This is the first in a series of articles created specifically for venture and private equity fund managers operating in the impact investing space to highlight best practices and help demystify what it means to be an impact-focused investment fund.
By Aaron Bourke, Senior Counsel and Head of RPCK’s Fund Formation practice
When it comes to building and scaling the impact investing marketplace, impact funds play a special role. Whether they’re venture capital, private equity or some other structure, impact funds are often the first to identify cutting edge innovations that address some of our most important environmental and social challenges while delivering a financial return to investors. They are proving new models and sectors and have been responsible for bringing in more capital to impact and for widening the impact tent by attracting new, increasingly more traditional investors to impact.
But creating a successful impact fund can be a tricky business. And knowing what questions and considerations to discuss with your lawyers before you head down the path of fund formation will be key to your ultimate success.
1. What are some of the considerations when launching a fund in impact vs. a traditional fund?
The fact that an impact fund must account for impact outcomes drives a number of different considerations when it comes to setting up a fund. For starters, you can’t just take standard VC documents or PE documents and try to stuff them into an impact scenario. Why? A lot of the traditional approaches were designed for Silicon Valley tech investing. But impact investing poses different challenges and possibilities. For example, emerging market jurisdictions often have unique legal and regulatory elements. Finding structural solutions that work often requires patience and creativity as well a commitment to the impact mission – and this is where the alignment of interests and flexibility of an impact lawyer can really make a difference.
For the same reasons, an impact lawyer often has the willingness and desire to learn new areas of the law that don’t typically come up in normal fund structures, such as the tax ramifications for structuring a fund for a tax-exempt organization. Many impact deals are not cookie cutter deals, and this extra bit of enthusiasm and alignment of purpose can often help a lawyer arrive at the right answer.
Or your fund may be looking to attract investors with different risk / return profiles, for example, a blended finance vehicle, whereby some investors are providing more catalytic investment capital that can bear more risk in order for you to be able to bring in more institutional capital that requires higher returns. In one recent instance, our fund formation team worked seamlessly with our debt finance team to come up with a blended finance structure that required both debt and equity components.
When it comes to impact outcomes, the right legal counsel can also help bake impact outcomes and metrics into the fund or deal documents – just like you bake in provisions for financial outcomes and what to do if they aren’t met. This is all the more important in today’s era of heightened regulatory scrutiny of asset managers that claim that their funds promote important impact benefits, so as to reduce the practice known as “greenwashing” (whereby an asset manager or company falsely claims or overstates the real impact outcomes of their strategy).
2. What is the spectrum of impact a fund can achieve and how does that affect the structure of the vehicle you choose?
Just like in traditional deals, you want a fund structure that matches your investment strategy. If you’re going to make loans, you want a credit fund. If you’re investing in early stage companies, you’ll want a venture structure. If you’re buying and selling liquid securities, then you’ll likely need a hedge fund structure. And so on.
But a fund that is fit for purpose often means something different in impact, and that’s largely a function of the broad spectrum of impact returns and financial returns that your fund sets out to achieve. In other words, not all impact funds are built alike. For example, if your fund primarily seeks to deliver market-rate risk adjusted returns, you may only apply an impact screen when making investment decisions to ensure that the fund only invests in sustainable companies promoting certain ESG characteristics that you articulate in your strategy.
On the other end of the spectrum, you may have an impact-first investment strategy that calls for your generating a below-market financial return.
Whichever strategy you have along this impact / financial return continuum will drive the fund structure, kinds of investors you are going to target and ultimately, the types of deal documents you will need to invest.
In the first instance you’ll likely be looking for commercial investors that are more institutional, such as corporates or even pension funds. In the latter, mission-aligned investors, such as foundations, high net worth individuals and family offices might be willing to come in to accept higher risk, for example, first-loss capital. This could sweeten the deal for other investors who want to come in at a market risk-adjusted return. This might mean you want a blended finance vehicle, where some of the equity is coming in to provide a cushion. Or everyone may come in as equity investors, but you do a waterfall that prioritizes the order of financial returns.
In my next installment of our Fund Manager Series, I will explore why having an impact lawyer can pay real dividends for fund managers. If you have any questions about this post, please feel free to contact me at aaron.bourke@rpck.com.