Contracts with Benefits: The Implementation of Impact Investing

Impact investing has rapidly become a major force in both the public and private financial markets. In just a decade or so, it has grown both on the money-management side and on the entrepreneurial side from a niche to a sector with at least $35 billion in deals in 20181 and may be the vanguard of a broader movement to incorporate social concerns into for-profit economic activities.

Impact investing adds a new dimension to traditional contracting problems. The essence of impact investing is the service of two goals at once: financial return and social benefit. Impact investors provide capital; their agents—the funds—distribute capital, and social entrepreneurs deploy the capital. The parties bundle financial returns and social benefit goals in each step of the process and reduce their relationships to written contracts that address both goals. The terms of these contracts thus reveal tensions between the goals and mechanisms for resolving these tensions, as well as opportunities to cooperate.

We empirically analyze contracts struck by impact-oriented Private Equity (PE) and Venture Capital (VC) General Partners (“GPs”)—both forward to portfolio companies (“PCs”), and back to impact investors (“LPs”)—to determine whether and how impact contracts differ from traditional contracts in practice and theory. Our sample is a set of 216 legal documents pertaining to impact funds, representing 53 funds and 96 of their portfolio companies. These contracts include private placement memoranda (PPMs), limited partner agreements (LPAs), term sheets, letters of intent, and other legal documents governing the relationships between parties.

Our analysis identifies the impact-related content in contracts through two sets of comparisons. One comparison is between the impact funds in our sample and the non-impact funds whose contracts are analyzed elsewhere in the literature. This contrast shows how the industry handles the addition of impact goals to financial goals. The other comparison is between the funds within our sample, setting those targeting market returns, i.e. the market-rate-seeking (MRS) funds, against those aiming for lower financial returns, the non-market-rate-seeking (NMRS) funds. The MRS/NMRS contrast sheds light on contracting from another direction, using the cross-section of tradeoffs between financial and non-financial goals to relate terms to the intended intensity of impact.

To systematize and streamline these comparisons, we develop a scoring methodology that quantifies the strength of each contract along seven dimensions, such as impact, return protections, and different forms of governance. We also examine compensation terms for each fund.

In GP-LP contracts, we document both aspirational and operational impact terms—i.e., both terms that describe intended impact goals, and terms that incorporate these goals in an actionable way. Aspirational impact is unsurprisingly standard, but operational impact also proves to be widespread, manifesting for example as requirements that funds measure impact ex post and consider it ex ante during diligence.

Contracts with PCs can operationalize impact by giving the fund a veto on business-model deviations, and by requiring the PCs to identify, measure and report on their impact goals. Impact terms are less ubiquitous in GP-PC contracts than in GP-LP contracts, especially for PCs held by NMRS funds. At the same time, most funds have impact terms with at least one of their PCs, suggesting there is a choice when to use or skip impact terms with PCs. Finally, more operational impact terms in the GP-LP relationship correspond with more impact terms in contracts with PCs, indicating a flow-through of impact contracting.

Another way to encourage impact would be to pay for it, i.e. to tie compensation to impact outcomes, but we find little of this. Most impact funds tie compensation to financial performance with the usual waterfall compensation structure, including a catch-up period for GPs and carried interest – though we see alternative arrangements too, especially among NMRS funds. Building on models of multi-tasking (Holmstrom and Milgrom 1991), our observations are consistent with the idea that there should be less financial incentive compensation in impact funds than in non-impact funds, to prevent distraction from the impact task. At the same time, many impact funds still use traditional financial incentive compensation structures, and pairing strong rewards for dollars with weak rewards for impact seems at odds with the existing theory. Impact-focused contract terms—both direct terms (e,g.,  operational impact) and indirect terms (e.g., enhanced governance)—may help reconcile this pattern with the theory and suggest new explanations unique to impact.

Finally, we observe particularly high participatory governance, e.g., monitoring, information rights, and other collaborative supports, in impact funds. Almost all impact funds in our sample have LP advisory committees, and these seem to play meaningful roles, like advising on investment strategy, due diligence, and conflicts of interest. At the PC level, we observe an emphasis on contracting for board seats and on information rights. The prominence of these terms is consistent with theory advanced by Gilson, Sabel and Scott (2010), that in rapidly developing environments participation and communication play a critical role in solving the incomplete contracting problem.

The effect of impact goals on traditional contracts sheds light not only on how contracting parties address the problem of the multi-tasking agent, but also on the benefits and costs of creating enforceable rights and incentives through contracts (Bolton and Dewatripont 2005); on the value added by ‘rigid’ versus ‘flexible’ contracts when the nature of the task is uncertain, as could be the case with impact (Hart and Moore 2008); and on the general question of addressing agency problems with incomplete contracts (Grossman and Hart 1986; Hart and Moore 1990).


2018 Global Impact Investor Network (GIIN) Report, available at https://thegiin.org/assets/2018_GIIN_Annual_Impact_Investor_Survey_webfile.pdf.

Download the complete
article PDF

Comments

There are no comments for this entry yet. Be the first to add your thoughts!

Add Your Comment