RI long read part 2: Private equity giants’ foray into impact: a sign of the market evolving or cause for concern?

Some LPs are wary of the flurry of fundraising for PE impact funds.

Click to read Part 1 of this 2-part long read article

At a London sustainable investing event in October organised by EMPEA, the global industry association for private capital in emerging markets, Raj Shah, President of the Rockefeller Foundation, urged GPs active in impact to “have a high bar and hold yourself to a high standard”. 

Rockefeller has invested in a number of impact funds and manages a $60m impact fund: “You can get away with a low bar”, Shah told delegates, as a vast majority of the investor community don’t have the time or experience to evaluate the difference between seasoned and serious impact investors and “people who crowd in and do impact to raise fees”. 

And some LPs are definitely wary of the flurry of fundraising for PE impact funds. 

Raj Shah, Rockefeller Foundation

“The more fundraising we see, the more reason to step back and think ‘hey what’s really driving this’?” says a director of a US pension fund with an allocation to TPG’s Rise Fund. He cautioned that investors need to judge each fund on its own merits rather than “following the spinning fundraising machine”.

There are various initiatives and third-party frameworks looking to drive more transparent and comparable impact reporting. Many private equity funds already look to the GIIN’s IRIS+ impact management system and the Impact Management Project (IMP) network – supported by the likes of the PRI, IFC and UNEP FI – for guidance on impact methodologies and reporting. 

In addition, the IFC’s Operating Principles for Impact Management, which was developed by the IFC in collaboration with institutions including Partners Group. Leapfrog and Nuveen, are gaining traction. 

The goal of the principles is to provide transparency, credibility and comparability in impact investing. The principles include: establishing an investor’s contribution to the achievement of impact; conducting exits considering the effect on sustained impact; and assessing the expected impact of each investment, based on a systematic approach. “By April next year, around 60 signatories to the principles will have published their first disclosure report,” the IFC’s Neil Gregory told RI last month

Private equity signatories include Partners Group, Leapfrog, KKR and The Rise Fund. 

Very broadly, there are three common approaches to quantifying impact in private markets; the specifics of which will vary from fund to fund. 

One way is to link investments to one or several SDGs. 

KKR would classify something as an impact investment if the investment company’s core product or service contributes to at least one SDG, and therefore the majority of company revenues are linked to contributing to an SDG, explains Elizabeth Seeger, its director, sustainable investing.

KKR evaluates, measures and tracks companies’ contributions to the SDGs using indicators defined by third-party reporting frameworks, and incorporates relevant third-party guidance, such as the Operating Principles for Impact Management and the Impact Management Project, into its impact management system. To ensure the fund’s impact model is authentic, Seeger says: “we decided to leverage expert third-party methodologies rather than creating our own metric or a black box methodology.” 

Partners Group’s impact methodology also assesses investment opportunities for impact against the SDGs, and uses the IMP impact measurement framework to compile an impact assessment. It subsequently scores each investment on a five-point scale using the IMP’s dimensions of impact (see here from Page 4 ). It then selects relevant impact KPIs to track, measure and report on. 

A second approach is to quantify and measure impact by the number of people reached by an investment. 

Leapfrog, which uses a proprietary framework to measure financial, impact, innovation and risk management factors, measures its ultimate social impact by the number of low-income people reached through their investments. 

Nick Moon, partner at Leapfrog, explains that it provides “a very detailed social impact analysis as part of quarterly reporting – we combine financial and social in one report”. It is also aligning its reporting with the SDGs: “We’ve worked with our investors to enable our results to be allocated or defined under the SDGs,” he says. “I think people want to see that of the 150 million low income people reached [across the portfolio], how many of those people could we say are supported with, for example, the SDG of gender equality,” he says. Investor demand for SDG-aligned reporting is driven by investors themselves looking to report social impact to their members in line with the goals. “SDGs are emerging as the benchmark of social impact in one universal language people can work towards,” he says.

TPG’s impact model stands out: the investor has developed its own ‘impact multiple of money’ (IMM) approach, which ultimately aims to put a dollar value on impact. In short, the IMM works like this: TPG evaluates an investment’s measurable impact – for example based on how many people it will reach. It identifies the expected impact output of these outcomes to society based on evidence from existing academic research. It then estimates the economic value of those outcomes to society – again, based on studies providing evidence for the company’s impact claims as well as economic research to put a dollar value on the projected social or environmental change. After adjusting this measurement for various risks, TPG calculates how much of the outputs it could attribute to its investment based on how much it plans to invest in return for the equity stake it looks to acquire . It finally comes up with an IMM value. For example, an IMM of 5X would mean $5 of social or environmental return for every $1 invested. TPG Rise’s minimum impact threshold is an IMM of 2.5X. 

