4.4 How to Evaluate Impact Investing Fund Managers¹¹

Institutional impact investing¹² in start-up and growth companies was inspired by the venture capital (VC) model, in which two criteria are key for fundraising: first, a risk-adjusted target return based on a distinct investment strategy; and second, the track record of the fund manager’s team. To successfully raise capital, the management teams develop fund strategies based on assumptions about distinct venture developments, their risk profiles and exit opportunities.

Not surprisingly, impact investment fund managers focus their fundraising efforts on articulating a strategy that leads to an expected return, both financially and socially; and, on emphasizing fund management’s experience in relevant areas of social impact and/or fund management’s financial performance.

However, given the early stage of the impact investing sector, such focus on the fund’s target returns and the management team’s track record may hold the industry back. First, it is difficult to know whether sustainable positive social or environmental impact has been achieved due to the longer time horizon needed to effect social change, and the lack of standards for measuring and benchmarking non-financial impact. Second, past experience of most impact investing professionals lies either in the traditional investing or philanthropic sector and, therefore, is a poor indicator of a fund’s future both impact and financial performance.

While it ultimately matters whether a fund reaches its impact and financial targets, until this can be properly evaluated, asset owners and investment advisers should focus on understanding the internal workings of an impact investment fund when conducting due diligence. In particular, the following key factors that determine impact investment fund managers’ decision-making could be analysed: 

1. People: How are decisions made and by whom?
2. Mission: How does the fund manager combine impact and finance?
3. Business model: How does the fund finance its operations?
4. Practised governance: How is the fund organization actually governed? 

1. People: How Are Decisions Made and by Whom?

As with other investment funds, impact investors are involved in three major types of activities and decisions: forming a fund investment strategy, raising capital and investing. To complete these activities, fund management organizations typically include an investment committee (IC) or board, managing partners, investment managers and other personnel such as sector experts, associates and assistants. 

Being in a nascent sector, few people can claim to be long-term, experienced impact investing experts. Board members, managing partners and investment managers may come from investment banking, venture capital, asset management, strategy consulting, development organizations, philanthropy or development work. These professionals make decisions based on how they were educated and socialized. If not managed carefully, such diversity in backgrounds can lead to unintended outcomes based on unconsciously diverging beliefs. Ideally, assumptions should be openly addressed to use diversity as a source of innovation rather than as an internal lack of clarity. 

For those funds that separate the final investment decision from the preparation of the decision, potential investment opportunities undergo a due-diligence process and are then presented to the IC in a written document distributed in advance, as a presentation at the IC meeting or on a conference call, with a subsequent follow-up discussion. While intended to be an objective decision process in which the final decision-makers have no ties to the entrepreneurial ventures, the relationship and reputation between the deal’s presenter and those evaluating it have an impact on the decision. To understand past decisions or to assume future ones, asset holders might consider the following: 

• What are the experience profiles of those presenting deals and of the IC? 
• How many deals are declined, and at which stage of the investment process does this happen?
• Which investment managers have been more or less successful in convincing the IC?

As the sector is still prototyping new approaches, impact investors should share how decisions are made flexibly, rather than overemphasizing a strategy that leads to predefined outcomes. Likewise, asset owners and advisers should appreciate, as a sign of agility and transparency, when a fund manager answers their questions honestly, as in “we will decide depending on how the sector develops”, rather than perceiving such answers as a lack of experience and focus. 

2. Mission: How Does the Fund Manager Combine Impact and Finance?

Impact investors may need to make decisions that trade off greater impact against financial returns. For example, an impact enterprise can reinvest its profits into scaling its impact, or cross-subsidize lower profit areas and forgo offering its investors an early or higher pay-out in the short term. 

Asset owners should evaluate impact investment fund management organizations based on their ability to foster productive debate between the two (or three) camps of managing for double or triple bottom lines. Here it is useful to ask the following questions: 

• Does the fund organization equally employ champions for financial performance and for societal impact?
• Do the fund managers maintain dialogue between financial and social impact experts?
• Does the fund organization encourage team members to contribute to shaping the fund’s focus while preventing mission drift? 

Decision-making is likely to be a collective process in which the individual managers and the key (financial) stakeholders influence not only the outcome, but also the organization’s shared intent as codified in the mission statement and as realized in the organization’s core practices. Here, Jed Emerson and Sarah Williams of ImpactAssets offer useful guidance by calling for analysis of the impact investment fund’s intent and practices¹³. How fund managers understand and translate the mission statement into practice is important. The following questions can help ensure a consistent, coherent and meaningful decision-making process: 

• Are the fund’s impact targets as clear as the intended rate of financial return? 
• Do the managers investigate impact performance as regularly and rigorously as they check the financial performance of their portfolio companies? Do they take into account that impact performance needs to be contextualized as opposed to evaluated using quantitative metrics only?
• Are portfolio metrics (other than individual company metrics) in place? 
• Is the investment process an iteration between financial and impact due diligence, or are both dimensions evaluated simultaneously? 
• Does the fund hire separate specialists for finance and impact, or are they expected to master both? 

