Conference notebook: Sustainability-linked carry edges towards the mainstream

“We’ll have to keep watching this space, and see how we all push it forward,” said Abrielle Rosenthal, chief sustainability officer at TowerBrook, a private equity firm with an impact investing platform. She was wrapping up the final panel discussion at the Impact Investor Global Summit in London.

The panel topic was benchmarking: specifically, the long-standing issue of how to make ESG and impact performance comparable and consistent, so that managers can be assessed and compared, not just on their financial returns, but on their extra-financial impact as well. The conversation had moved onto the topic of linking managers’ compensation – specifically their carried interest allocation – to impact performance.

“I think we can all talk about how important this – the ability to compare – is,” said Clara Barby, senior partner at Just Climate. “But I wonder if this will ever really mainstream, if we don’t have it baked into incentive structures across the financial services industry.”

“At the moment it’s financial performance [benchmarks] that enable us to think about asset classes in certain ways, and say performance is ‘good’ or ‘bad’ and ultimately, therefore, can link to compensation,” continued Barby. “But until we do that with impact, I think it’s going to be really hard for this to be taken as seriously as it deserves to be taken.”

Barby then outlined the approach for Just Climate’s debut fund, which has 100 percent of its carry linked to an impact objective.

“This is just one step,” she continued. “I say it with humility: all of us need to be creative across the whole asset management industry about this. And I point to you guys [indicating fellow panelists from the California Public Employees Retirement System, Finnfund and Allianz Global Investors] and say: it’s asset owners that have to start asking for this, because the ripple effect will be enormous.”

Over the two days of the impact event, the topic of impact-linked compensation had been a recurring theme. On day one, L Catterton, a long-standing private equity firm with a newly launched impact strategy, had revealed to delegates that it had introduced an impact-linked carry element for its debut impact vehicle.

During a panel on innovations in fund structures, L Catterton partner Tehmina Haider described the process that led the firm to design and incorporate the mechanism. Alongside Haider was Pia Irell, impact partner at Trill Impact. Trill was established in 2019 and its €900 million debut fund has impact-linked carry.

Both Irell and Haider said that humility had been important in discussing the topic with limited partners. “In our fundraising, we called it a ‘pilot’,” said Irell. This was because when they were sketching the mechanism out, Trill only had one portfolio company. “So I wanted to wait until we had three portfolio companies and to understand, and to show investors how it could look in terms of target setting.” Trill uses a combination of ESG metrics – applied to all portfolio companies – and company-specific metrics relating to impact. The firm is now working out how to apply the same principle to its debut venture capital fund.

“We have also gone in with the humble position that there are things we are going to learn as we implement this, and we need to keep an open mind about that,” said Haider.

Both firms pointed to an ancillary benefit: that these mechanisms play well with target company management. “For the founders, the idea that there is compensation at stake to remain mission-aligned with them matters a lot,” said Haider.

From an investors’ point of view ESG- or impact-linked carried interest is “a great signal and a great accountability tool”, said Jonny Page, head of social and impact investment at the Esmée Fairbairn Foundation.

To have something that binds the manager to the impact mission over the long-term – to minimize the risk of “impact drift” – has value for Page, who is “very supportive” of carried interest-based impact incentives. He acknowledged, however, the difficulty in implementing it, choosing the right metrics in particular.

He described seeing quite a lot of carry-related proposals in GPs’ first pitch deck, only to find that “at first close signing, the complexities have won out: it’s not there anymore and often for very good reasons.”

While nice to have, impact-linked compensation is not the be-all-and-end-all, said Page: “The DNA of the fund manager matters infinitely more.”

Delilah Rothenberg, co-founding partner and executive director of the Predistribution Initiative, noted that the frameworks of metrics currently available to assess ESG and impact performance are “still very much under development,” which raises the question as to whether you can “holistically address both positive and negative impacts” when coming up with financial incentive mechanisms.

Rothenberg gave an unnamed example of an operator incentivized to install residential solar panels in Sub-Saharan Africa. The incentive structure pushed the operator to get as many households connected as possible to create the most impact. The unintended long-run consequence, however, was that the finance packages used led to a lot of households indebted and unable to pay.

Rotherberg pointed delegates to upcoming research from Oxford-based academic Aunnie Patton-Power looking at how impact-linked compensation is being put into practice. Verification firm BlueMark has also published research into the topic.

Much of the discussion around impact-linked compensation at the event centered on the experimental, early-stage nature of it; we are currently in version 1.0, with multiple iterations to come.

This was acknowledged by limited partner Allianz Global Investors. “We’re very supportive of any effort to try and progress towards impact-linked performance incentives,” said Diane Mak, AllianzGI’s director of impact measurement and management. “We will be open to discussion and adjustments of targets […] because we’re all still in the learning phase.”

Said TowerBrook’s Rosenthal in wrapping up the final panel: “I’ve been surprised how often this has come up over the past two days. This topic is really now reaching the mainstream and becoming imperative for the industry.”