Impact Investing: Deal Selection

The success of an impact investor depends on its ability to access and participate in deals that allow them to deploy their capital with social enterprises that can deliver the financial and impact returns that the investor expects.? Fund managers must be able to demonstrate to prospective investors that they will be able to build and maintain a robust pipeline of potential investment opportunities, which will require fund managers to develop a strong profile in the marketplace and a network of contacts among the various sources of deal flow.?

Selection, due diligence and negotiation all take time, usually nine to twelve months, and once the deal is completed the fund should expect to be actively engaged in monitoring for three to five years, perhaps more, depending on the portfolio company’s stage of development at the time that the initial investment is made.? In many cases, the fund will make a “follow-on” investment in a subsequent round of funding.? Clearly, the fund and its portfolio companies will have a long-term relationship and what happens while they are “doing the deal” will be important in laying the foundation for mutual success.

A large pipeline of potential investments is important for fund managers and surveys indicated that established funds may have literally hundreds of prospective portfolio companies in their databases at any point in time.? However, quantity is no substitute for quality and the fund managers need to implement screening mechanisms to weed out opportunities that are not aligned with the fund’s impact goals and objectives and, for those deals that survive the initial screening, identify key issues that will need to explored and resolved during due diligence in order for the fund to make a commitment.? Surveys illustrate how demanding and difficult the selection process can be—for example, from the initial group of companies that have been placed into the fund’s pipeline during the run-up to the fund’s initial close and the months following the close, perhaps 25% will turn out to be a good fit the fund’s investment strategy and only half of those prospects will be selected for additional review due to resource limitations within the fund (e.g., the available time of the fund managers and their internal team).? Only 20% to 25% of those companies will survive the additional review, which will include close scrutiny of impact data available from a review of the business plans offered by the promoters of the target companies, to move into the due diligence phase and of those companies it is likely that the fund may ultimately invest in 50% to 80% of them.[1]???

If you do the math on the selection process outlined above it is clear that only a few companies—usually somewhere around 2% of all that started—will survive and end up in the fund’s portfolio.? Not all investment opportunities are suitable, even if they ultimately turn out to be “successful” by some measure, and the decision for the fund managers will be based on their specific strategies, impact goals and objectives and risk tolerance, among other things.? According to the Global Impact Investment Network (“GIIN”), some basic factors that fund managers should consider in their initial screening include the following[2]:

• For sponsors or owners, who are the driving forces and what are their motivations for managing the business?
• What is the market opportunity for the business?
• Can the company deliver its products or services efficiently?
• How is the company organized?
• Does the company operate transparently?
• Does this investment align with fund mission or impact objectives (ideally grounded in an organizational theory of change)?
• How is the company currently performing toward impact goals? Can it optimize for higher impact?

The fund managers bear the ultimate responsibility for the choices made during the deal selection process; however, as discussed in the previous chapter, it is common for funds to provide for the creation of an investment committee that includes representatives from the key investors in the fund who are available to provide input to the fund managers on the companies that are included in the fund’s portfolio and, as requested, the specific terms of particular transactions.? The role of the investment committee, and the requirements of investment committee members regarding information and participation, will vary depending on the circumstances.? In many cases, the investment committee will convene several times during the deal process, beginning with the point where decisions are made about which opportunities will move forward into due diligence and then picking up again when the due diligence is completed, and it is time for the fund managers to negotiate the terms of investment and prepare and sign the transactional documents.? Earlier involvement by the investment committee means that it will have more input into the design of the portfolio, but some investment committee members prefer to limit their participation to reviewing proposals that have already been vetted by the fund managers and their team, thus relying on the fund managers to do the hard work of sifting through the blizzard of potential deals that occurs when the fund is first formed.

This article is an excerpt from my recently updated chapter on Impact Investing: Doing the Deal . To learn more, see my new book: Launching and Managing an Impact Venture Capital Fund: A Guide for Fund Managers and Sustainable Entrepreneurs.

Notes

[1] Developing a Private Equity Fund Foundation and Structure (Global Impact Investment Network) (Figure 11: Filtering the Investee Pipeline).

[2] Id.