A series of dynamic conversations hosted by Simon Witney, sustainable finance specialist, joined by two expert guests.  

Simon's guests, Ross Butler, Managing Director of Linear B Group, and Tosin Adeyeri, Partner in our Funds team, debate opposing answers to this topical question. Listen now to learn what ESG-linked carried interest means and how it works, plus the pros and cons of incorporating non-financial KPIs into fund economics from their frontline perspective.

The episode ends with a one-sentence answer from each expert guest to… Should your next fund include and ESG or perhaps impacts linked carried interest?

Hello, I'm Simon Witney. Welcome to the second episode in Travers Smith's podcast series that we're calling Sustainability Exchange. In this series, we address some simple, topical questions for an audience primarily interested in sustainability in the private markets. In today's episode, we're posing the question should your next fund include an ESG linked carried interest? I'm delighted to be joined by two experts.

We're going to help me to shed some light on that question. Ross Butler, managing director of linear B, and a colleague of mine from Travers Smith, Towson at the Arie. Hello. Welcome, both of you.

Hello.

Thank you.

First, a quick introductions. Towson is a partner in the Travers Smith Private Funds team. She advises fund managers on a range of issues, including establishment and structuring of private equity in venture capital funds, internal governance, and ongoing fund maintenance. Towson practice includes advising on secondary transactions and GP LEDs, as well as representing global investors on their investments into private investment funds.

Ross is a communications, compliance and governance consultant to private capital firms. He's managing director at Linear B Group, a UK based marketing agency and host of the excellent fund Track Private Capital podcast, now available, I think, on Substack. Do check that out. We'll put a link in the show notes. Ross was director of communications at EVGA. Now, of course, Invest Europe from 2009 until 2011.

Editor of Real Deals. Before that, relevantly, he worked with I.F. and others on a booklet called impact, Accountability and Venture Capital, which Ross might say a few words about later. But first, as we do on this podcast, I want to start with a one word that means yes or no. Answer to this question from each of you, please.

Should your next fund include an ESG linked carried interest? Ross.

No.

I hate to caveat this. Simon. And, maybe that's the lawyer in me. I would say perhaps yes. And that would be the gold standard.

Okay, good. So we've got some measure of disagreement, without two guests, which is always more interesting. But first I just step back and, and give a little bit of context before we dive into the reasons, for the views we've just heard. So I should first explain what I mean when I say ESG linked carried interest.

And actually what I'm talking about is carried interest mechanisms that are in some way linked to non-financial outcomes as well as to financial ones. In other words, there are some KPIs, some key performance indicators that have an effect on whether carried interest is triggered, and perhaps then on how much carried interest is actually paid. These KPIs might be related in some way to value creation.

You might think that focusing the GP's attention on these issues will help the fund to deliver better returns, or they might not. You might just want to focus the GP's attention on these things because you think they're important in and of themselves, whether or not they enhance returns or reduce risk. So there could be two motivations for including these KPIs as a trigger point for carry in an impact fund, where generation of positive environmental or social outcomes is regarded as important in and of itself, achieving the impact goals might be important irrespective of whether they enhance risk adjusted returns.

In fact, you might even want to achieve those KPIs if they dilute, financial outcomes. But in a more mainstream fund where financial returns are the primary goal, maybe the only go, you might want to focus that GP's attention on certain issues because you believe that they will deliver better value, for your investors. Towson. First, maybe you could explain a little bit how we see these mechanisms typically working.

How would such a carried interest operate in the context of a private equity or venture capital fund?

Sure. Thank you. Simon. Well, the details can of course, vary from fund to fund. In a majority of cases, what we see is that the total carry a sponsor is eligible for is first calculated on a financial basis. And you run through the waterfall in a typical way. And then after that, the impact performance is considered, which means that a penalty would apply to a sponsor's carry percentage if it does not achieve its impact.

