Impact Investing: Due Diligence

Careful selection of potential deal opportunities should bring the fund managers to the point where they can devote their resources, and the skills and experience of their team managers, to conducting comprehensive due diligence on the prospective portfolio companies and their managers.? Due diligence is arguably one of the most important activities that the fund managers will undertake and a solid process of conducting due diligence should be in place before it all begins.? According to the GIIN, due diligence serves several important purposes: aligning internally around intended impacts and priorities; assessing and managing impact risk; constructing more impactful portfolios through improved investment selection; identifying and communicating an enterprise’s intended social or environmental impact; identifying ways to add value to and improve an investee’s impact; and attracting additional capital to both investment funds and enterprises by demonstrating the increasing sophistication by which impact capital is deployed and utilized.[1]

To realize the benefits of due diligence, consideration must be given to the key elements identified by the GIIN[2]:

·?????? Current, historical and projected financial performance

·?????? Overall business strategy and market position and environment

·?????? Overall impact strategy

·?????? Financial management strategy

·?????? Operating efficiencies and inefficiencies

·?????? Potential externalities

·?????? Integrity and background checks for sponsors, owners and managers

·?????? Potential financial, environmental and social risks analysis

·?????? Legal due diligence

·?????? Governance structure and company management

·?????? Opportunities for growth and improvement

There is no universal standard for conducting due diligence and the sequencing of the focus on elements of the process depends on the preferences of the fund managers and the availability of information from the prospective investees.? In most cases, several elements will be investigated simultaneously and the due diligence will require request and review of documents, completion of questionnaires, interviews and inspections and inquiries of the company’s business partners.? In addition to the fund’s internal team, due diligence may also be conducted by outside professionals such as attorneys, accountants and consultants with expertise in a specific sector and familiarity with the techniques associated with impact measurement.

Gauging and projecting impact of an investment before it is made is understandably difficult; however, it is obviously an essential part of the due diligence process for any new impact investment.? There are several different approaches to impact due diligence and best practices would be to rely on a combination of qualitative and quantitative approaches.? For example, the process can begin with an impact-focused due diligence questionnaire (“DDQ”) based on a standard list of questions about prospective investees’ impact that will often be customized to the specific investee and the anticipated form of impact.? The goal of the impact-focused questionnaire, which may be stand-alone or integrated into a longer “traditional” questionnaire designed to assess investments expected financial risk and return, is to identify linkages with the components of the theory of change and identify areas of potential misalignment.? Investors can also use quantitative impact due diligence tools based on weighted criteria and standardized, numeric scores that facilitate comparison across investment opportunities. Qualitative information should be collected through “storytelling”, written narratives of expected impact typically covered in an investment memorandum, that investors can use to understand how change is expected to occur.[3]

The GIIN has published guidance on how to use its IRIS+ impact measurement system within impact due diligence to inform investment decision-making and enhance investors’ ability to achieve their impact and financial goals.? Among other things, the GIIN encouraged investors to use IRIS+ to identify key indicators in the IRIS+ Core Metrics Set to inform key questions to be included in the DDQ relating to the five dimensions of impact: “What is the goal?”, “Who is affected?”, “How is change happening?”, “What is the contribution?” and “What is the impact?”.? For example, assume the Strategic Goal associated with a proposed investment is “improving financing health”.? Key indicators in the IRIS+ Core Metrics Set related to this goal are outcome (i.e., increased savings, measured through Value of Voluntary Savings Accounts) and importance of outcome to stakeholders, and recommended questions related to these indicators include: “What is the total value of the voluntary savings accounts held by the organization?”, What value of savings accounts would the organization like to achieve?” and “How important are savings for target stakeholders?”.[4]?

Risk Management

The limited partner investors in a fund rely on the fund managers to?identify, manage and mitigate the risks associated with the deployment of their capital, assuming that the fund managers are better placed to fulfill those responsibilities as a result of their experience and the resources that they have collected in putting together their team.? Risks should be assessed in a number of ways during the due diligence process and the results of the risk analysis should be used to determine whether to proceed with an investment and, if so, how the investment should be structured in order to fit within the risk profile that the fund managers have presented to their investors.? The first step is to identify all of the risks associated with the prospective portfolio company, which can include macro, market, human resources, products, operations, financial and ESG, and assess the company’s ownership and financial structure (e.g., how is ownership and financial distribution preferences already allocated among debt and equity holders, as well as outside lenders).? Once the risks have been identified and quantified, the fund managers can take steps to mitigate the risks through the choice of the investment instrument, pricing and creating options for exiting the investment (either completely or through conversion into another form of investment instrument with different risk characteristics).? Another strategy is the fund managers to condition the fund’s investment on certain risk mitigation actions by the portfolio company, such as purchasing insurance to cover a specific potential risk.[5]

