Contracts with (Social) Benefits: The Implementation of Impact Investing

Anne Tucker is Professor of Law at Georgia State University College of Law. This post is based on a recent paper, forthcoming in the Journal of Financial Economics by Professor Tucker; Christopher Geczy, Adjunct Professor of Finance at The Wharton School at the University of Pennsylvania; Jessica Jeffers, Assistant Professor of Finance at The University of Chicago Booth School of Business; and David Musto, the Ronald O. Perelman Professor in Finance at The Wharton School at the University of Pennsylvania.

In our paper, Contracts with (Social) Benefits (forthcoming Journal of Financial Economics), we ask how private market contracts adapt to serve social-benefit goals in addition to financial goals. In particular we consider the potential impact of these additional goals on canonical principal-agent problems: first between investors and the fund, and, later, between the fund and the portfolio companies in which the fund invests.

To examine contracting for impact, we analyze a unique set of impact fund legal documents compiled by the Wharton Social Impact Initiative (WSII). Documents include private limited partner agreements (LPAs), private placement memoranda (PPMs), term sheets, and letters of intent. These documents are a window onto the rapidly growing sector of private markets, which by 2019 exceeded 13,000 deals and $33 billion per year (GINN, 2019). In addition to contract observations summarized below, our paper provides a novel descriptive account of the impact funds contributing documents, and of the sector itself.

Impact funds display a wide range of tradeoffs between financial and social-benefit goals. At one end are funds targeting market returns (market-rate-seeking, or MRS, funds). At the other are those with lower financial targets (non-market-rate-seeking, or NMRS, funds), whose willingness to forgo higher financial returns implicitly elevates the impact goal. Comparing contract terms between these two groups, and between impact funds in general and the funds analyzed in the existing private-markets literature, highlights the balance between financial and social benefit goals on the contracts.

First, our findings show impact funds committing to their nonfinancial goals, rather than making empty gestures, i.e. ‘greenwashing.’ Both MRS and NMRS fund contracts contain impact-specific terms. Importantly, impact contracting flows through from a fund’s contracts with its investors to its contracts with its PCs, as more direct impact terms in a fund’s LP contracts correlates with more impact terms in its PC contracts. Neither boilerplate language nor law-firm fixed effects drive our results.

Our second finding challenges the theoretical literature on multitasking agents, in which principals avoid focusing compensation on only one of two important tasks. We find that impact funds focus compensation on financial performance using the usual waterfall structure, but generally have no direct compensation for success toward social benefits. Impact funds also generally have management fees which vary substantially, with the NMRS funds’ fees at the higher end.

Does focusing pay on financial performance alone detract from the impact goal? The answer hinges on whether financial performance complements or conflicts with the delivery of impact, and on the extent to which other contractual terms channel effort toward impact. For example, profit and impact may complement one another in funds focusing on ‘embedded impact’ (e.g., clean energy companies), where financial success can be a precondition for achieving impact. Complementarity is less clear, however, when impact is a choice, such as when funds or their portfolio companies commit to employing convicted felons.

Do impact funds condition compensation exclusively on financial performance because the impact terms, noted above, are simply bolted onto non-impact contracts? There may be some inertia in contracting practices, but we observe many other modifications to the contracts, such as impact-specific covenants and enhanced participatory governance. This widespread modification indicates that continuing to tie compensation to financial performance is a choice.

This brings us to our third main finding: impact funds emphasize governance terms, many of which indirectly reinforce impact goals. This aligns with the ‘braiding’ model of contracting which argues that the importance of governance increases when tasks are uncertain and hard to contract over ex ante. For example, we find that almost all funds give LPs advisory roles that impart substantial oversight over deal selection, diligence process, conflicts of interest, and other material fund activities that affect impact. This is true in impact funds of all sizes, and as far as we can tell, is not common in nonimpact funds. At the PC level, the vast majority of funds contract for guaranteed board seats, a guarantee perhaps necessitated by what we find to be small voting shares. The combination of these contract adaptations—direct contracting on impact and emphasis on governance—combats the distortive effects of compensating for financial performance. While these additional terms help explain how funds balance impact and financial goals, a deeper puzzle remains as to why funds prefer to encourage impact through these mechanisms rather than through diversifying compensation away from financial performance.

A possible resolution to this puzzle is that contracting for impact is likely to be less complete than contracting for dollars because the parties know little about the nature of the best impact opportunities until the fund is well underway. We find that impact funds recognize and adapt to this incompleteness with both direct contracting on impact and flexible participatory governance terms focused on process and reporting. Participatory governance allows investors to braid what they learn from monitoring into the funds’ operations, thereby implementing their impact goals dynamically. In this way, impact goals elevate the role of informal governance.

Contracting for private investment is challenging enough when everyone is just in it for the money. The additional goal of social impact adds a new dimension to the challenge, and the new database of impact investing contracts shows us how this growing sector has risen to it. Our work contributes to the limited, but important, field of impact finance scholarship including papers examining impact investing, community development venture capital, and social value for investors.

Our impact investment document collection and coding work continues through the newly formed Impact Finance Research Consortium (a collaboration between the Wharton School, Harvard Business School, and the University of Chicago Booth School of Business). With additional data points, we will update our findings as the field matures and expand our research questions. We invite interested readers to contact the authors for more information or to participate in the data effort.

The complete paper is available for download here.

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