KPIs. Therefore, the sponsor keeps its carry if it meets its impact objectives and forfeits a portion of its carry if it's failed to do so. What we see is that the GP's put anywhere between 10% to 100% of their carry on the line, although as you would expect, the latter would be would not be the norm.

Typically speaking, in the kind of market range is between 20 to 30%. There is also the possibility to prorate impacts performance with the size of the penalty. So for example, if you hit 50% of your impact performance, you should then be able to keep 50% of the carry. That is contingent on such performance. Where carry is forfeited, its may be donated to charity related to an impact mission or distributed to investors.

For completeness, I should add that impact linked carry is not limited to sponsors that are impact focused. There are a handful of managers in the markets that I've tied that carry to ESG related outcomes, and therefore improvements in their underlying, portfolio companies from an ESG perspective.

Thank you. Tosin and Ross, I mentioned earlier, you were involved in, producing a guide to ESG linked carried interest in the context of the kind of BEF approach, if I could call it that. Maybe you could just describe a little bit how that works. I think that's a little bit different in some respects to, to to to other models that we see in the market.

It's very much impact focused. And there's a paper online called an impact accountability in venture Capital. So I partnered with my coauthor, Karen Wilson, who's, a well known impact academic and a group of venture capital and impact investors. And the purpose of this is that the IIF has a, a a requirement for the funds that take their money to account for impact.

And the model is called the gamma model. It's been running for quite some time. It applies not only to impact investors but impact driven investors. So it's the mainstream venture capital world as well. And the mission of the paper really was to try and find the the commonalities in the application of that model, because it's not really written down anywhere.

There's no rulebook or guide. And in the main part is very similar to what Tosin just outlined. But it's not ESG, it is impact. And so, there are there are differences. And so I could run through maybe the how you go about that. So the goal of the gamma model is to validate the theory of change.

The theory of change, is it's a strange word. Although if you're in the impact industry, you'll know you'll be very familiar with it. But really, what I think it means is it's something like the mission of the company. And, and so the idea is that you identify ex-ante what that theory of changes, and then you set up a system whereby you can measure the success of achieving that goals and then, be rewarded based on that achievement in the way that chosen, chosen, outlined.

It's it's rife with complexities. It's at an extremely early stage. We did find some consensus among the the investors on the working group as to how to do this, but I would say we raised probably more questions than we did find answers.

I see. So so there's a percentage of the carried interest that's responsive to these impact related metrics.

Yeah. So it's it's a portion of the carried interest. And so there are three dimensions that you have to consider. There's the innovation dimension. There's the outreach dimension. There's a scale dimension. And they map fairly neatly on to the stage at which you're investing. And so if you're a very early stage company, you might, be judged based on, how well, in theory, your innovation works, even if it never actually makes contact with the market.

And so you could, achieve your impact goals, even if it's not validated in a financial way. And that's why impact is a slightly confusing term, because you might not actually have any impact in the real world. And you may still achieve your impact targets. And so we think of it more as being this more impact driven, demonstrating your purpose.

As you say, you're trying to incentivize people to, to to engage in the behaviors that you want them to engage in. You're not so much focused on whether they achieve their objective, but whether they do their best to try and achieve the objectives that that they're incentivized to, to create innovation, even if that innovation ends up not succeeding.

Yeah, exactly. If I was to really strip it back, what I would say it's trying to do is to ensure that people who take fund managers, who take public money, the way they make money is additive. So it's not zero sum, it's not asset stripping, it's not leverage. If they make their money in that way, then they're not really impact investors or even venture capital investors at all.

And therefore they don't merit the the reward that accrues to that. So that's the idea. But of course the devil's in the detail, because how can you ensure that what they're doing is additive. And and that's why they have to come up with all the, all the metrics. And that's where the complexity starts. Because then you move from the objective world of is it going to make a profit to the subject of world of what do we consider of value aside from profit?

What's a good target? How do we measure it and who judges us on it?

