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From Fiduciary Duty to Impact Fidelity: Managerial Compensation in Impact Investing

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Abstract

Investors with standard monetary preferences will give a fund manager incentives to increase firm profits, which can be achieved through a share in profits via carried interest. When investors have social preferences, it is not clear which incentives the manager should receive. We explore this puzzle by applying an agency theory perspective to impact investing, a practice where investors seek both financial returns and a measurable social or environmental impact. Using an inductive, qualitative approach, we identify and describe the ethical tensions and challenges faced by fund managers to structure and implement impact-based variable compensation schemes. Our results indicate that economic incentives tied to non-financial objectives are useful to alleviate goal incongruity between principals and agents during fund creation but have the potential to lead to perverse effects during the fund lifecycle, where managers may exploit subjective non-financial metrics to maximize personal wealth. We introduce the concept of impact fidelity, a conceptual equivalent of fiduciary duty, to ensure that investment decisions reflect the asset owner’s impact preferences.

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Notes

  1. LeapFrog website (https://leapfroginvest.com); Bamboo Capital Partners website (http://www.bamboocp.com).

  2. In this paper, we exclude venture philanthropists (VPs) from our analysis. Although many VPs use the same financial instruments as impact investors more broadly, the principal-agent relationship varies considerably, and as a result, we limit our focus in this paper to funds that can return principal at a minimum.

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Authors and Affiliations

  1. HEC Ecole de Gestion, Université de Liège, Liège, Belgium

    Isaline Thirion

  2. elea Center for Social Innovation, IMD, Lausanne, Switzerland

    Patrick Reichert

  3. HEC Ecole de Gestion, Université de Liège, Liège, Belgium

    Virginie Xhauflair

  4. Telos Impact & Solvay, Brussels, Belgium

    Jonathan De Jonck

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  1. Isaline Thirion
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Correspondence to Patrick Reichert.

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Appendix A: Interview Questions

Appendix A: Interview Questions

Have you included the impact performance of your organization (or of the funds you manage) in your compensation scheme?

  1. A

    If no, why not?

    1. 1.

      What is your state of reflection / proposition on the topic? To what extent have/would 2.you consider including the impact performance of an impact investing fund in the financial reward scheme for the fund’s ma3.naging team?

    2. 2.

      Do you believe that it would be interesting for you? How would it be perceived by the different stakeholders (investors, team, investees)?

    3. 3.

      What do you need/miss to implement such scheme?

    4. 4.

      What is your opinion on the challenges described below? I.e., challenges in terms of setting impact targets and metrics, impact audit and reporting, stakeholders’ involvement…

  2. B

    If yes, how is it structured?


I. Detailed impact-based compensation structure.

  1. 1.

    Can you describe the mechanisms of your impact-based compensation structure?

    1. i

      Is it part of a bonus or carried? To what extent do financial and impact performance, respectively, contribute to the financial reward? What’s the threshold and what is then the minimal/maximal possible reward?

    2. ii

      How often can the financial reward be received? Is it fixed (all or nothing, e.g., in case of targets achievement, over-achievement…) or does it increase according to the level of targets achievement (e.g., when various impact scenarios are tied to specific levels of compensation)?

    3. iii

      Where does the financial amount foreseen for the reward go if not distributed? E.g., Does it return to investors, or is it donated to a third-party pursuing similar impact objectives?

  2. 2.

    What are the biggest difficulties you encountered in setting up such scheme (defining thresholds, impact metrics, reporting, auditing, acceptance from team members/investors…)?


II. Lessons learned on defining metrics.

How does the integration of impact-based incentives in your remuneration structure affect the impact assessment process?

I.e., trade-off between the extra impact assessment burden and the incentivized incremental performance.

  1. 1.

    When assessing the impact of your organization, do you set targets and measures at the investee level, the fund level or both?

  2. 2.

    If you consider impact at the investee level, to what extent are impact objectives included in your contractual relationships with investees?

    1. i

      Do you contractually impose impact targets to your investees? If so, do you allow for flexibility according to investee’s capabilities?

    2. ii

      How do you make sure that those targets are stretched, yet realistic? To what extent are you able to review the targets if they seem unrealistic vs. unchallenging? How do you proceed?

    3. iii

      To what extent and how do you expect investees to report on specific impact measures? Do you provide tools for them to report on their impact, or do you assess their impact achievements directly?

    4. iv

      Do you consider impact generated by investees, or the incremental impact generated thanks to your investment only? I.e., the actual impact generated by your investment thanks to your organization’s financial resources and expertise

  3. 3.

    If you consider impact at the portfolio level, how do you ensure a common set of metrics applicable or comparable across the portfolio?

    Do you have a set of indicators at portfolio level that is applied as such for each investment, or do you aggregate investments in a way that allows for a variety of distinct metrics?


III. Lessons learned on reporting/audit challenges.

How do you include impact performance in your reporting system from portfolio companies and to investors/clients?

What are the biggest challenges you are facing when it comes to reporting and the quality of reporting? How do you manage those?

  1. 1.

    How does the integration of impact-based incentives in your remuneration structure affect reporting to your clients/investors and how do you manage it? I.e., trade-off between the extra reporting burden and increased value for clients/investors as it demonstrates that their money was used effectively toward achievement of the targeted impact.

  2. 2.

    To what extent are clients/investors involved in the process of setting clear impact goals, defining impact indicators, performance measurement and incentives? What’s their view on/demand for an impact-based incentive structure?

  3. 3.

    How do you ensure the quality, reliability, and transparency of reporting?

    1. i

      What are the human and financial resources needed for your impact assessment?

    2. ii

      Is a third-party needed to assess impact performance (professional external auditor or external advisor, independent review…)?

    3. iii

      How often is impact monitored? How often is the amount of the variable compensation determined and paid?

  4. 4.

    How often do you revise your incentive system?

    1. i

      What data needs to be collected? How and how often is it collected?

    2. ii

      Have you developed a specific expertise and/or specific tools in order to be able to measure and assess the impact delivered by your organization?

    3. iii

      Who is involved in the impact performance evaluation and how?

    4. iv

      What are the reporting requirements for investees? Which human and financial resources do you expect them to dedicate to their impact assessment and reporting?

IV. Team dynamics and motivation.

How does the integration of impact-based incentives in your financial structure contribute to alignment of all stakeholders (managing team, investees and investors) toward impact achievements?

  1. 1

    To what extent does the integration of impact-based incentives in the compensation structure incentivize the fund’s managing team to go the extra mile?

    1. i

      What are the expected results regarding motivation of the fund’s managing team and resulting fund’s performance?

    2. ii

      To what extent does it drive the impact investing fund’s portfolio efficiency?

  2. 2

    To what extent are investees incentivized on the same targets?

    1. i

      To what extent does it secure alignment between your organization’s impact targets and investees’ activities?

    2. ii

      To what extent does it instill motivation and increase performance among investees?

V. Other


Are there, in your opinion, any additional advantages, disadvantages and/or challenges regarding the implementation of impact-based incentives? Is there anything more you would like to add?

Which other financial or non-financial mechanisms have you set up in order to incentivize your impact investing fund’s managing team?

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Thirion, I., Reichert, P., Xhauflair, V. et al. From Fiduciary Duty to Impact Fidelity: Managerial Compensation in Impact Investing. J Bus Ethics 179, 991–1010 (2022). https://doi.org/10.1007/s10551-022-05155-5

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