foundation – an arrangement the firm expects to continue for subsequent funds, says partner Beth Houghton. “There’s a lot of complexity around setting targets for our portfolio,” she says. “We recognise that we are still learning how to set them, so they are stretching but also realistic. We don’t want to be setting soft targets – we want to really drive impact performance.”

The firm takes the view that the consequence of not achieving impact and returns is already built into the private equity model. “If investors are not happy with our performance on impact or financially, we won’t raise our next fund,” says Houghton. “That is a far bigger financial penalty than forgoing a percentage of carried interest – especially when not all funds reach carry anyway.”

However, she is watching developments with curiosity: “We may never know what happens since carry is not publicly announced. But it would be interesting to see if funds implementing this always hit their targets.”