And is it that complexity that meant you answered no to my initial question? Because everything you've said so far for a kind of responsible investor seems to me to make perfect sense. You want to motivate your, invest funds, your GP's, to engage in the kinds of behaviors that any kind of responsible investor would want them to engage in.

So everything you've said so far seems like, a great idea, but but now you're coming on to talk about the complexity, and I'm wondering if that's why you you said no when I asked you whether, ESG linked carried interest was, was the right approach.

Well, I think the problem with the responsible investment industry, per se, is that it tends to jump to, the technicals and what sounds good and doesn't stand back and think, actually, what justification do we have that this is going to work because when you intervene or innovate in a complex system, the rule is it's not going to work.

You know, and I think it's incumbent upon the people that come up with these schemes, the innovators, the inventors and the advocates to explain not just why it would be a nice thing if it's going to work, but precisely why they think it's going to work and they really never do. And so the job of.

Theory of change in a way.

Right, exactly. And so, my job becomes harder because now I have to reverse engineer what might not make sense. But, I mean, I can give you the the thousand feet view perspective, which is some I mean, I think this will the whole responsible investment industry comes out of the idea that, I think, you know, profit isn't a perfect, proxy for social good.

And, but it also comes from a kind of a, a perception that free markets are man made and that we can replace profit with something else. It's just one of many ways in which we can organize our economic affairs. The problem with that is that free markets aren't manmade. They're just they're just like the summation of all voluntary exchange.

And the profit can't just be. Profit is basically like the manifestation of value itself. It's it's not exact. It's not perfect, but that's what it is. And so if you're going to even partially replace profit with something else, you've got to be very, very clear. You know what that something else is to begin with. That's just to begin with.

And I know not many of your listeners will like this, but I've never, for example, heard a definition of ESG, not in 15 years that is even internally coherent, not when you really dig down. And so I think that's that's a big problem and that's the foundation stone. And then there's but there's problems. I think fundamental problems at every level of analysis because the deeper you go, the more complex it sounds.

People think, oh, this, this is sound serious. Now this is good. This is accountability. But actually all you're doing is introducing subjective ity at every level. And when you're dealing with incentives, that is the last thing you want to do.

Because the beautiful thing about a financially driven, carried interest is that there is no subjectivity involved. It's you're dealing with a profit of 102. You split it 2080. Nobody can. I mean, you could disagree about how much the profit is, I suppose, but you can certainly get some, relatively objective verification of, of the number and split it according to a predefined percentage.

Whereas what you're saying, I think, is that once you start introducing these KPIs and there is subjective judgment at all stage in terms of which KPIs you pick and how you measure them and and evaluate.

Them and what scale you apply to the actual carry. Yeah, this is rife with subjectivity, but I also go back to a slight issue with how you couched this in the in your introduction, because you said something like, you know, the distinction between profit and social good, and it could even sometimes be divorced. I would say that profit is the best proxy we have for social good, and we just recognize that it's it's imperfect, but to think that we know better than profit is, is a huge presumption.

And I'm not saying that we shouldn't try and go beyond it, but we should try to do so in all humility.

I and I mean, perhaps for my perspective, just on the, subjective point, it's the way in which that's mitigated when we come on to it in a moment that, would properly address some of those concerns, i.e., what processes are put in place to ensure that, the metrics or the KPIs that are being set by sponsors have been well considered and going back to some points that you made on the financial incentive, perhaps that's table stakes for what we're talking about here.

When you think about the private equity model and you know what sponsors ought to be driven by, it's the financial incentive that's derived from it. But to your point around properly implementing that, when you're thinking about the, kind of non-financial outcomes that are being set is maybe taking into consideration also the qualitative data behind it and assessing the behaviors that are driving sponsors is ability to be able to achieve the non-financial outcomes that they all set out to achieve.

