In the VC world “2 and 20” (2% management fee and 20% carried interest or profit participation) is considered a “best practice” fee structure, but for #impactinv it may be a recipe for disaster.
Let’s start from the premise that management fees should reflect the cost structure mandated by the level of service appropriate to a particular investment strategy. Can the 2/20 formula align interests appropriately for impact investors? My gut says no and there are two sets of reasons why I think not.
The first set of reasons relates to the fact that impact investment is not the same as venture capital, even if both sectors look at early stage ventures. Multiple bottom line ventures may reach scale, but few of them operate in markets where an IPO or 10x exit is even a remote possibility. A fee structure that constrains operations but promises a high potential upside in the future isn’t realistic in a “reasonable exits” scenario. While most VCs invest in companies in their own geographic space, many impact investors are investing in companies that are farther from home, requiring greater time and effort (at higher cost) to provide a similar level of hands-on involvement. VC has typically focused on technology-driven innovation, while impact investment is more often focused on client-driven innovation, requiring knowledge across a broader range of sectors. Last, but not last, VC is about making equity investments, whereas impact investment covers a broad range of financial instruments. Convergence can offer useful lessons, but rather than taking VC standard practices at face value, we need to reflect upon how to use these to create appropriate practices for impact investment.
The second set of reasons focuses on the practical implications of fee structure, namely how and why are fees determined and what outcomes are they meant to incentivize?
Impact investment funds run the gamut of debt and equity instruments, primarily debt. Some funds are local, others are regional or global. The costs of running a small debt fund in Uruguay will be dramatically different than the costs of running a global equity fund. Let’s put some numbers on this for illustrative purposes. Can the Uruguayan manager of a $10mm fund provide hands-on value-add to a half dozen companies on $200,000 a year? After legal, accounting and admin costs are taken into consideration, what kind of budget does the fund manager have to hire and retain top tier talent?
Now, let’s say our global impact equity fund raises US$100mm. The manager has to address tax, legal and regulatory issues in a dozen or more countries and spend a lot of time traveling. How far will the $2mm management fee go when we’re talking about investing in roughly 20 small, unlisted private companies in a variety of emerging markets? If we assume that good governance is a priority and that portfolio companies have quarterly boards, we’re talking 80 board related trips a year and 70-80 weeks of staff time to prepare for, attend and follow-up on board level governance issues. Sure, you can put less time and effort into governance, but how will this affect the fund’s performance? Will Board representatives spot potential problems early enough to address them? Does the planned engagement level allow time for Board reps to interface with non-executive management in the company or with stakeholders in the local competitive environment?
Chances are that the appropriate management fee for most impact funds will be more than 2%, as a function of size and strategic scope. That’s the bad news. The good news is that impact investment is not driven only by money. Higher (appropriate) management fees can and should be offset by lower and or different carried interest/profit participation structures. Our goal should be to ensure that impact investment managers have the resources to achieve operational excellence around strategic objectives and sufficient incentive to produce positive long-term outcomes around these financial and non-financial objectives.
The goal of offering fund managers a carried interest is to ensure that they aim for high exit multiples (HEMs). This makes sense if you’re investing in the tech sector and can shoot for that 10x acquisition by Google or Microsoft or an IPO. In the new and evolving world of impact investment, a 20% carry can do more harm than good, especially if combined with an artificially determined and inadequate (sub-budget) management fee. Impact investments can produce solid financial returns plus incremental non-financial (social and environmental) returns, but HEMs and IPOs are neither likely nor necessarily appropriate. Almost by definition, HEMs will lead to an increase in cost to the target market, or a decrease in product/service quality. Some call this “mission drift” but it’s mostly a question of economics. In order to generate a reasonable return on an investment that you’ve paid a high price for, you need to substantially increase sales and/or margins to recoup the cost of acquisition and then generate a positive margin on top of that.
The most insidious aspect of a 20% carry coupled with sub-budget management fees is that it encourages “cherry picking”. What I mean by this is that managers have every reason to focus intensively on the one or two portfolio companies for which HEMs and IPOs are feasible (i.e. companies located in countries like Brazil and South Africa that enjoy robust capital markets, or in sectors like technology that attract mainstream interest) and devote less attention to companies that can offer decent, but not windfall, returns. If a manager reduces engagement with the majority of portfolio companies, most of these companies won’t get the value-added attention needed to achieve full potential. The result is overall lower returns to investors and diminished impact across the portfolio.
