In our most recent discussion with Lara Viada, Investment Director at Creas, and Cyril Gouiffès, Head of Social Impact Investments at the European Investment Fund, we unpacked the role of financial remuneration of fund managers in the fund’s value creation. Traditional for profit investing has an embedded incentive for fund managers to optimise the fund’s goal to create positive financial returns – as their very own compensation is linked to the fund’s returns. Impact investing however does not share the same inherent financial goal, but aims at the creation of sustained societal impact (next to certain financial targets). The question that arises is how to tie financial compensation of impact fund managers to impact outcomes.
Creating a financial incentive in impact investing aids in prioritising social impact in fund management, in other words, putting impact first in fund decisions, according to Lara Viada. Once impact is the main focus it creates accountability and alignment of incentives between LPs (Limited Partners) and fund managers that allows for the creation of rigorous impact frameworks. Accountability is improved as outcomes are then being measured and continuously monitored against predetermined goals. A clear set of impact goals ensures that fund managers and investees work towards the same outcomes. Moreover, adequate incentives encourage feedback and learnings as firms are able to learn from one another. Similar to for profit investing which aims to maximise financial returns, real impact is then able to be efficiently maximised.
As measuring and monitoring the social impact of investees is an instrumental step that can be interpreted subjectively, an independent supervisory committee is essential. Fund managers along with each portfolio company select between one and five indicators which the supervisory committee then needs to approve. The committee, usually composed of the main investors, ultimately signs off on the impact indicators and targets that the fund manager is required to monitor for its portfolio companies during the holding period. This methodology and governance offers reassurance to fund managers and investors alike while providing space for continuous feedback. The supervisory committee in essence removes the subjectivity and ambiguity of incentives that the fund managers would face in case the target setting was up to them.
The process of tying compensation to funds’ impact performance requires a concrete impact plan. The impact plan includes a well-defined theory of change and a set of scale and outcome indicators suited to track progress. Scale indicators, represented on a definite scale, are set alongside outcome indicators to calculate the percentage level of achievement called the social impact multiple. Indicators may get a specific weight in the consolidated social impact multiple to reflect the different importance of the outcomes. Due to the nature of scale and outcome indicators, a good mix of both is required to create the right incentives.
The way to account for social impact has been challenged ever since, however, the principle of tying financial compensation to impact isn’t rare anymore. Currently there are more than 40 funds across Europe, supported by the EIB, aimed at creating social or environmental change that are implementing a similar methodology.
Finally, it goes without saying that before considering the idea of linking compensation to impact, a proper and well-defined impact measurement strategy needs to be in place that leads to measurable indicators. More social investments do not necessarily equate to increased impact – the idea of measuring impact in a tangible manner is often overlooked. Far and foremost, its purpose for investors is to be able to incorporate social impact into investment decisions and support entrepreneurs to maximize the additionality of their work rather than representing yet another reporting tool. It is clear that creating a tangible Theory of Change and setting relevant impact indicators is an absolute necessity to tie fund manager’s compensation to impact.