3. Business Model: How Does the Fund Finance its Operations? 

Asset owners should analyse the nature of a fund’s investor base to understand the manager’s decision-making process behind the investing style and outcomes. For example, Acumen Fund, the impact investing pioneer, targets foundations and philanthropists as primary limited partners (LPs), whereas the specialist fund manager, Bridges Ventures, raises capital from institutional investors that require a financial return. Similarly, if one wealthy individual is the main investor in a fund and also covers most of the operational expenditures, that individual’s opinion about a potential portfolio company’s social impact may be more relevant than other decision points along the well-structured investment process. 

Another critical factor affecting a fund’s investing style is the strength of investor influence, which is determined by the ratio of operational budget to funds invested, and may also be a proxy for the fund’s efficiency. As a rule of thumb, the more that revenue comes from the actual investment activity, the stronger the pressure will be on efficient decision-making, larger deal sizes and lower risk profiles. By contrast, donation-based impact investors may not reach a comparable financial sustainability and scale to those applying a stand-alone business model. However, impact investors financed by donations and corporate and public sponsorships may have more space for innovative approaches, trial and error, sector development activities, pre-seed deals, highly contextualized impact analyses and investments in regions where purely commercial funds would not be able to get involved.

Therefore, understanding the source of revenue for the manager’s operating budget is essential. The revenue source for a mainstream VC fund is the management fee (usually 2% of committed capital) and carried interest (usually 20%). In impact investing, “carry”, which is the exception rather than the norm (e.g. Bridges Ventures), and the management fee are not the only sources of income. Some fund managers’ operational expenditures are primarily covered by grants (e.g. Acumen Fund), some are linked to a corporate or institutional parent (e.g.LGT Venture Philanthropy), and some may be initiated as an investment into a new business line (e.g., responsAbility). Some fund managers generate revenues from private wealth advisory mandates; others accept grants from public funders for technical assistance, advisory and coaching of ventures; and some pursue revenues from investment activity alone, i.e. management fee and potential upside in case of exits (e.g. Bamboo Finance, Social Venture Fund). While they bring the mainstreaming of impact investing ever closer, few regions and sectors today allow for purely commercial impact investments in start-up and growth companies. A large number of impactful ventures fall through their due diligence processes.

4. Practised Governance: How Is the Fund Organization Actually Governed?

Understanding fund governance must go beyond the fund’s mere ownership structure; it needs to include analysis of factors such as the performance incentives for fund managers, distribution of expertise within the fund manager, and the fund’s organizational structure. 

Larger impact investment fund managers may have teams distributed across the globe, with regional offices responsible for deal screening, negotiations and post-investment support of portfolio companies. Some impact investment funds have strongly independent regional teams, whereas other funds tend to centralize main decision-making at the fund manager’s headquarters. The degree of decision-making distribution across the globe affects a fund’s activities. Strong regional-team independence is conducive to adapting a fund’s strategy to the local context. While this may help fund managers to align with local realities, it is harder to adhere to one coherent, global fund strategy that can be communicated to asset owners looking to invest in a fund.

Incentives can translate intended governance into behaviour. In mainstream VC, a carried interest financially aligns fund managers’ goals to investors’ goals. A carried interest in impact investing must be well designed to avert prioritizing financial over social impact goals. For mission-oriented talent that tends to gravitate towards impact rather than mainstream investing, non-financial incentives such as a sense of ownership, independence in decision-making and clear understanding of a fund’s social purpose may become more relevant than financial incentive structures.

Asset holders and entrepreneurs should ask about the governance practices in place; how people are incentivized; and how governance has actually worked in past strategy and operational changes. Key questions may be: 

• How much independence do local investment teams enjoy?
• How do local investment teams and individuals respond to strategic changes?
• Does the fund have a carried interest? If so, does it include impact targets?

Conclusion

Asset owners and stakeholders of impact investing funds should know the backgrounds of people involved in a fund management organization, how revenues are generated, the organization’s purpose and how governance is actually practised. By presenting some new perspectives and emphasizing intuitive thoughts, this article is meant to contribute to mitigating a few pitfalls of the emerging impact investing sector. Fund managers should be allowed to prototype and pilot their approaches, stay humble with expectations for returns, and reach out to mainstream investors, rather than emphasizing novelty.