Gompers and Lerner (“An Analysis of Compensation in the US Venture Capital Partnership”,Journal of Financial Economics, 51(1999) 3-44) note that one of the goals of the 2/20 structure is to keep the manager “hungry” and focused on generating performance that will allow for better compensation on later funds. Again, this assumes that HEMs are an appropriate goal and that there are enough of these to provide a substantial upside to the fund manager. For impact investment managers, the potential upside may not compensate for the negative personal impact of sub-budget management fees. These managers often sacrifice retirement savings, fringe benefits (such as health care!) and educational outlays for their children in order to make fund level economics work. Without a golden ticket down the road, burnout becomes increasingly likely, as does the temptation to abandon impact investing in favor of more highly compensated mainstream financial employment.
It’s one thing to argue that impact investment managers should be paid sub-market salaries, either because mainstream financial sector wages are perceived to be too high, or because fund economics won’t support market or near-market salaries. Viewed with a long-term lens, this position is too simplistic and counter-productive. For one thing, sub-market salaries limit the manager’s ability to accumulate capital to seed new product offerings, which constrains a single fund manager from evolving organically into a sustainable multi-product investment manager. For another, investment managers who cannot cover personal or family level budgets may be forced to pursue external consulting or revenue generating activities that bring the family budget into balance but can negatively impact fund performance. There’s an ethical issue here as well. Is it reasonable to ask impact investors to accept lower standards of living because they have chosen to dedicate their lives to improving standards of living at the base of the pyramid?
Now, what if we go back to the beginning and start with the premise of budget-based fees and appropriate upside? We’d determine the management fee based on the projected operating expenses associated with a particular scope and strategy. The size of the fund, geographic scope, strategic range, planned level of engagement (especially with regard to governance) and fair compensation of staff would all be taken into account in determining the management fee.
Recognizing the need to offset higher management fees in order to preserve target ROI to investors, we’d then adjust the carried interest or upside promise offered to the fund manager. Perhaps the number is 10-15% rather than 20%. Or maybe it’s 20% but only after a higher hurdle rate payout to investors. Alternatively, perhaps we should replace carried interest with transaction fees wherein the manager receives a minimum fee on all exits (because any exit requires time and effort on the part of the manager) plus a performance bonus fee on exits about a pre-determined multiple or hurdle. Another option might be to split upside into short-term and long-term components, which could mean a small transaction fee on a current basis, plus a bonus payout at the end of the fund-life if the total fund return exceeds the target return.
To make this long story short, compensation practices in impact investment need to reflect the costs of doing business and align both the short and long-term incentives of investors, fund managers and portfolio companies. Taking the VC world’s 2/20 as a “best practice” is a cop out. It may eliminate tiresome budget negotiations or increase the comparability of returns across funds, but 2/20 is unlikely to effectively support the impact outcomes you’re looking for. Investing in new business models in unlisted and often early stage ventures in emerging markets is complex and risky. Effective risk management requires a serious overlay of human judgement and a proactive engagement plan with respect to portfolio companies.
The way to reduce the cost of doing business without sacrificing performance is NOT to bet on stand-alone funds and argue for arbitrarily low fee structures. Common sense implies that we need different business models. We should be encouraging managers to create “institutional investor ready” platforms spanning front and back office policies, processes, systems and tools that can be used to design, launch and manage multiple products. If each new fund or instrument leverages this same platform, the cost and time to market for new funds could be lowered over time. Economies and efficiencies of scale would come into play in a way that cannot happen with the small stand-alone funds that dominate microfinance and impact investment today.
If we look at the mutual fund industry instead of VC, we can see a wide range of “no-load” products on offer, especially from large multi-product firms like Vanguard, Fidelity and Schwab. We can also see a range of specialty funds that charge front-end fees of 1-5%, justified by the additional cost of pursuing a niche strategy. If this range and justification hold true in the US public equity markets which boast high transparency, extensive comparables and vast amounts of available information, wouldn’t we expect the need for a range of fees in the much more opaque impact investment markets? Wouldn’t it make more sense to incentivize sustainable multi-product managers that use economies of scale to reduce costs without sacrificing performance?
Minimizing the fees paid on an investment is a tried and true component of achieving desired returns. My personal motto has always been “First, pay no fees” – and yet, there are niche funds in my investment portfolio on which I’ve paid fees because I believe that fee is justified by the manager’s strategy. The key for impact investment is that the fees paid need to reflect the costs of achieving desired outcomes and align stakeholder interests around these outcomes. In a vacuum, low fees do produce higher net returns to investors. In practice, if the management fee paid does not provide sufficient resources to execute on strategy, poor performance will reduce the net return despite low fee levels. Let’s first do our best to create conditions that support excellent performance and then focus on how we can achieve these results at a lower cost.