The structure of a traditional venture capital fund provides two sources of revenues to fund managers. The first is the management fee, which covers the costs of the team, the investment processes, and the monitoring of portfolio companies. It is calculated as a fraction of the total amount invested in the fund and is paid monthly to the management company. The second form of compensation is the carry cost. Early in the life of the fund, the manager and the investors agree on a minimum expected annual financial return. If the return is exceeded, a portion (usually about 20 percent) of the excess amount is due to fund managers as success fee.
This is a structure that has worked relatively well when the objective of the fund is solely financial return. There is a clear alignment of interests between investors and managers: Both sides want to maximize the financial return on investments. But in the case of impact investing, how do we ensure this alignment when impact metrics are also part of what we are trying to achieve?
Impact investments, of course, are made with the intention of generating positive social and/or environmental impact, beyond financial return. This is the exact motivation that made investors join our fund at Vox Capital; blending these two aspects was traditionally seen as irreconcilable. It became clear to us that a more traditional structure that rewarded our team based only on our financial return would not ensure the best alignment between investors and us (fund managers). For this alignment to happen, we needed to link our long-term incentive to the social impact that our fund’s activities are generating.
A good example of this is Saútil, a Vox Capital portfolio company. Saútil was created to make it easier for people with no health insurance (75 percent of Brazilians) to access free services already provided by the public sector. The company geo-localized all the public health services providers in every Brazilian city so that the customer, using her ZIP code, could get information on where she should go and what documentation to carry to access a free medication, exam, or vaccination. To monetize the product, Saútil began selling, on a B2B model, a concierge service for blue-collar employees at large companies, who usually do not have a health plan. The product was so useful that insurance companies wanted to offer this same service to their high-income clients, thus reducing the number of claims and their costs.
Soon enough, it was clear to the management team that it was easier to sell to companies that serve high-income clients, compared to those that employ blue-collar workers. However, the intention of the entrepreneurs and their team (as well as Vox Capital’s) while creating the company was to provide access to low-income clients—to reduce the gap on health care and services that we experience in Brazil. After much discussion, we decided to sell to high-income clients to guarantee the short-term financial results for the company, but to focus primarily on sales and product development for the bottom of the Brazilian pyramid—those who do not have access to a quality health plan. But then, how do you guarantee this mission lock on the long term? How do we guarantee that Vox Capital, as a member of the company’s board, will always vote to serve the less-favored individuals?
The solution we found was to link part of our carry compensation to social impact metrics. That is, we will receive the full 20 percent success fee only if we deliver both the financial return and the social impact expected by investors. The mechanism works as follows: If the fund delivers beyond its benchmark financial return rate, we have access to the full carry compensation only if we also reach a certain level of impact. If we do not reach the minimum expected social impact level, our team is entitled to only half of the carry. At the same time, if the financial return is below its target, we are not entitled to any success fee, regardless of our social impact results, avoiding another potential conflict of interest: managers earning money, even when investors lose it.
The tool we are currently using for impact measurement is Global Impact Investing Rating System (GIIRS). Today, it is the most accepted and adopted methodology within the impact investing market worldwide. Of course, as with any other tool, it still has its limitations, and there is room for improvement. In this sense, and because it is such an important subject for us, we are also committed to helping improve GIIRS so that it increasingly reflects the full impact of our businesses. In fact, the GIIRS team has been consistently responsive to feedback provided by fund managers and investors as to improve their measurement methodology. As the impact-investing infrastructure continues to develop, we are open to adopting a new methodology if one proves more appropriate in the long run.
In a new and growing market like impact investing, it is important to ensure maximum alignment of interests among all players involved in its development. More traditional tools can and should be used, but small changes and adaptations are critical to guarantee that we are actually measuring what we intend to accomplish. It is essential that the structure described in this article is considered as a possible standard in the market. Only then, will impact investors be sure that they are supporting managers who are seeking the same goals. This is an important step in the maturation of the industry, which aims to transform the world for the better through its investments. To achieve that, I believe it is time to link the compensation of managers to social impact, the same way it is linked to financial return, to guarantee that everyone is truly accountable for delivering all the promises that impact investing is making.