So are you incorporating it into your or how are you incorporated into your governance structure? For example, how are you incorporating those outcomes into or the ability to achieve them into your investment processes? How are you incorporate into your fund strategy so it goes, therefore beyond the quantitative and extends to a little bit more of a qualitative analysis of what you're trying to achieve.

So I think we probably need to separate two things because I should put them. I could I fundamentally disagree with your analysis of profit being the best measure we have for social good. I think profit can be, an indication of social good, but it's definitely not always, the best proxy we have for social benefit in, in my view.

But I suspect we don't have time in the context of this discussion to get into, that rather more philosophical, complex debate. But this.

What is if it's not profit, then.

What is what.

You said? You don't think the profit is the best proxy for social good. So what do you think is,

I think you need to adopt a range of different measures to identify whether a social good is arising. I think you cannot boil it down to one single measure. Profit may be and it may be an important component, but profit made at the expense of people's human rights of, of of climate degradation, is not profit. That is, good proxy for, positive, social environmental outcomes for, for social good generally, certainly not for the good of future generations.

So I so I don't agree with you that profits the best measure we have. But but let's put that to one side because it's not really what we're discussing. I suspect the better, discussion to have now is on this question of subjectivity, because I do agree with you on that. I do agree with you that introducing, you know, layers of subjectivity, is potentially, a recipe for misalignment and disagreement.

And so I'm interested in just delving into Tosin's point a bit more, which is how in practice to people deal with this subject. Tivity what is it that we see people do to try to address the fact that the KPIs are themselves subjective, and measurement of the might be difficult.

What we see is, I mean, kind of going a step back. Ultimately, the concern of investors there is that they are not scalable, given that they are being set by sponsors themselves. So how are the targets sets, how is it measured and what discussions are you having in the event that carry has been forfeited on what should happen to that portion that is that is, subject to that forfeit from a GP's perspective, they typically lean on external advisors, to assist with target setting and performance measurements, such as an impact focused committee or a consultant.

And in the same vein, investors would expect to see a similar process in terms of external oversight. Obviously, given those concerns, that I just raise in addressing the points around subjectivity to ensure that targets are properly set, in a way that's relevant to the objectives that are trying to achieve, that they are being measured.

And on top of that, LPs may expect to see a third party audit, in respect of those kind of performance measurements that are being achieved in the same way that you, typical financial, measurements would be, would be all would be audited. Rather, LPs may also be keen to negotiate some sort of, lpac, oversight in terms of the opportunity to review KPIs as well as, as I've mentioned from the outset, in the events that targets are not being achieved, how that portion of carry is been distributed.

So essentially there are pros and cons from each side. You know, when you think about why the GP's would lean on an external auditor or an external, party, it's to perhaps give that clarity and it goes without saying from a an investor perspective. You just want to ensure, as I said, that the data that is being set is not game of all.

Right. So if I could add the impact perspective to that, I think that makes a lot of sense from an ESG perspective. The way that the impacts on VC well, look at that is so there's probably three ways that you can bucket it. One, it can be manager led. The other is that it can be, as you said, have oversight from an internal committee such as a subcommittee of the lpac, that kind of thing.

And often these things, they're they're not in the fund documents. They can be a side letter. So it will be a certain proportion of the LPs that this relates to. And they can sit on the committee or as you say, as well, it can have external validation. I think the broad consensus, and this isn't for everyone, is that the feeling is that the theory of change is set by the managers, is not by the portfolio companies.

You can have a portfolio company with several investors, all with different theories of change. So this is what the manager thinks is, is the, the mission, let's say. And and given the subjective qualitative nature of this, I think the consensus was external validation doesn't really make sense that like the auditing approach, particularly since in venture capital you're dealing with potential a lot of the time.

And what you can measure isn't necessarily always the thing that matters. You want to be as objective as possible as well, but it's difficult. So I think the consensus was manager led with some form of LP oversight, but not an overbearing oversight, whereby the LP start setting targets and overstepped their limited boundary.

