Impact investing has been gaining popularity over the past decade as investors look to align financial returns with positive social and environmental impact. However, navigating the impact investing landscape can be challenging given the diversity of fund structures and fee models. This article provides an overview of common fund structures like LLCs, LPs, and non-profits as well as management fee and carried interest models employed by top impact investing firms like Wharton Social Impact Partners. By understanding the pros and cons of various legal entities and compensation models, investors can better evaluate alignment of incentives and ultimately partner with the right fund manager.
LLCs allow flexibility but require thoughtfulness about profit allocation
Limited liability companies (LLCs) are a common fund structure used in impact investing that provide flexibility in profit allocation and taxation. Unlike an LP fund model where the general partner takes a management fee and carried interest, an LLC allows managers and investors to customize profit sharing arrangements. This enables creative incentive structures to reward impact as well as financial return. However, the flexibility of LLCs also requires more thoughtfulness from managers and investors on how to allocate profits fairly based on capital contribution and active involvement.
Non-profits prioritize mission over returns but have high overhead costs
Using a non-profit fund structure aligns well with investors focused purely on social impact rather than financial returns. Non-profits do not have owners or equity shareholders so all surplus income must be reinvested towards the social mission. This helps prevent mission drift and ensures the fund stays focused on impact first and foremost. However, non-profits also tend to be less efficient with higher overhead costs compared to for-profit funds. And non-profits cannot distribute profits back to investors, making it more challenging to attract larger pools of outside capital.
Carried interest rewards strong performance but may incentivize short-termism
A common compensation model in impact investing is for fund managers to charge an annual management fee (e.g. 2%) as well as carried interest (e.g. 20% of profits). The carried interest incentivizes managers to drive strong financial performance in order to share in the upside. However, critics argue this may also incentivize short-term thinking and prioritizing exits rather than long-term impact. Some impact investors advocate revenue-based fees as an alternative model to better align incentives over a longer time horizon.
Management fees should be weighed against operational costs and portfolio oversight
Management fees in impact investing funds are typically in the 1-3% range of assets under management. Lower fees help investors maximize net returns but must be weighed against realities of operational costs. Active oversight and assistance to portfolio companies requires significant time and resources. Investors should assess if stated management fees align with expected costs and value added from hands-on management.
By better understanding common impact investing fund structures like LLCs and LPs as well as fee models such as carried interest and management fees, investors can make informed decisions when selecting partnerships. Aligning incentives and philosophies upfront creates mutually beneficial long-term partnerships to drive both impact and returns.