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“From theory to practice: Tying financial incentives to impact”

May 4, 2023

This piece originally appeared in New Private Markets.

Linking financial incentives to impact performance is increasingly seen as best practice in impact. Jack Isaacs and Ellen Maginnis from verification firm BlueMark, having assessed 84 investors’ approaches, describe the various ways of doing it.

One of the many things that unites impact-focused investors and traditional, returns-focused investors is that they are both motivated by incentives. However, while traditional investors can follow predefined guidelines for linking their compensation to financial performance, impact-focused investors have a range of options for linking compensation and other incentives to impact performance.

Aligning impact performance to compensation is increasingly defined as a best practice across impact management industry standards, including the Operating

Principles for Impact Management (OPIM) and the SDG Impact Standards. As the number of asset managers linking employee-related financial incentives and impact performance continues to rise, there is debate across the market about the best approach to designing and implementing impact-linked incentive systems.

It is crucial to know the range of mechanisms available to impact investors, and to understand the practical considerations and recommendations for embedding these structures across a range of contexts, including across asset-classes, thematic objectives and return expectations.

Different types of impact incentives

In BlueMark’s 100+ practice verifications to date for impact investors managing more than $200 billion in impact assets under management, we’ve found growing levels of adoption for different impact-linked compensation structures. Based on a recent sample size of 84 practice verifications (excluding 16 re-verifications), we found that 31 percent of investors align impact achievement with staff performance management and/or incentives. These incentive programmes typically come in one of three forms:

  • Performance review integration: BlueMark’s data shows that 25% of investors take this approach. In cases such as these, aspects of impact performance and practice are integrated directly into annual staff performance reviews, resulting in decisions related to compensation and promotion.
  • Compensation and bonus incentives: In these models, staff compensation is linked directly to impact performance targets. These payments typically come in the form of annual bonuses and may be tied to portfolio or individual investment level goals. Around 15 percent of investors take this approach.
  • Carried interest: Incentive systems based on carried interest are typically only applicable for private equity and venture capital investors, which helps explain why only 7 percent of investors use this type of structure. These models are structured such that the fund manager will forfeit a portion of its carried interest if the fund does not meet certain impact targets. While some models are punitive, several impact carry incentives are   structured to be more ‘carrot than stick’. This model is applicable to employee incentive structures because many PE and VC employees have carried interest as a core part of their compensation.

Different ways to anchor impact incentives

Broadly speaking, there are two different approaches to goal-setting that are essential for anchoring impact incentive structures into impact management systems:

Portfolio level performance – Given the nature of how they are structured, longer- term incentive structures and carried interest structures are often tied to the achievement of portfolio level goals. In instances where there is a narrow strategy, these may be tied to specific impact KPIs (for example, a climate-focused fund may have a specific emissions reduction target). For instance, I&P’s Afrique Entrepreneurs 2 fund has an incentive structure tied to a number of portfolio-level goals, one of which is to have 70 percent or more of its portfolio companies owned or led by leaders rooted in Africa for the long term.

In instances where the strategy is more diverse, we’ve typically seen funds anchor goals on an impact score. This practice is common among DFIs (like BII, DEG and FinDev Canada) where compensation is linked directly to an average portfolio impact score.

Individual investment performance – This structure is most applicable for more diverse strategies and where impacts may vary significantly between investments. In these models, individual KPIs and associated goals are defined for each investment, and compensation is linked to the achievement of these goals. We’ve seen these models applied to all three types of system listed above. For example, Trill Impact defines specific ESG and impact targets for each investment. The achievement of these goals is weighted and linked to the fund’s carried interest.

Within both types of impact “anchors” there are a range of emerging practices applied by investors. An increasingly common approach is to consider alignment to a specific standard and/or international threshold when assessing impact performance. For example, EQT Future plans to link its carried interest to the achievement of portfolio-level KPIs, including the reduction of GHG emissions using Science Based Targets. Furthermore, Apollo’s Impact Platform leverages B Impact Assessment (BIA) scores, which are subsequently linked to carry compensation. We have also seen an increase in managers anchoring portfolio goals, and related impact linked compensation to align with the Paris Agreement.

Key considerations for structuring incentive systems

Given the diverse range of strategies across the impact investing market, we strongly believe that there is no one-size-fit-all approach for linking employee incentives to impact performance. Regardless of the type of incentive system or the goals to which those incentives are anchored, there are potential unintended consequences that investors may face if impact incentive structures are not properly thought through. To mitigate these consequences, it is essential that incentive programmes are built around the following considerations:

Robust impact management is a prerequisite – For staff incentive systems to be adequately meaningful, investors need to have robust processes for holistically and accurately assessing impact performance across their portfolio. Whether impact performance is assessed and monitored using individual KPIs or a scoring tool, it should be considered consistently throughout the lifecycle of each investment to facilitate a clear understanding of investment-specific and portfolio-level impact.

Goals must be ambitious – Incentive systems should be structured in a way that promotes ambitious goal setting. For example, it would be counterproductive for an incentive system to encourage less ambitious targets in order to achieve the incentive benefits. Robust impact governance mechanisms, including the practice of separating roles between drafting and approving goals, can help address this challenge. Some investors have also sought verification for the KPIs and targets on which their incentive systems are anchored, ensuring that KPIs and targets are both material and ambitious relative to impact performance at any given time.

Credit should be given for incremental progress – Achieving goals should be rewarded, but so too should incremental progress. For example, if there is a goal to improve a company’s net promoter score (NPS) from 30 to 50, progress should still be rewarded if this goal is not achieved (say if the NPS score is 49). A number of incentive systems we’ve reviewed have been structured to have a very binary interpretation of goal achievement, which can disincentivise performance Improvements.

Account for both positive and negative material impacts – Accounting for all material negative and positive impacts can be challenging. While the industry as a whole is still grappling with how best to do this, it is essential that an incentive system does not anchor on cherry-picked impacts. For example, incentivising improvements in immaterial aspects of positive impact can divert focus from improving aspects of material negative impacts.

Take for example a manufacturing company with a significant emissions footprint but with impact incentives linked to the amount of money it spends on corporate social responsibility (CSR) activities. This incentive structure would potentially distract improvements in emissions reductions. Robust impact incentive systems should consider both positive and negative impact and performance, with a focus on material impacts.

Ensure incentives are aligned – Fund managers do not operate in a vacuum and incentive structures should be aligned across the fund management value chain. This includes LPs, GPs, portfolio company management, and ultimately the people (and planet) that are impacted.

We’ve seen examples of this as an emerging best practice. For example, Bain Double Impact ties management compensation to the achievement of impact metrics for all actively managed portfolio companies. We have not yet seen, but hope to see, incentive structures with alignment mechanisms designed with the stakeholders ultimately impacted.

Designing the right incentive system

Aligning incentive mechanisms with an investor’s purpose and strategy is a core practice that has the potential to advance and embed impact objectives into the way funds operate. While we want to encourage all organisations to implement the processes required to put this accountability in place, we also recognise the difficulties and challenges that these systems can create. Therefore, BlueMark makes the following three-step call to action to investors:

  1. Develop clear processes for understanding investment and portfolio-level impact as a prerequisite for anchoring incentive systems to impact performance;
  2. Consider potential unintended consequences associated with implementing incentive programmes and find ways to mitigate and manage these risks;
  3.  Be prepared to test and pilot different approaches and share lessons learned with the industry.

Given the lack of existing guidance for developing and implementing such incentive systems, it is vital that organisations are continuously refining existing approaches and innovating new ones. Just like other evolutionary aspects of impact investing, it will take time for the market to align around best practices.