And I guess in some cases you will need to, set the KPIs on a sort of company by company basis rather than at manager level, because different companies will have different.

In a, in every case in.

The impact.

World. Yet you want to be as specific as possible. So you don't want to be saying reduced carbon emissions. You may want that in the ESG world, but in the impact world, it's got it's much more tied to, you know, this company's trying to solve this specific problem with a technology. Let's try and be as specific as possible with regards to all to achieving that mission.

I would agree with that. I think the way in which it's incorporated into if it's a question, it's an exam question. As you think about the process, which is are we looking at it across the fund? So as you say, maybe it's more relevant in impacts, but in ESG you ought to look at the relevant sector as it relates to underlying company that it's subject to, the objective of the speaking set and also the context that applies to to that company.

Good. And you mentioned Thyssen, that, there's a question about what you do with excess carried interest. The spare carried interest, if you like, in the event that you don't meet the KPIs. And it's always struck me as problematic that there is a bit of a misalignment here. In other words, if you if the Jeep doesn't hit the impact targets and the investors actually make more money because they pay less carry, and therefore the returns that the net of fee returns increase.

But is there a magnet to to people worry about that? What do they do with the excess carry? I know in the, in the, ESG linked financing world, they sometimes donate it to charity to a foundation or something. Is that also what we see here?

Yeah. That's right. I mean, this is all very much given what we've discussed in, it's kind of nascent stage in practice. It's still very much evolving, but typically it's between donating that portion to a charitable cause, that has an impact linked to mission in, substitution for distributing that to investors.

So in the impact world, we can't came to the same conclusion that giving it back is a misalignment of incentives and charity is probably the way to go. If you want my personal opinion, and this isn't in the paper, I don't like that at all. I think to some degree, impact kind of came out of the the venture philanthropy world, which was a bit of a reaction to, you know, giving charity, charity, charitable donations passively and then getting seeing it was wrapped up in bureaucracy or ending up in the hands of dictators.

And so venture philanthropy, you know, let's get involved and actually make sure that our money is doing good. And so I see this is a bit of a reversion back to the bad old days. I also suspect that in no time at all, it'll end up in the hands of, the charity run by the husband or wife of the fund manager.

So even more conflicts of interest. I would it's it's a difficult one, but personally, I think you should destroy the money.

Burn it.

But I think that's the most sustainable thing you could do. But that's that's for another podcast.

And on that point, the example about the wives of the fund manager, I think that's where investors are keen to have some sort of maybe it's an lpac discussion on that calls, or, you know, where it could potentially be going to mitigate some of those concerns. Exactly.

Have control or at least a strong.

Absolutely.

And what happens to the to the spare carrier? Okay. So what do investors think about this I guess if is keen on it? Ross, do you want to say a few more words about, about the kind of investor community, any I have in particular?

I won't say much about it other than, look, the if is a is a very particular investor. It's got public money as duty to public stakeholders. And you know, it. It's it's entirely understandable. It needs to find ways to ensure that that money isn't being, made in zero sum in zero some ways, but I think in some senses it's a, it's a really intractable, intractable problem, you know, that that their motives are all in the right place.

But I worry that the more they try, the more it becomes a little bit, a little bit counterproductive, maybe because particularly in venture capital, it's very difficult to make money in venture capital. What we want is a self-sustaining European venture capital industry. And, and, and we want things that are going to free that up and let it fly.

Having said that, one thing I didn't say, and one of the many things I didn't say in the description of the gamma model is that this isn't it's not like a second hurdle, and it's not supposed to be hugely onerous. It's just a validation of the theory of change. And so, you know, one interpretation, maybe not all of the not all impact investors would agree with this, but one interpretation is that it's like a minimum bar.

It's a minimum threshold. I think one of the VCs called it minimum viable impact. So from an impact perspective, would you do this deal again? It's not like necessarily reaching for the stars.