Adding Value

The due diligence phase is the first time that the fund managers have an opportunity to interact directly with the founders and executive team members of the prospective portfolio companies and all parties should use this as an opportunity to develop a foundation for the fund managers adding value to the business, assuming that an investment is eventually made.? For example, if potential problems are discovered during the due diligence, actions will certainly need to be taken to resolve them or mitigate their impact for the fund managers to be comfortable with proceeding.? However, the fund managers can facilitate this process by making specific suggestions to the leaders of the company and perhaps introducing consultants and other resource providers who can offer specialized assistance.? The fund managers may also provide input on possible changes to the company’s business model and strategies that will improve its overall financial and impact performance.? In addition, certain requirements imposed by the fund managers at the behest of their own investors, such as expanded impact measurement and reporting, will also lead to improvements in the company’s transparency and its ability to communicate to other stakeholders.? Depending on the situation and the investment terms that are eventually negotiated, one of the fund managers may join the company’s board of directors, providing him or her with a direct and formal role in the stewardship of the company.? The due diligence phase is an opportunity for everyone to see whether that sort of relationship would be workable.? Even if the fund does not have a representative on the board, its fund managers should be comfortable that they will have access to the management team to provide counseling and share experience and expertise.

Identifying and Measuring Impact

Investors considering placing their capital with the managers of traditional venture capital and private equity funds certainly expect those managers to carefully analyze the business and financial models of prospective portfolio companies to determine a reasonable risk-adjusted financial return on investment.? When it is intended that the fund engage in impact investing, another layer of review is added: identifying and measuring the environmental and/or social impact that can be expected from an investment in a portfolio company.? An initial impact screening should occur well before companies are selected for the more intense due diligence phase and fund managers should create an “impact committee” that includes members of the internal team and experts recommended by the fund’s investors to focus specifically on the proposed impact thesis and theory of change for each of the companies that the fund managers are considering moving forward to due diligence.? At this stage, since due diligence has not started, the group will have relatively limited information on how the company is actually performing; however, the impact committee can compare the company’s business model to the fund’s own impact goals and critically review the projections made by the company regarding growth and projected impact and the company’s assumptions regarding risks and challenges.? If the company’s business plan raises too many questions, the fund managers may pass on the opportunity.? On the other hand, if the impact proposition of the company is solid and the assumptions are reasonable, it may be moved forward into more extensive financial due diligence.? In close cases, the fund managers may request additional impact-related information from the company before committing to full-blown due diligence.? Another output of this process is ideas that the fund managers can provide to the company on improving their messaging and strategies relating to impact.[6]

Investor Expectations

The primary goal of the due diligence process is to make the best decisions regarding the deployment of the capital provided by fund’s investors to the fund managers.? Once an investment is made in a portfolio company, it cannot easily be undone.? If adverse information about the company comes to the attention of the fund managers after a deal is closed, the fund may have legal rights; however, this is not a productive path for any of the parties.? As such, the fund’s investors will expect that the fund managers will put in place a comprehensive and professional process for both financial and impact due diligence that is clearly aligned with the issues and best practices in the sectors in which the fund will be operating.? The scope of the due diligence should also demonstrate a recognition and understanding of the specific risks and operational issues that are most commonly found among the typical target portfolio companies.? The fund managers should create and maintain a record of the due diligence investigation for each of the portfolio companies and be prepared to share with the fund’s investors how they identified and managed potential risks and the steps that they are taking to monitor issues that may have been identified during the process (including covenants for post-closing actions by the company and its management included in the deal documents).

This article is an excerpt from my recently updated chapter on Impact Investing: Doing the Deal. To learn more, read my new book: Investing for Impact: A Guide for Impact Investors and Sustainable Entrepreneurs.

Notes

[1] IRIS+ for Impact Due Diligence | IRIS+ System (Global Impact Investment Network, January 2020), 2.

[2] Developing a Private Equity Fund Foundation and Structure (Global Impact Investment Network) (Figure 13: Important Elements of Due Diligence)? See also M. McCreless, Social & Environmental Due Diligence: From the Impact Case to the Business Case, (Root Capital, 2014).

[3] S. Godeke and P. Briaud, Impact Investing Handbook: An Implementation Guide for Practitioners (Rockefeller Philanthropy Advisors, 2020), 132 and IRIS+ for Impact Due Diligence | IRIS+ System (Global Impact Investment Network, January 2020), 1.

[4] IRIS+ for Impact Due Diligence | IRIS+ System (Global Impact Investment Network, January 2020), 3-4 (including explanation of formulation of DDO questions for each of the five dimensions of impact).

[5] Developing a Private Equity Fund Foundation and Structure (Global Impact Investment Network) (Figure 14: Managing Risk)

[6] The GIIN has assembled a list of various resources that fund managers can use to integrate impact considerations into their investment management including The Impact Management Project, Navigating Impact Project, IRIS and the Impact Toolkit.?