With a growing focus on aligning investment portfolios with mission and increasing options for investors wishing to do so, putting a process in place for analyzing and negotiating such investments is more important than ever. Below is a summary of key terms that investors in any type of private fund should review, with a special emphasis on how to think about these terms in the context of an impact fund:
Definition of Impact: Whether a fund is called a thematic fund with a particular focus on sustainability or an impact fund with a focus on increasing access to clean water, for example, investors will want to make sure that their desired impact aligns with the stated investment criteria of the fund. Taking the time during the due diligence and negotiation process to understand in detail what impact is being sought and how it will be measured is key to ensuring that an impact investment supports what the investor intends to support. Particular provisions to consider include:
- Is the impact or theme of the fund stated in enough detail?
- Is 100% of the fund dedicated to the particular impact or are there exceptions to the impact goals (i.e., a percentage of the fund that can be invested in ways that do not further the impact goals)?
- What rights, if any, do investors have in the event of mission drift?
- How will the fund ensure a commitment to impact at the investee level - are investees required to be certified B corporations or organized as a public benefit corporation or L3C?
- If a fund is investing in public equity or debt, is the fund screening those investments and, if so, what criteria are they using for the screens? Does the manager’s proxy voting policy properly reflect the impact goals of the fund?
Measurement and Reporting: It is equally important to understand how impact will be measured and reported. Investors will want to pay particular attention to what type of impact reporting will be provided by the fund and how often. Investors may also want to probe deeper. Is the fund requiring realistic reporting by its investees? What steps will be taken, if any, when reporting shows underperformance on the impact goals? Do the fund’s confidentiality provisions allow investors to share the information they need with their own constituents?
Management Team Composition and Conflicts: Meaningful performance on impact goals can require specialized expertise, so investors will also find it valuable to ensure that appropriate controls are in place regarding changes to the management team. For example, is there a key person provision that requires notice to investors if certain individuals leave the management team and rights for investors in those instances? Are the right individuals named in the key person provision? Are there appropriate restrictions on a key person’s activities outside of the fund? When can the manager be removed and by whom?
Management Team Compensation: Investors will want to understand how the management team is being compensated to make sure that management teams are aligned with investors. Specifically, investors will want to understand how the management fee is calculated (i.e., on a base of committed capital or net asset value of the fund) and if there is an incentive fee. To ensure that management teams are incented to achieve the fund’s goals, impact investors may wish to integrate impact goals into provisions governing when and how management teams receive incentive payments. If so, is there an impact-related condition (a hurdle) before the manager begins to earn a carried interest? Is the timeline for performance earnings aligned with the timeline for impact? Are incentive fees calculated on a deal-by-deal basis or a whole fund basis?
Most Favored Nation Status: It is also important to understand whether any investors have preferential terms regarding fees, liquidity or other provisions. For example, certain investors (a state school, a private foundation, etc.) may have special redemption rights that provide increased liquidity due to regulatory requirements. Investors will want to understand any preferential rights that have been granted and evaluate how those rights might affect the fund and the other investors. Investors with sufficient leverage may want to request “most favored nation” status in order to obtain special rights or benefits the manager later provides to another investor. At a minimum, investors may want to require that the manager provide notice to all investors upon granting preferential terms to another investor.
Allocation of Investment Opportunities: Investors will also want to understand whether the manager is managing other similar funds and how investment opportunities will be allocated across the manager’s funds and any separate accounts. Are there parallel funds? If so, are investments allocated pro rata across the funds? Is there a requirement that redemptions will be pro rata across the funds? Can the fund invest in other commingled funds or only direct investments? Are managers investing in the fund? If managers are co-investing alongside the fund, are appropriate conflict provisions included that, for example, prevent managers from cherry-picking particular investments?
Expenses: It can often be time-consuming and expensive for a fund to make investments, perhaps particularly so when managers are investing with both financial return and social return in mind. Investors will want to understand what additional expenses the fund is paying for due diligence and measurement and may want to pay particular attention to expenses related to travel and fees for third-party consultants, and whether there is an overall cap on expenses.
Additional Key Terms: Other key terms that warrant review when considering becoming an investor in any investment fund include the following:
- Liquidity: What is the frequency of redemptions? Is there an initial lock-up period? Does the manager have the ability to gate redemptions in certain circumstances? Will redemption proceeds always be distributed in cash or can the manager make in-kind distributions of interests?
- Clawback: Does the manager have the ability to recall distributions in certain circumstances?
- Valuation: What is the process for valuing the assets of the fund? Is there an independent administrator? How are assets custodied?
- Fund Size: How large is the fund permitted to be? Is there a required minimum size before investors are required to make capital contributions or before the manager is allowed to make any investments?
- Indemnification: In what circumstances does the fund indemnify the manager?
- Compliance Check: What is the manager’s compliance program? Have there been any regulatory or other issues in the past with the adviser or members of the adviser?
- Tax: For tax-exempt investors, what is the potential for exposure to UBTI (unrelated business taxable income)? Are there any foreign tax implications based on the fund’s investment strategy?
- Amendments: In what instances can the manager amend the fund documents without investor consent? When consent is required, what percentage is required?
Impact investments can take many forms but for investors taking advantage of the growing number of impact and thematic commingled funds available, the above are some of the key terms to keep in mind. There are many variations on these terms that can be appropriate for different circumstances, which is part of what can make impact investing such a customized endeavor. For more information on how we can help investors review and implement impact investments, please read about our impact investment and social finance practice.
This document, which may be considered advertising under the ethical rules of certain jurisdictions, is provided with the understanding that it does not constitute the rendering of legal advice or other professional advice by Klavens Law Group, P.C. or its attorneys. Please seek the services of a competent professional if you need legal or other professional assistance.
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