But I say so as long as as long as the gap is doing the right things, they're unlikely to miss the targets and forfeit carried interest. Is that what.

You. Yeah. That's right. I mean while I'm while you ask me would I recommend this? And I said no and I wouldn't if you kind of got to do it because you taking public money I think the, the solutions that we came up with, it's it's work.

It's a good it's worth giving given. Yeah. It's a, it's a, it's a difficult problem to solve. We've got to be aware of the unintended consequences. So I suppose you need to tread carefully, to, to, to make sure you don't fall foul of too many of those unintended consequences. Great, great perverse incentives. And what do we see from other investors, Tosin, do you see much appetite for this in the market?

Yeah, sure. I mean, I think that investor exploitation varies across jurisdiction. It's more common with European GP's and not surprisingly, given ESG related backlash in the US, North American investors are not focused on it. I mean, you could even go so far as to say that it could be seen as a deterrent to invest if there's a specific ESG or impact related, mandate.

In terms of European investors, arguably it's certain types of LPs that are requesting it as opposed to interested in. I think that's slightly different in terms of those that are specifically requesting it. It would be more common with, development finance institutions that are perhaps of historically invested in to sustain their, sustainable businesses, amongst other types of institutional LPs.

It's a good to have. Perhaps it's a conversation that they're happy with that GP's a nice to have. Is this something that you're being considered? Are there other ways in which you can incentivize your wider team, to, to focus on, non-financial outcomes? Anecdotally, having spoken to, a fund to fund a global fund, a fund manager recently, they are not asking for it.

They do though, see it, infrequently. What they had noted is maybe four out of four of four out of eight, rather, of, the impact, investments that are made are linked to impact linked carry. So for them it's about how it's done. Is it being done properly. What are the robust processes. So that I mean LP appetite unsurprisingly varies depending on the type of LP and the jurisdiction.

It is still very much a mixed picture, isn't it? So, you know, certainly amongst the mainstream funds, it's relatively unusual, amongst those that categorize themselves as impact funds or article nine under SFD, we are seeing an increasing number. But as you say, still by no means all of those funds have adopted some kind of impact linked to carried interest.

Absolutely.

Good. All right. So thank you. So I think we've got some, interesting disagreements and some measure of agreement. From, from, the three of us. I'm going to end, as I do with this podcast, by asking each of our guests to summarize their position once more in this time, and in one sentence rather than one word.

At the beginning, you gave us a one word answer. So, Ross, what's your one sentence answer to the question? Should your next fund include and ESG or perhaps impacts linked carried interest?

Okay. It's going to be a long sentence. I think you can make it work if you're an impact investor. It's harder I think on the ESG side, the problem being that you swap, the limited partnership structures objectivity for subjectivity. It's quantification for qualification. It's it's I would say fairly objective value approach with, what looks virtuous and it's simplicity and elegance with complexity and burden.

And so I would leave the innovation to the VCs and allow the lawyers to, you know, tailor, tried and trusted, tried and tested strategies to help their clients innovate upon.

So it sounds like, yes, if you think you need to, but with great care.

Exactly.

Yeah. Okay. And Tosin.

I'm more comfortable with a one sentence response. So thank you for that. My position still remains, I think perhaps yes. That would they be the gold standard. And I think that a key advantage would be, alignment with between the GP and the investors as it demonstrates its impact objectives and its returns. But the practice is evolving, as we've discussed and, the kind of maybe small uptake in the market suggests that it's not suitable for all strategies.

Kind of to your point, Ross and that it can be quite challenging to do it properly and to adopt it properly in your in your fund docs, in your process.

It's great. Thank you very much. Thank you both for an interesting discussion, for sharing your perspectives, for doing so with Canada and, and it was a interesting and robust discussion. Certainly from my perspective. So, that's the end of this, second edition of the Travis Smith Sustainability Exchange podcast. Thank you for listening.

Please look out for future episodes. Thank you. Goodbye.