CASE STUDY – Carried Interest by Verified Impact Calculations (CIVIC)

Introduction

In a standard venture capital or private equity fund, the fund manager is entitled to 20% of the fund’s profits. This is known as the “carried interest.”

The innovation of Buckhill Capital and Morrison & Foerster is a set of provisions that can be imported into the relevant documents of most venture capital or private equity fund so that the carried interest is paid out to a fund manager only to the extent that the fund achieves quantified, verifiable impact metrics agreed upon by the fund manager and the fund’s investors. This has the potential to create billions of dollars of incentives for institutional investment managers of all kinds to pursue impact goals alongside financial returns.

Background

Henrik Jones and his company, Buckhill Capital, seek to “finance companies on a mission.” In the course of doing this work, Buckhill encountered a multitude of companies and investment funds claiming to seek environmental, social, and other impact goals, along with delivering a compelling financial return. At times, after investors have signed their agreements and wired their money, Buckhill has observed that the initial focus on impact alongside financial return has faded or took a back seat to financial return and even disappeared altogether. Even when a company or fund addresses impact in the narrative of its periodic reports, it does not always get the same rigorous treatment that the financials get.

Buckhill was not aware of any investment fund manager that has its receipt of carried interest depend directly on whether or not the fund achieves quantified impact goals that are independently audited and verified and that has done so in a manner specifically designed to be easily repeatable and used at scale by other fund managers.

Buckhill decided to things differently when it was presented with an opportunity to gather a group of investors and pitch itself as an attractive source of Series A funding to a highly impactful socially responsible company, Higg Co, that was spinning out of the Sustainable Asset Coalition. Buckhill did not want to give mere lip service to impact and wanted to “put its money where its mouth was” and do something different. That something is the Carried Interest by Verified Impact Calculations (CIVIC).

Carried Interest by Verified Impact Calculations (CIVIC) innovation

BHI’s Carried Interest by Verified Impact Calculations (CIVIC) began with Buckhill’s vision of materially and financially aligning a fund manager’s interests with those of its impact-minded investors and impact-minded portfolio companies. It took the Social Enterprise + Impact Investing team at Morrison & Foerster to fully flesh out and implement the idea both in a way that would work for BHI and its investment into Higg Co but, per Buckhill’s directive, for any venture capital or private equity fund looking to do the same.

CIVIC Overview

The first key feature is the modularity of the BHI CIVIC approach. The documentation Morrison & Foerster prepared for BHI is set up so that any venture capital or private equity fund manager can customize and integrate the CIVIC distribution mechanics from BHI’s term sheet and BHI’s operating agreement into their own fund’s term sheet and operating agreement, leveraging the work that Buckhill and Morrison & Foerster have already done in thinking through some of the details discussed below.

The CIVIC mechanics then reference to a separate quantified Impact Test, which sets forth the quantified impact test for BHI or another fund. The quantified Impact Test is designed to be fully customizable on a fund-by-fund basis. This gives flexibility for different funds to have different impact goals, in different ways, and on different timelines. So the CIVIC provisions do not need to be reinvented with each fund, but each fund has full freedom in defining its own impact goals.

The other key features are reflected by the terms of the CIVIC provisions. To implement BHI’s general idea, Morrison & Foerster thought through some of the details that the solution would need to address. For example, is it more appropriate to the Impact Test be a staged, cumulative test (e.g., whereby the real goal is to reduce carbon emissions by X tons by year 10, but with interim, trend-line goals along the way) or a series of independent annual tests (e.g., prevent X tons of carbon in year 1, then regardless of year 1 results, prevent Y tons of carbon in year 2). Morrison & Foerster advised that the test use the former approach, as it better allows for the potential high variation year to year as a fund pursues impact goals that are intended to be achieved over its entire term. A related issue is what happens if a fund does not meet its interim goal for a given year — does the fund manager forever lose the carried interest associated with that year, or can the fund manager earn it back by overly successful follow-up years that get the fund back to the desired trend-line vis-à-vis its impact goals?

Morrison & Foerster advised allowing the fund manager to earn back carried interest not received in a previous year, again because the impact goals are determined by the desired end of a long journey, and at the outset we might know the rate of progress along the way.

Please find here the terms of the CIVIC waterfall that can be replicated in funds’ Private Placement Memoranda and Limited Partner Agreements.

Conclusion

Buckhill hopes that the CIVIC waterfall will be a standard in impact investing and promote accountability of fund managers across the entire ecosystem. By promoting its adoption, if it is not already in fund documents, investors will have the knowledge to ask for the term.

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