A Guide for Impact Investment Fund Managers

A step-by-step resource to creating and managing a private equity impact fund

Developing a Private Equity Fund Foundation and Structure

To operationalize a thoughtful and supported investment thesis requires a robust foundation; this is a crucial piece of effective fundraising. LPs interviewed during the development of this guide said that one common reason fund managers fail to secure capital commitments in today’s market is that they underestimate the importance of a robust design, which includes the critical elements of fund structure; a balanced team who can execute for financial and impact returns; a substantial deal flow pipeline that indicates the ability to find good deals and deploy capital; and thoughtful consideration of details including terms, drivers of return, and opportunities to add value. Fund managers should consider not only how each of these elements may be characterized at the start of a fund’s life but also how they may evolve alongside the fund.

Impact funds invest mostly in the early stage, expansion, and growth stages of companies. Through private equity, impact investors can shape portfolio companies’ strategies and work directly with companies to help them meet the intended impact.

Most venture and private equity funds use a limited partnership as their legal structure (Figure 2), which involves two main types of actors: (1) a general partner (GP) and (2) limited partners (LPs). The limited partnership is usually a fixed-life investment vehicle, wherein the GP, or the management firm, has unlimited liability and the LPs, or investors, have limited liability and are not involved with day-to-day fund operations. The GP receives a management fee and a percentage of the profits, while the LPs receive a portion of the income and capital gains. Policies laid out in a Partnership Agreement manage the relationship between the GP and the LPs, covering terms, fees, investment structures, and other items that require mutual agreement before investment. A limited partnership model usually also includes an advisory committee and an investment committee.

Why would a business want private equity investment?

An enterprise may seek private equity (PE) financing for various reasons (Figure 2), but the first and foremost goal is to grow the company to increase its profitability. Private equity capital can increase a firm’s working capital, which is an important measure of both a firm’s efficiency and its short-term financial health. These important signals of stability can help attract other investors while giving a business the flexibility to pursue potential expansion opportunities, such as developing new products and services or acquiring other businesses. A PE investment can also give a business the freedom to buy out certain shareholders to restructure their financing. For entrepreneurs, the fund manager can act as a trusted advisor who can help them make these crucial business decisions.The type of capital enterprises receive depends in large part on their stage at the time of investment (Figure 3). For example, expansion and growth capital may be used to fund market or product development, finance increased production capacity, or provide additional working capital. For this reason, this type of investment capital is sometimes termed development capital. During this stage, the firm is producing and selling products or services while also seeking to expand its output of products or services to increase revenues. At this stage, operating revenues are usually not sufficient to fund the expansion, and so, to expand, the firm seeks financing through formal and informal risk capital or debt. Impact funds operate mostly in the venture capital and expansion and growth stages of financing. Investing through private equity allows impact investors to directly shape portfolio company strategy and help companies achieve the intended impact.

Growing SMEs through Technical Assistance Facilities in Emerging Markets

Fund managers that invest in small-and medium-sized enterprises (SMEs) in emerging markets should also consider the role of Technical Assistance Facilities (TAF) in helping to grow such businesses. Capital alone is often not enough, particularly for SMEs in emerging and frontier markets, many of which need capacity-building support through technical assistance (TA) to ensure sustainable growth. Technical Assistance Facilities (TAFs)—specific pockets of financing dedicated to the provision of TA interventions—are becoming more common among emerging market SME fund managers. It is important to note that providing TA is not unique to impact investing; mainstream, commercial PE and VC funds also commonly offer TA facilities.

The GIIN’s issue brief, Beyond Investment: The Power of Capacity-Building Support, found a variety of reasons that interviewed impact investors provide capacity-building support, most commonly (1) to improve the investors’ level of competitiveness, (2) to enhance investees’ financial performance, (3) to improve or expand the investees’ impact, and (4) to strengthen markets more broadly.[1]

Financing for TAFs usually comes in the form of grants, with a fund’s LPs, as well as the investee company, bearing portions of the costs. Many interviewees for the GIIN issue brief shared that development finance institutions (DFIs) increasingly provide TAFs alongside their investments.

TAFs are typically sized between 4% and 10% of investment capital. This money is most often used after investment; though pre-investment TA is also performed, it is typically harder to fundraise for. The usage of TAFs generally falls into two broad categories: (1) TA for business development and (2) TA for building out environmental, social, and governance (ESG) or impact measurement practices. TA for business development includes general support for business planning and accounting, specialized TA for management information systems and legal support, and identification of partnerships and distribution options for products.

Common challenges in implementing TA include difficulty raising funds to support it and a dearth of quality consultants or service providers to execute on the needed services. One factor potentially limiting the amount of funding available for TAFs is the perceived risk that TA usage will distort markets. For example, one DFI constructed the following categorization of TA risks to evaluate funding decisions and design the governance process for using a TAF.

  1. Pre-investment Risks of TAFs:
    • Spray and pray: Arbitrary allocations of TA in the hope of uncovering or unlocking ‘investible’ companies.
    • Subsidy: Obscuring the true, long-term prospects of a business and thereby detracting from commercial discipline.
    • Reputation risk: Gaining a reputation for ‘handouts’ or wasting resources on disingenuous TA applicants who have no intention of meeting investment criteria.
  • Post-investment Risks of TAFs:
    • Dependence risk: Avoiding unsustainable or damaging investee reliance on TA.
    • Moral hazard risk: The risk that the availability of TA encourages investments that a fund otherwise would not make.

In addition to the perception of risk, cynicism about the effectiveness of TA may also limit the availability of funding. Few TA providers measure the results of their interventions, which hinders confirmation of the efficiency or effectiveness of TA usage. Despite these challenges, many investors continue to see value in TA and offer it as part of their investments.

ADDITIONAL RESOURCES:

  • Beyond Investment: The Power of Capacity Building Support, The GIIN
  • Insights from the Impact Programme: Using Technical Assistance to Build Impactful Businesses, UK Department for International Development
  • Five Years of the AAF’s Technical Assistance Facility, African Agriculture Fund’s Technical Assistance Facility (AAF TAF)
  • A Guide to Effective Capacity Building, Asia Venture Philanthropy Network (AVPN)
  • A Practical Guide to Adding Value through Non-Financial Support, European Venture Philanthropy Association (EVPA)
  • The Role of Technical Assistance in Mobilizing Climate Finance, GIZ
  • Private Equity and Venture Capital in SMEs in Developing Countries: The Role of Technical Assistance, The World Bank
  • Technical Assistance: A Development Tool Serving the Private Sector, PROPARCO
 

 

[1] Aliana Pineiro and Rachel Bass, Beyond Investment: The Power of Capacity-Building Support (New York: The GIIN, 2017), 3, https://thegiin.org/research/publication/capacity-building.

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