Sustainable or ESG (environmental, social and governance) investing has become a major global investment trend. According to Morningstar, global sustainable fund assets soared to USD2.5 trillion by end-2022, more than doubled compared to end-2019. However, when investors take a closer look at sustainable investing, they may question if fund managers have sufficient incentives to integrate ESG and sustainability considerations into their investment process.

Adding Sustainability Links to the Private Equity Market

Sustainability-linked loans and bonds are not new in the debt market. Compared to green, social and sustainable loans and bonds which tie the use of proceeds to specific expenditures, sustainability-linked debt products provide borrowers with more flexibility. They also boost borrowers’ sustainability profile by aligning financial terms with the borrower’s performance against relevant predetermined sustainability performance targets (SPTs) measured by predefined key performance indicators (KPIs).

Adding Sustainability Links to the Private Equity market is not a novel idea either. On the one hand, private equity fund managers have experience in sustainability-linked borrowing as investors or sponsors. On the other hand, the idea of linking sustainability and/or impacts to private equity performance and manager incentives has been floating around for quite some time—bridging sustainability performance and fees/carry of funds sounds like a fascinating idea that could potentially revolutionize compensation structures in the private equity industry, effectively tying fund managers’ pay not only to their financial performance, but also to their sustainability and ESG performance to show LPs that they really “mean business”.

However, as the private equity market is, by and large, more bespoke and less regulated compared to the debt market, there is still no standardization on how to create better incentives for fund managers to promote their sustainability-related performance.

Mainstreaming Sustainability-Linked Compensation Incentives for Fund Managers

Attempts to mainstream sustainability-linked compensation in the private equity market are not lacking. According to the UK-based law firm Travers Smith, a growing number of impact funds is weighing up whether to link fund managers’ compensation to sustainability-related performance as a strategy to make sure that the firms they back are good corporate citizens. As a more recent example, in October 2021, EQT launched EQT Future, with up to 20 percent of the fund’s total carried interest being tied to achieving KPIs on sustainable transformation. Furthermore, as a pioneer in sustainability practices, AIIB has designed a sustainability-linked incentive scheme in its investment into CEL Infrastructure Investment Fund II, where the fund manager’s carried interest is linked to three sustainability performance targets on (1) climate finance, (2) gender diversity and (3) ESG governance.

With the market momentum being built, a set of sustainability-linked fund principles would be required to roll this out more broadly and effectively. Similar principles for sustainability-linked loans and bonds have helped tremendously in establishing trust, coherence and market discipline.

The sustainability-linked fee/carry incentives could be structured like sustainability-linked debt products, where fund managers’ financials are closely pegged to predefined SPTs. For example, investors may consider defining a set of SPTs and specific KPIs that are central to the asset class in which a fund is investing and negotiate a management fee or carried interest reduction mechanism if the fund manager fails to meet these KPIs. Alternatively, it could also be structured as a financial premium to fund managers by forfeiting a portion of the distribution to investors, thus rewarding those who meet or exceed the agreed KPIs.

These options are available to both fund managers and their investors and shall be designed in a way to avoid excessive associated costs. While the linkage could be formed as either premiums or penalties or a combination, both have merits for different players to choose from. For established players, penalties may be considered and, if the investors agree, the fee/carry reduction could potentially be set aside to fund specific sustainability enhancement initiatives. For boutique firms that commit extra efforts on sustainability performance, a premium could be more appropriate to motivate both the manager and competing firms in the market.

SPT and KPI selection is another key component for this construct. For fund managers, there is a range of themes to choose from, including both broader themes related to specific sectors mapped against the Sustainable Development Goals as well as more focused themes such as climate change and gender equality. While there is a tendency to focus on KPIs at the portfolio-level, considerations should also be given as to whether fund-level KPIs may be appropriate, or potentially even firm-level KPIs.

Looking Ahead

Undoubtedly, the growth of sustainable or ESG investing is seen as a positive trajectory toward a green and sustainable transition, but it may also lead to several challenges, including concerns regarding consistency, comparability and the risk of greenwashing.

International financial institutions have a role to play in addressing these challenges. Not only can they try and test sustainability-linked fee/carry structures in their fund investments and promote the awareness of these incentives with like-minded investors, but they can also leverage their robust understanding of key sustainability issues and participate in market efforts to harmonize KPI selection, monitoring and reporting frameworks.

As the sustainable investing market matures, a set of sustainability-linked fund principles should be established. These would enable fund managers to have better ESG management systems and tools to measure their sustainability performance and, hopefully, cause the emergence of more investors and managers who are willing to set ambitious SPTs and KPIs, together with proper financial incentive mechanisms.

This article was first published in The Sunday Times.