TPG published a case study of the IMM process in the Harvard Business Review, and has since opened it up for others to use through Y Analytics. 

For the US pension fund director, it’s exactly the IMM that attracted the fund to TPG Rise. A second LP with allocations to numerous impact funds – although not to Rise and primarily to those managed by dedicated impact investors – says “it’s great, money talks – people need impact translated into their own language”. 

But the approach has proven to be divisive and comes with various challenges. “We often deal with softer factors and it’s not always easy to translate these into dollar terms,” says the second LP. “So I think it’s a very good development but implementation isn’t easy”. 

When asked whether it’s possible to put a dollar value on impact, Adam Heltzer, New York-based head of ESG and sustainability at Partners Group, said: “It's possible, but we haven't yet seen a methodology that we believe is robust enough to do this.” 

A sustainability focused fund manager questioned TPG’s approach: “It’s effectively quant measuring,” says one UK-based fund manager. “In public markets it would work, but in private markets it doesn’t matter how many quants you have, the data quantity and quality just isn’t there.” 

Maya Chorengel, co-managing partner of the Rise Fund, says it’s important to listen to market players questioning their IMM methodology, but says that “the approach that we took was not to let the perfect be the enemy of the good in putting forth a new framework to drive impact underwriting” adding that “part of the work involves uncovering where data doesn’t exist and working with research institutions to build the data and the evidence on what drives positive impact outcomes”. 

Meanwhile, another way of ensuring private equity firms’ impact funds meet their impact targets is to link impact performance to carried interest, or carry, a key metric in private equity. Carry is effectively a way to financially compensate GPs to meet or exceed financial targets. Fund managers get paid a percentage of the fund’s profits – so it’s a way to ensure GPs and LPs interests are aligned. Some market participants say there is no reason why impact funds shouldn’t also link their carry to impact targets, although it’s not yet common practice. 

There is growing investor interest in impact-linked carry, says Michele Giddens, a partner at UK-based impact specialist Bridges Fund Management. The manager hasn’t yet taken this approach, partly because its multi-thematic approach to impact doesn’t lend itself to aligning carry with a few specific metrics. What’s more, Bridges invests in companies “where impact and financial performance go hand-in-hand, [which] has made us more comfortable with the more traditional carry”, Giddens says. However, the manager will continue to look at impact-linked carry and could consider it in the future, she adds. 

Michele Giddens, Bridges Fund Management

Gerhard Pries, CEO of emerging markets private equity manager, Sarona Asset Management, says it does not link impact to carry in its primary funds: “We’ve certainly done it for a few bespoke mandates, but we are firstly a fiduciary steward of capital, and most investors are justifiably afraid that linking carry to impact might confuse a manager’s focus,” says Pries. “We want our local partners – private equity firms and company leaders in emerging markets – to truly champion social and environmental leadership as opposed to just ticking an ESG or impact box.” 

Impact-linked carry might be far from a mainstream approach, and most private equity firms don’t yet offer impact strategies. But “pretty much all” big firms are trying to get their head around impact, says an ESG director at a European private equity firm, which is contemplating an impact fund but is yet to make a decision. 

A big question for PE firms not yet active in impact is whether to adopt a broad impact strategy, for example across all SDGs, or to create a more niche impact fund. 

Some asset owners want to allocate to broader impact funds investing across a number of sectors and SDGs – most big PE-backed funds fall into this category – but others prefer more narrowly defined impact strategies, says Ameya Bijoor, a partner with New York-based sustainability-focused private equity firm Encourage Capital. The firm’s funds include a solar strategy specialised in financial institutions in India that can develop rooftop solar financing products for small and medium-sized enterprises. “There are [investors] who are more specifically mission-driven and in that regard they have a particular sector they’re most interested in,” says Bijoor. “So that’s why we’re building these deeply impactful and highly commercial investment strategies to work with those investors that have particular sectoral impact interest and seek market-rate returns.”

 This is also the approach of, for example, France-headquartered private markets investor, SWEN Capital, which in July launched its first impact fund focused on renewable gas production and distribution projects in Europe. SWEN’s deputy CEO Isabelle Combarel says the manager felt it could make more impact through a niche strategy, “even if it means smaller funds”. 

Combarel explains that for SWEN Capital Partners, launching an impact fund is a natural progression of ESG integration across traditional funds. “We feel that ESG progress among GPs has plateaued,” she says. “So, we started to reflect – we want to go further and impact is the next place to go.”Isabelle Combarel, SWEN Capital