The label “impact investment” is controversial. Many firms use it for marketing purposes with little to show in behavior. Others avoid using it, despite their strategies and outcomes being quite impactful, because of the negative assumptions some people make about it. In fact, there are just as many “impact washers” as there are “closet impact investors.” For investors seeking to generate strong financial and social/environmental returns from fund commitments, diligence must go beyond just reading a label to deeper investigation into whether the actions taken within investment firms and funds are likely to drive the outcomes they seek.
This level of deeper investigation requires a framework, rigorous due diligence, and perspective. Many of the due diligence tools employed by investment professionals to assess funds are still useful, including onsite meetings, track record analysis, pipeline review, reference checks, operational and business risk assessment, legal review and negotiation, and background checks. However, impact fund diligence requires both a specific framework to apply these tools with an impact lens and the perspective to judge what comes out of that diligence process.
The framework we developed for Impact Engine’s Private Equity Fund comes from the perspective I gained as an institutional investor and developer of ESG strategies. It focuses on three areas:
Team
Assessing a team begins with asking why a fund manager is launching an impact fund. This also helps evaluate intentionality. Across leadership teams, we look for coherent educational backgrounds and career paths that lend themselves well towards investing in for-profit companies to drive outcomes. Even if a manager did not work for an impact investment firm, we look for evidence of a long-term, authentic commitment to impact. This may manifest in their professional initiatives (i.e. incorporating ESG practices within a firm, driving impact initiatives in a traditional fund) or personal pursuits (i.e. non-profit service, a personal account invested in impact vehicles).
Beyond a management team, alignment across a firm is essential. If the fund is embedded within a large, traditional asset manager (i.e. a bespoke offering), assessing motivations and structural incentives are important. In a “pure-play” firm, where impact is in the DNA, hiring choices must reflect a founder’s impact intentions. Regardless of fund type, understanding how teams and firms define and measure success can provide insight into their potential to generate financial and social/environmental returns.
Beyond motivation, teams also must possess the necessary investment skills. Given the nascency of impact investing, it is common to see professionals with credible but not relevant experience launching funds. For example, I have met lauded public equity investors seeking to launch sustainability-themed private equity funds because of their passion for the environment. I have also met many entrepreneurs, management consultants, non-profit executives, marketing professionals, or policy experts without relevant investment experience who are seeking to launch an impact fund. While they may have done well selecting stocks, leading organizations or driving impact, managing a private equity strategy requires a particular skill set and network.
Similarly, if a strategy focuses on a particular social issue, geography or sector, the team must have relevant experience and networks to source deals, recognize patterns during diligence, evaluate risks, make prudent investment decisions and create value in those specific markets. This should be reflected across the team, including advisors and operating partners, not just the lead investment professional. Gaining conviction means triangulating around a team’s collective track record, experience, working dynamic, and incentives — these elements are necessary for success across market environments.
Throughout the iterative process of meeting each team member and conducting references, we often return to one key question: “if the fund does or doesn’t succeed, what will this person and firm do next?
Investment Strategy
Strong investment strategies have a clear thesis. In the case of impact investing, the thesis should make clear how the investment itself will play a role in driving both a financial and social return. We look for fund managers that understand the problem they seek to address, and have an investment strategy that effectively contributes to a solution. For example, if a fund’s impact strategy requires not just product-based impact but also business practices that prioritize multiple stakeholders, does the deal size and governance structure provide enough influence over management? If a fund’s thesis is to narrow gaps in access to education, healthcare or financial services, does the strategy target the right end users or employees? In other words, fund managers should have a grasp on both the opportunity and the risk to the investment.
If there is a clear thesis, our diligence efforts then focus on evaluating the firm’s investment process and how impact management is operationalized. This includes sourcing, diligence, structuring, selecting, managing, and exiting investments. Throughout the process, it should be clear that there is rigorous and continuous consideration and management of the impact opportunity and risk in addition to financial opportunity and risk, and that the two should ideally be linked.
Assessing a strategy also requires independent analysis in addition to taking in what a manager tells us. Analyzing the size of a market, competitive dynamics, valuations, macro risks, and trends are required before judging whether a manager’s strategy will lead to the results targeted. Fund size, portfolio construction, and deal structures must also be analyzed within the context of the opportunity set to determine probability of success.
Another aspect to strategy diligence focuses on whether the targeted impact outcome is likely to last and result in further market adoption. For Impact Engine’s Private Equity Fund, we assess whether a strategy is filling a market gap and if a successful fund can create a multiplier effect by unlocking additional capital.
Upon reviewing all the diligence related to strategy in aggregate, one key question we ask is, “will the investment strategy and process generate financial and social returns that are greater than the risks being taken?”
Accountability
Similar to the rest of our framework, evaluating accountability begins with intentionality. From our initial interactions with a fund manager, we look to see if they seek to be held accountable. Do they willingly measure impact or is it something we have to ask for? Has it improved over time? Do they use these metrics to manage outcomes or is it only for reporting or fundraising purposes? Are they looking for others’ input about what types of business models will solve a social issue or does the mere optics of it seeming impactful clear their hurdle?
Assuming there is strong intentionality about accountability, we then evaluate and provide feedback on how to help operationalize and incentivize continuous improvement of impact management. This begins with a significant personal investment in the fund through a GP commitment. Advisory committees that provide input on impact management processes are also helpful, especially for firms early in their life or impact evolution. Guardrails around investment criteria and impact measurement, in legal documents and side letters, can provide additional levels of accountability. A firm’s willingness to participate in industry associations and be transparent about their portfolio are additional factors to consider.
Our key question when synthesizing diligence on accountability often is “what does success look like for this fund, and are they creating feedback loops to help them stay on course?”
No fund is perfect and no investment firm has all of this figured out. However, having a leadership team with the right skill set, intention, ability to learn from successes and failures, and culture of stewardship provides the foundation for each of these aspects to an impact framework to be robust and drive lasting outcomes. Investors in funds also hold the responsibility, especially as it relates to accountability, to work towards these objectives. Much of the growth in impact investing came from client demand and that should go beyond simply asking for a fund with a label.
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