In a private equity and venture capital context, carried interest is a share of a fund's profits that a fund manager is entitled to receive, as incentivisation for generating profits for the fund.
Impact-linked carried interest involves tying fund manager incentivisation, at least in part, to ESG-related impact performance.
We continue to see interest among international institutional investors such as sovereign wealth funds, pension funds and government-linked institutions to invest responsibly and integrate ESG into their investment strategies. From a fund manager's perspective, the implementation of impact-linked carried interest can be adopted as a method by which they can demonstrate to investors a commitment to achieving positive measurable ESG-related outcomes.
How is ESG impact benchmarked?
Impact-linked carried interest can be benchmarked against the delivery of various impact outcomes by fund managers in respect of the funds they manage. Some examples include avoided carbon emissions measured in tonnes, targeted levels of investment into portfolio companies with diverse leadership structures, or into portfolio companies serving displaced or low-income communities (e.g. if a fund invests in the healthcare sector, then a target could be set against the number of patients within a low to medium income bracket provided with care). Benchmarking metrics can vary on a sector-by-sector basis, selected with the objective to support a fund's investment strategy whilst maintaining the objective of optimising financial returns.
What a distribution waterfall structure typically looks like
A basic example of how a private equity distribution waterfall works is set out below. Steps 3 and 4 refer to the carried interest share paid to the general partner or fund manager-related vehicle (FM Vehicle).
Examples of impact-linked carried interest models
Impact-linked carried interest arrangements would typically be set out in the limited partnership agreement, as well as the private placement memorandum of the fund (Fund Documentation). The arrangements could take the form of different models. Examples include:
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Forfeiture model – This model involves foregoing, deferring or ultimately forfeiting a certain impact-linked portion of the carried interest in the event agreed impact performance targets are not met. An escrow arrangement can be established to hold a portion of the carried interest made subject to release based on the achievement of the fund's impact targets. Clawback mechanisms can also be utilised to return amounts paid to the FM Vehicle to LPs at the appropriate juncture. If preferred and in alignment with stakeholder objectives, the amounts forfeited could be donated to independent charities or not-for-profit organisations contributing to ESG-related causes.
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Reward model – This model involves setting out in the Fund Documentation that the amount of carried interest to be received by the FM Vehicle (either at base level, or as additional carry) would vary depending on pre-defined ESG metrics achieved. As an example, in Step 4 of the diagram above, the 80:20 split could be subject to an adjustment to a 70:30 split in the event ESG targets are met, with a higher split allocated to the FM Vehicle for achieving those targets. The allocation could also be structured on a sliding scale, with the FM Vehicle receiving a pro-rated portion of the impact-linked carry depending on the level of targets met (e.g. 50% to the FM Vehicle if 50% of the set ESG targets are met), commensurably incentivising the fund manager to the extent of their impact contributions.
Conclusion
Irrespective of the preferred approach, the model adopted should be carefully considered and clearly documented in the Fund Documentation. Clear articulation of the definition of impact, and transparent monitoring of the nature and scale of impact achieved are recommended to ensure credibility and to prevent greenwashing. Fund managers should also consider any tax considerations that could arise with respect to carried interest and the structuring of those arrangements. Legal and regulatory considerations differ from jurisdiction from jurisdiction. For further information or assistance on this subject, please get in touch with the authors.
