Structure of Impact Investment Funds
Alan S. Gutterman
Experienced Business Advisor & Legal Counselor | Best-Selling Author | Working on Sustainable Impact Entrepreneurship
Venture capital funds focused on impact investing are typically organized and structure as either a for-profit limited partnership or a limited liability company (“LLC”), with the fund manager serving as the general partner or manager, respectively, of the entity. ?The investors in these funds are institutional investors, foundations, charities, endowments and wealthy individuals that meet specific criteria established under applicable securities law and that have contributed cash to the limited partnership or LLC for investment and management by a group of impact investing professionals with experience in sourcing, vetting and selecting impact investments and managing those investments through engagement with the leadership teams of the fund’s portfolio companies to achieve both traditional financial return and significant positive environmental and/or social impact.[1]? The diversity of the investor base for impact investment funds has expanded in recent years and most of the investors have incorporated environmental and social impact into their own formal set of internal investment guidelines.
The number of “portfolio companies” that a fund manager invests in will depend on the size of the funds and the availability of human resources to properly manage each investment, and regardless of fund size a manager will typically receive and review thousands of business plans.? While funds may supply all the capital required by a portfolio company for a specific round of investment, the more typical approach is for the fund managers to participate in co-investments into portfolio companies with other funds.? Funds may form a special purpose vehicle with a strategic investor, perhaps one or more of the investors in the fund, to make a specific investment.? In instances where the fund seeks greater involvement in the development and management of an enterprise’s business model, the parties may form a joint venture directly with the enterprise.? Finally, the fund’s investment guidelines may permit the fund managers to use a limited amount of capital to make grants or loans to enterprises; however, the bulk of the fund’s holdings will be equity instruments and investors will generally impose restrictions on the percentage of committed capital that can be distributed in the form of debt.
Limited partnerships and LLCs are used for impact investing funds to provide investors with certain tax benefits including avoidance of double taxation if the corporate form was used and to provide investors with limited liability with respect to the operations of the fund: the liability of the investors is limited to the total amount of cash they contribute to the fund.[2]? In exchange for limited liability, investors must surrender any rights to actively participate in the management of the fund (i.e., they become “passive investors”); however, investors will have the right to vote on various material and fundamental matters relating to the fund and the fund managers are obligated by contract to follow the fund’s pre-existing investment policies and guidelines.? It is also commonplace for fund managers to form a limited partner advisory committee that includes key fund investors with relevant experience and/or whose organizations are involved in activities that are aligned with the fund’s investment guidelines and environmental and social mission. Committee members provide advice to the fund managers regarding investments and address issues such as conflicts of interests involving the fund managers on behalf of all the fund’s investors.
Like traditional venture capital funds, impact investment funds are long term businesses with a life expectancy of 10–12 years, and most of the investments are made during the first several years of the fund’s duration with the expectation that they will mature into an exit opportunity before the end of the term of fund.[3]? While the fund managers only contribute a nominal amount (e.g., 1%) to the fund, they receive a disproportionate allocation of the profits. For example, it is common for profits to be allocated 20% to the managers and 80% to the investors, thereby providing tremendous incentives to the managers to maximize the return from an investment in a company (profits also received preferred tax treatment as capital gains). Managers will also receive some form of management fee to cover salaries and other overhead expenses over the term of the fund.? Assuming they are successful with their initial fund, the managers will usually operate more than one fund at a time; however, managers will be expected to commit to devoting sufficient time to each of their funds to ensure that investments are properly managed and that investors will realize liquidity on their capital contributions with the specified term of the fund.?
The requirements and expectations of the investors, and the duties and rights of the fund manager, will be set forth in a comprehensive limited partnership or operating (if the fund is formed as an LLC) agreement, the length and complexity of which have grown steadily as the years have gone by.? A good deal of space in the agreement will be devoted to provisions that are driven by the tax treatment of the entity and its owners.[4]? The agreement will also cover the fund’s economics (i.e., time of capital contributions, allocations of profits including the general partner’s carried interest, distributions and “claw backs” of previous distributions, management fees and organizational and entity expenses); term and structure including extensions of the fund’s term and the creation and use of vehicles investing alongside the fund; duties of the fund managers and other “key persons”; fund governance (i.e., fiduciary duties, cross-fund investment, co-investment allocations, advisory committee rights and processes, valuation of portfolio investments and independent audit requirements); and financial and impact disclosures (i.e., quarterly and annual reports on financial performance, portfolio companies and progress against impact goals).? The agreement will typically be supplemented by policies relating to specific issues such as conflicts of interest and sustainability reporting which are incorporated by reference into the agreement.?
