Aligning carried interest with impact: Understanding the ‘how’ and what’s next

Author: Arvind Agarwal, Founder & CEO - C4D Partners

Publication: Times of India

The coalition of philanthropists and investors has led to the advent of impact investing in the venture capital sector. The practice of impact investments seeks to create environmental and social benefits alongside financial returns, which other business models cannot capitalise on. According to recent market data, India has a high potential of mobilising $8.2 trillion of retail wealth towards ESG objectives by 2030 if certain barriers are removed.

While there has been a surge in impact investments in India, the business has also encountered various growing pains. The longer time horizon needed to effect social change, and the lack of standards for measuring the impact, have held the industry back in determining whether a sustainable social or environmental impact has been achieved or not. In addition, the expertise of impact investing professionals lies either in traditional investing or philanthropic sector. This has been a proven challenge for the industry because it leads to Impact Funds following the same structure as that of either a VC fund or a not-for-profit, and consequently achieving the same outcome as a VC fund or a not-for-profit.

Furthermore, despite its unprecedented growth rate, the impact investing industry is yet to become a mainstream investment option. For this, industry stakeholders need to come up with new standards of impact measurement. Momentum is gathering behind this movement and it will gradually discover its way.

In this process, one of the important areas that the stakeholders need to explore are ideas to design carry schemes that link the carried interest or incentives to impact or ESG targets.

Carried interest is a staple of the PE (Private Equity) or VC (Venture Capital) firms. It is a critical component in aligning interest in equity partnerships to ensure the profits are distributed equally and provide the highest possible returns to the beneficiaries. When properly calibrated, it has the potential to be an emerging trend in the impact investing sector.

Having said that, any alignment in the carry and impact operates as a penalty or bonus that puts the GP in a position of ‘carry at risk’. Another big structural challenge in an impact fund is that the manager’s incentive is only tied to the financial return they can generate. Neither the portfolio companies nor the fund manager is incentivised for the impact created on-ground which requires robust operational expertise.

Alignment of interest

As part of the broader economic model, the carried interest should be aligned with the interest of LPs by encouraging GPs to create a balance between the financial returns and the impact objectives of the fund. This can be accomplished by emphasising on target setting that can resolve the issues around alignment. Designing a robust target achievement process can remove the challenges for LPs and enable them to further capitalise on incentives to go above and beyond to exceed the pre-defined impact targets. Additionally, the alignment of carry to impact can acquire a further boost by identifying the correct KPIs for the environment and social outcomes that are presently leading to distortions and greenwashing.

Considering this, the pressing need of the hour is to align the carried interest with the key impact objective of the fund. Presently, the measurement frameworks in impact investing are not sophisticated. To up the game, the next step should be to link to carry with a few other measurable key impact objectives, even if it means that the investors will have to allocate a portion of the funding for an independent audit of the fund. This initiative needs to come from the top. Impact LPs should put a cost to their funding which should be a commitment to such impact objectives.

Bottom line

Albeit from a low base, the size of the impact funds and the sector is clearly growing at a fast pace. Definitive progress needs to be made in standardizing the linkage of carry to impact objectives, providing adequate transparency to investors and the public. Gaining true comforts around impact incentives can further unlock the exponential potential of the impact investing sector, and correspondingly benefit all parties associated with the fund.