Transforming impact funds: 3 reasons to link compensation with impact

Amid the scourge of various social and environmental challenges, impact funds have emerged as a powerful tool to drive positive change. However, with their growing popularity, distinguishing genuine efforts from mere marketing has become increasingly difficult. This is where impact-linked compensation steps in, helping impact fund managers turn their intentions into measurable outcomes and align their interests with the interests of their fund stakeholders.

Originally, impact investments were envisioned as catalysts for change. Today, however, we observe an increasing number of impact funds created by mainstream financial service providers. The once niche concept is now big business: large funds, prominent in conferences and heavily marketed.

With this rapid growth, investors face the challenge of differentiating PR stunts from real commitments to positive impact. Enter the rising concept of impact-linked compensation. Current research shows that this concept is gaining traction and my personal prediction (and hope) is that it will become the industry standard within five years.

Impact fund managers should see this as an excellent opportunity to; transform their stated intentions into tangible results; align their interests with their fund stakeholders, particularly their limited partners; and contribute to the growth of the still-young impact investing sector through greater accountability.

Let’s dive deeper. Impact investors are united by intentionality: the explicit pursuit of creating a positive, measurable impact for society or the environment next to a financial return. Such intentionality is a critical element of impact investment and must also be clearly and transparently stipulated in the prospectus of an impact vehicle.

Impact investors want to contribute proactively to positive solutions for our planet and society. Thus, implementing impact-linked compensation should come naturally to an impact fund manager; it helps fund managers turn their committed impact into reality.

One common approach to impact-linked compensation is to base the fund managers’ performance bonuses (carry) on how well they achieve positive impact outcomes. This practice helps distinguish “impact by accident” from “impact by design” and demonstrates a general partner’s (who manages the fund) impact intention.

Linking a fund’s performance fee to positive impact outcomes also shows a long-term commitment to limited partners (investors). Plus, it helps fund managers stay focused on achieving impact over time and prevents them from “mission drift” i.e. straying from their intended social and environmental goals in favour of traditional financial returns.

Investment teams in impact funds must balance risk, return and impact. However, many impact fund managers still use the same compensation models as traditional funds, focusing only on maximizing financial returns. This approach is becoming outdated.

In the near future, investors who share the same values will start demanding compensation tied to achieving a positive impact. Fund managers will also see that linking performance fees to impact is a powerful way to motivate their partners and team members who share in the profits.

The third key reason impact-linked compensation will thrive is that it promotes growth in the impact-investing sector with greater accountability. This is especially crucial in today’s environment, where “impact washing” is widespread.

Looking ahead, I believe that impact fund managers will increasingly adopt impact-linked compensation. It will allow them to prove their commitment to creating significant social and environmental change. This approach will also enhance their accountability and integrity, making it easier for investors to trust their intentions and make informed decisions.

Most importantly, by adopting this model, impact investors can set a strong example for the industry. The increased transparency and alignment of interests will lay a solid foundation for the responsible growth of the impact investing sector.

When designing and implementing impact-linked compensation mechanisms, these incentive structures should align with the fund’s overall strategy, impact objectives and operations. There is no one-size-fits-all solution.

A clear methodology for integrating impact-linked compensation into a fund structure is essential, but it should be approached with a learning mindset. Flexibility is necessary, as fund managers may need to adapt the approach over time. Internal solid governance is crucial to ensure that non-financial metrics are used ethically and effectively, preventing potential misuse.

Embedding impact into fund managers’ incentive structures will strengthen accountability between general partners, limited partners, and entrepreneurs. This increased accountability among key stakeholders will support the responsible growth of the still-young but rapidly expanding impact investing sector, ensuring it scales with integrity.