Investors making the largest commitment of capital to the fund may also be afforded special rights under “side letters” between them and the fund managers granting them special rights and privileges not offered to all fund investors. Many institutional investors have a list of personalized “standard” side letter requests relating to “most favored nations” undertakings (if not addressed directly in the fund agreement), transfer and/or redemption rights, co-investment rights, information and/or disclosure rights, investor tax and regulatory concerns and other matters particular to the investors.? Side letters may also be used to address various issues related to the impact-related activities of the fund and impact measurement and reporting including[5]:
When drafting the fund’s limited partnership or operating agreement, particular attention should be paid to defining the scope of the fund’s mission and ensuring that it includes impact-related requirements that are specific enough to facilitate meaningful measurement yet still provide the fund managers with flexibility to adjust their strategic decisions in response to changes in market conditions over the life of the fund.[6]? The terms of impact-oriented funds are often longer than traditional funds (e.g., 12 years as opposed to ten, with provision for up to three additional years at the option of the fund managers to bring the full length of the term to 15 years) because impact investments require significantly longer periods to yield acceptable returns and a longer term supports a mindset of focusing on portfolio companies that will take longer to reach profitability because of their own social missions and business models. ?Some funds are actually structured as “evergreen funds”, which have been described as having “an indefinite lifetime in conjunction with redemption options for investors, e.g., allowing investors to opt-in or opt-out on an annual basis; allowing redemption following a formal notice process; or allowing redemption at will, with another impact investor or a foundation functioning as guarantor to the fund”.[7]? Impact-focused funds may also use different compensation structures for the fund managers, such as distinguishing between financial and impact performance in the “carried interest” provisions (e.g., fund managers may be eligible to receive up to the traditional 20% carried interest; however, 15% might be awarded based on financial performance and 5% would be awarded based on agreed measures of impact performance among the portfolio companies).? Certain impact investors may also be given preferences with respect to distributions.
The use of an advisory committee consisting of representatives of the fund’s investors is mentioned several times in this chapter and such a committee can serve a valuable role in providing the fund managers with access to professional investors with specialized expertise on topics central to the fund’s mission and goals.? Advisory committee members should be called upon to weigh in on matters that are not within the core management functions of the fund managers—selecting the fund’s portfolio companies—but which are nonetheless essential for sound fund governance.? Among other things, the advisory committee may be involved in review and resolution of conflicts-of-interest, audits of financial and impact performance and valuation of portfolio companies.? The documentation for the fund will make it clear that the members of the advisory committee owe no fiduciary duties to the fund or any of its investors and that the reasonable fees and expenses of the committee will be borne by the fund.
Reports and other communications from the fund managers to the fund’s investors should also be addressed in detail in the fund documents.? At a minimum, investors should expect to receive quarterly and annual reports which include financial statements for the period covered by the report and a narrative discussion of the progress of each of the fund’s portfolio companies along with credible data on valuation.? Financial information and valuations should be confirmed by outside auditors.? In addition, the fund managers should expect to be required to provide detailed qualitative and quantitative assessments of the financial and impact performance of all the portfolio companies.? Written reports should be supplemented by regular meetings between the fund managers and the investors in the fund.? If possible, arrangements should be made for investors to visit the facilities of portfolio companies and meet with their managers.? Good communication with the fund’s investors is essential for smooth relations and building a long-term foundation that results in the investors supporting future projects of the fund managers, such as participating in new funds that the fund managers may decide to launch.
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Notes
[1] Participation of certain types of investors in an impact investment fund may lead to complex additions to the basic structure.? For example, nonprofits will be concerned that by investing in fund structures as a “pass-through entity” for tax purposes (i.e., a partnership or LLC) the underlying investments of a fund will cause their activities to be characterized by the business of the underlying investment, thereby raising the risks of unrelated business income tax and that their activities do not exclusively serve its exempt purposes.? These issues will typically be addressed by inserting a corporate entity, referred to as a “blocker”, between the nonprofit entity and the underlying fund entity (i.e., the partnership or LLC).? These types of structural changes will be authorized in advance in the fund’s governance documents (i.e., the limited partnership or operating agreement).? Other areas of attention for foundations seeking to engage in investment activities include potential conflicts of interest and issues relating to excess business holdings.
[2] While traditionally funds were formed and structured as a limited partnership, there is a trend toward structuring funds as LLCs to provide all the participants—investors and the managers of the fund—with the benefits of limited liability (general partners of a limited partnership are potentially subject to unlimited liability, although that risk has been effectively managed by structuring the general partner as an LLC).?
[3] While liquidation is generally done by selling securities in the fund’s portfolio and distributing the cash to fund investors, there are instances where the securities themselves are distributed to the investors, although most investors prefer that the fund managers make the decisions regarding holding or disposing investments since they are in a better position to understand how the underlying businesses are operated.
[4] While the structure of limited partnership and operating agreements is relatively standard across jurisdictions, the domicile of the fund will depend on the preferences of the target investors, tax considerations and other regulatory issues such as restrictions on the flow of investment funds.
[5] E. Fleishhacker et al., “Special Considerations in Forming An Impact Investment Fund” in A. Gutterman and R. Brown (Editors), Impact Investing and Social Enterprises: Global Progress and Challenges (Chicago: ABA Press, 2022), 47-48.
[6] S. Mac Cormac, J. Finfrock and B. Fox, “Impact Investing” in A. Gutterman et al. (Editors), The Lawyer’s Corporate Social Responsibility Deskbook (Chicago: American Bar Association, 2019), 237.? Investors will also insist that the “purposes and powers” provision of the agreement have consequences and that the agreement include remedies for material deviations from the fund’s missions and procedures for determining whether a material deviation has occurred.? In addition, provisions should be made for allowing tax-exempt entities that make program-related investments (“PRIs”) into the fund to exit if the fund’s mission changes in a way that could jeopardize the PRI’s tax exemption or the tax-exempt status of the investor itself. Id.
[7] Id. at 238.