The 2030 UNSDGS, adopted in September 2015, is based around 17 sustainable development goals, such as alleviating poverty (Goal 1), providing quality education (Goal 4) and taking climate action (Goal 13).
The only way to try to get near the US$ trillions necessary to achieve these goals is through the aggregation of funding from the widest possible sources—philanthropists, development finance institutions, multilateral development banks, institutional and retail investors—and the widest range of financial instruments. These include impact funds, "performance based" impact bonds, and other innovative financial mechanisms that catalyse public and private sector partnerships towards targeted environmental and social interventions.
In brief, impact funds are funds set up with a defined intent to contribute to measurable impact alongside a financial return. According to Preqin, as of May 2022 there were 495 funds actively marketed as impact funds, around a third of which were still fundraising.
The characteristics of each impact fund are likely to reflect what is common for the type of institution that set it up. For example, impact funds launched by private equity firms include carried interest provisions as a common remuneration mechanism for the industry, and may link a portion of the remuneration of the managers to relevant environmental, social, and governance performance metrics of the investments in addition to financial metrics. Impact funds launched by multilateral organisations and non-governmental organisations are more likely to rely on a considerable level of concessionary capital through grant funding to bring additional investors on board.
Impact funds can pursue investment strategies from a range of different asset classes. On the debt side, an impact debt fund can, for example, provide dedicated long-term debt facilities or grants in the case of "blended finance" facilities either directly to corporates and specific projects, or to financial institutions, which then onlend to the population being targeted for the impact.
On the equity side, a private equity impact fund would look to acquire an ownership stake in selected impact-driven companies. These would be actively managed and monitored during the lifetime of the investment to ensure that they achieve targeted outcomes, whilst also incorporating impact considerations (balanced with the private equity firm's fiduciary considerations) when investments reach exit stage.
UK Legal and Regulatory Framework of Impact Funds
The legal and regulatory framework of impact funds in the United Kingdom is very new. At the time of writing, the key piece of that framework is Consultation Paper 22/20 (CP 22/20) published in October 2022 by the Financial Conduct Authority (FCA). If implemented, it is expected that most of the rules set out in CP 22/20 will begin to apply from the third quarter of 2024.
CP 22/20 sets out the FCA's proposals for defined labels for sustainable investment products. These include a "sustainable impact" label for products that aim to achieve a "positive, measurable contribution to real world sustainability outcomes" alongside a financial risk/return objective.
To be able to use the "sustainable impact" label, firms will need to comply with a number of requirements, including making consumer-facing product disclosures and pre-contractual disclosures; providing ongoing sustainability-related performance information; and submitting a sustainability entity report outlining how the firm overall is managing sustainability-related risks and opportunities. For firms that don't want to use the CP 22/20 investment labels for their products, CP 22/20 sets out naming and marketing rules restricting the use of certain sustainability-related terms.
Despite Brexit, the European Union's Sustainable Finance Disclosure Regulation ((EU) 2019/2088) (SFDR) (see pg 9) also remains significant in the United Kingdom as funds launched in the UK will need to comply with SFDR to be marketed in the European Union. Even if a UK firm does not intend to market its funds in the EU, or to manage EU funds, that firm may decide to voluntarily comply with the SFDR because of investor pressure.
The SFDR contains two categories of financial products that are directly relevant to impact funds:
- Article 8 funds, which promote, among other things, environmental or social characteristics
- Article 9 funds, which have sustainable investment as an objective
Impact fund managers may prefer to set up their fund as an Article 8 fund rather than Article 9, owing to the less onerous disclosure requirements under Article 8. As a result, it is common to see an impact fund set up as an Article 8 fund, with a minimum level of investments in sustainable investments. This is commonly referred to as an "Article 8+" fund.
Impact Funds from Multilateral Organisations
Outside the UK and EU regulatory environments, impact funds can also be launched as unregulated funds by entities such as multilateral organisations.
Unregulated funds may not even have a governing law clause, as they are governed by a charter entered into by the relevant entities establishing the fund ("hosted funds"). As a result, these funds are highly bespoke and, rather than complying with the regulatory requirements of a particular jurisdiction, they instead incorporate detailed provisions to reflect the relevant requirements of the founders and to create a workable partnership amongst the involved parties.
Structuring an Impact Fund
Under the simplest structuring option, donor funding is allocated to an escrow account and is only released when the relevant impact metrics are achieved.
As structures get more complex, bespoke solutions become the norm. These generally depend on the investors, managers, and sectors involved in each case. The flexible nature of these funds can prove very effective in aggregating funds from different types of contributors, which brings together opportunities for both the public and private sector to finance positive change through partnerships.
A number of impact funds incorporate blended finance structures, which allow investors with different risk-return profiles ("impact first" or "return first") to opt for the level of risk they are comfortable with. In order to accommodate different parties' risk-return profiles, impact funds can set different tranches, using a junior tranche to de-risk the senior tranche, prompting a bigger investment amount than would otherwise be possible.
On the "patient capital" side of the transaction, a range of parties can be involved, such as development finance institutions, multilateral development banks, and philanthropists. On the less risky side of the deal, more traditional (return-seeking) investors can join in. These include private equity houses, pension funds, and the non-philanthropic arms of family offices.
Bringing the relevant institutions together over the same framework, and properly structuring the layers of risks, are key to the success of an impact fund, The relevant co-financing framework agreement will contain highly scrutinised eligibility criteria, so only transactions that meet those eligibility criteria can be co-financed by the relevant parties in the framework agreement.
Other benefits of blended finance fund structures are the better impact reporting metrics and synergies they facilitate. Private investors who are potentially inexperienced in impact metrics and reporting can benefit from the experience of more knowledgeable players.
Looking Ahead
There is a promising future for impact funds as investors and regulators become more experienced and demanding, and fund managers incorporate more robust standards, particularly against the risks of "greenwashing" or "impact washing".
Given the size of the funding needed to tackle the UNSDGs, financial ingenuity will be key. We are likely to see a rolling pool of funds offering first or second-loss guarantees to attract the private sector to invest in hard-to-insure risks, and the development of funds of funds for impact so investors get access to funds across a range of regions and sectors, all wrapped up in a single portfolio. The key is in ensuring that exposure is diversified and overall risk is reduced, resulting in a greater potential for the aggregation of funding.
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