Five things to look for in impact investment managers

By Oliver Rochman, William Yonge, Carl Valenstein and Zeke Johnson, Divya Thakur, partners, Morgan Lewis

Impact investing is a fast-growing movement seeking to channel capital and expertise to companies trying to solve some of the most urgent issues facing society. Impact managers will, in broad terms, be expected to target a financial return alongside measurable, beneficial social and/or environmental outcomes.

Impact investing is not the same as an ESG strategy, nor is it the same as sustainable investing – though there may be significant overlap across these investment criteria.

Here are some key considerations when assessing impact managers:

• Do they have clear outcomes?

“Impact” is perhaps necessarily vague, however, impact managers will need to be clear about their intended outcomes. Clarity is important in relation to what the impact manager is doing and as importantly what they are not doing. As with ESG strategies, managers may find that a focus on certain areas of impact throws up issues in relation to others. Financial inclusion may lead to conflict with carbon reduction. Gender diversity may not correlate to ethnic diversity.

Clarity is key in relation to the intended societal benefits and how they will be measured. Considerations of any negative impact should be included to try to establish the intended net positive impact of the strategy and mitigate negative impact. The name and description of a fund will have regulatory implications and may open managers to litigation risk.

• How do they report?

Impact reporting has yet to be standardised and codified. Impact managers will need to settle on a preferred form. However, they can expect that certain investors will have their own form of reporting or require certain specific data be included in the fund’s reports – often through the side letter process. This can be an expensive exercise especially if the required reporting varies significantly. As early as possible in the process, managers should identify their preferred reporting format and be prepared to discuss with investors the reporting appropriate to the fund’s strategy.

Managers should be sure of the reporting requirements mandated by applicable regulations. We expect regulators to impose more standardised reporting regimes for impact metrics. This is ultimately beneficial to the impact community, however, in the meantime managers should take part in the policy debates and consultations to ensure that their views are incorporated into the development of reporting regimes.

• Are they up to speed with regulation?

As impact investing attracts more investors it is increasingly attracting the attention of regulators. In relation to ESG strategies and sustainable investing, regulators are reacting to protect investors on issues such as “greenwashing”. Initiatives such as the SEC’s Climate and ESG Task Force in their Division of Enforcement, the EU’s Sustainable Finance Disclosure Regulation and UK Financial Conduct Authority’s consultation on Sustainability Disclosure Requirements are all major steps in regulating the classification of funds and the marketing materials of impact managers.

Impact managers will need to analyse if their strategy and the representations they make in respect of that strategy, even the name of their fund, fall within any of the regulations applicable to the manager and the fund. This can have an important, early effect, for example in relation to the applicable disclosure and transparency requirements. For managers of multi-jurisdictional funds care must be taken as the fund may fall within multiple and possibly divergent, regulatory regimes.

• Can they back up their claims?

Some investors have been focused on impact for years, others are relatively new to the sector. Managers must be prepared to explain their impact strategy and how each proposed investment is intended to achieve the desired impact and the effect on the anticipated financial returns of the fund. For funds with a financial return and relatively flexible impact parameters, not all investments will obviously fit within every investor’s idea of impact. Managers may need to set aside more time to discuss investment proposals with their limited partners and in some cases educate investors as to the impact potential of certain investments.

Getting this right is important, increasingly private investors and activist funds are willing to litigate on a perceived failure to meet a manager’s impact claims.

• Get the right structure

Impact funds come in a wide variety of structures and constitutional terms. Impact managers will need to assess the market and be clear as to where they wish to land in constructing their investment parameters and their financial compensation. This can vary from a fund compensation method with an annual management fee calculated as a percentage of commitments and a “carried interest” share of profits combined with a high-level impact overlay to a capped compensation model or even a not-for-profit model with detailed prescriptive investment criteria.