Structuring the Deal

After completing due diligence and selecting portfolio companies, the structure of the investment with the portfolio company must be negotiated and confirmed. The investment instrument should meet both GP and portfolio company financing needs, have a clear process for its deployment, and imply a strategy for ultimate exit.

Deal Structuring: Instruments

As a first step in deal structuring, the fund manager assesses the universe of potentially available investment instruments and determines which is appropriate. Which instrument most effectively allows a fund to benefit from its investment in a growing company? This guide focuses on equity funds, which invest through equity financing, a category of instrument comprising all financial resources provided to firms in return for some ownership interest, or shares, issued to the fund manager. Equity investors have no guarantee that any specific amount of money will be returned; rather, their return on investment is determined by the firm’s success. If a market exists, they may sell their shares in the firm, or they may get a share of the proceeds if the whole firm is sold. The larger category of equity finance is sub-divided into public and private equity. Below are a few examples of instruments commonly used for equity investments.

Preferred stock: Preferred shareholders have priority over other shareholders in terms of repayment. Preferred stock can be designed in various ways, depending in part on the governing corporate law. In general, the investor sets certain achievement milestones with an investee company that trigger certain payments to the fund. How much a fund manager then puts into the company at these different milestones varies, but managers should keep it simple and meet entrepreneurs at their level of sophistication. Investing through preferred stock gives an investor fixed dividends.
Common stock is subordinated to (1) all government claims or taxes, (2) all regulated employee claims (e.g., pension obligations), (3) all trade debt (accounts payable), (4) all bank debt, and (5) all forms of preferred stock.
A warrant is a security that gives its holder the right but not the obligation to buy the underlying stock of the company at a pre-agreed exercise price until the warrant’s expiration date. Warrants and options are similar in that both contractual financial instruments allow the holder special rights to buy securities.
In a participating loan, the investor receives a payment linked to the profits or turnover of the company in which the investment is made. Some fixed-interest payments can also be included in the contract.
Equity-like debt: Convertible debt, or bonds with an equity warrant, are a type of bond that the holder can convert into shares of the company or cash of equal value at an agreed-upon price and up to a specified expiration date. Investors may demand more regular repayments from smaller companies as a way to manage their potential risk.
Mezzanine finance is a combination of debt and equity financing. The investor in a mezzanine facility accepts more risk than a provider of a senior loan, normally receiving a higher financial return. Common forms of mezzanine finance include subordinated loans, participating loans, and equity-related mezzanine instruments, such as convertible bonds and bonds with warrants. In the case of company bankruptcy, the claims of holders of mezzanine instruments are second to claims of senior debt holders but prior to claims of equity holders. A mezzanine instrument has higher returns than senior debt but lower returns than pure equity.

Deal Structuring: Mechanics

Funds accommodate the needs of diverse portfolio companies by selecting appropriate financing structures, balancing risk and return and attempting to foresee exit strategies. This is a difficult task. Successfully structuring deals requires a fund to have strong communication with its portfolio companies and the entrepreneurs that lead them, and it also requires strong alignment between the financial, strategic, and impact goals of the company and those of the fund.

Deal Structuring: Exits

Exit means liquidating a fund’s holdings in a portfolio company through sale to another entity. Successful exit depends on a shared vision between the fund manager and the entrepreneur, who should have conversations about exit expectations before investment. Without a clear path to exit, many investors will be unwilling to agree to a deal in the first place—a reluctance that applies both to funds looking to invest in companies and investors looking to invest in funds. Exiting from a portfolio company is the culmination and ultimate test of a fund’s ability to create value for its LPs and portfolio companies. An exit strategy should first be developed when an investment is made and then adjusted throughout the life of the investment. This means selecting financial instruments that facilitate exit opportunities aligned with the expectations of the entrepreneur, which requires ongoing communication.

Impact funds must consider how impact will be maintained after they exit an investment. According to the GIIN’s 2016 Annual Impact Investor Survey, more than 80% of impact investors believe they have a responsibility to try to ensure continuity of impact after exit.^[1] As the impact investing industry and its investor portfolios scale and mature, a greater emphasis on exits is needed.

Methods of exiting an investment include a trade sale, sale by public offering (including IPO), write-off, sale to another equity investor, or sale to a financial institution. A management buyout (MBO) is one way to democratize companies, especially those that are family-owned where future generations do not want to work in the business.

How can a fund ensure it profits from an exit? Funds create performance plans from the beginning of their investment, that show how they plan to grow a company over time. Using data from the Annual Surveys from 2015 to 2017, GIIN research found that 36 investors reported making 158 exits from 2010 to 2016. Twenty-nine of these investors principally sought risk-adjusted, market rates of return, accounting for 119 of the 158 exits.^[2] About a third of sample exits were made via financial buyers, with a further 30% made via strategic buyers or trade sales. Seventeen percent were sales back to company management. Investors sold their entire stake in 72% of cases, with the remainder being partial exits or unknown.^[3] Sixteen percent of investors use impact data to inform their exit decisions.^[4]

Approaches to responsible exits depend on funds’ impact and investment strategies. In one example, a case study by the GIIN of Beartooth Capital, an investment required flexibility in terms of time horizon. Beartooth Capital held its real property investment until it found the right buyer whose plans for the property met its impact expectations. Beartooth Capital has found it useful to plan upfront for scenarios where they may need to hold a property for longer than expected to ensure it meets both its financial goals and its intended impact.^[5]

Funds’ exit strategies require discipline; funds should manage exit expectations and establish formal agreements regarding exit. One of the biggest mistakes a fund can make is to leave too much money on the table for other investors to exploit. One simple rule of thumb for knowing when a fund should exit a given investment is when it determines it has nothing else to offer an investee to take their enterprise to the next level.

ADDITIONAL RESOURCES:

Lasting Impact: The Need for Responsible Exits, The GIIN
A Practical Guide to Planning and Executing an Impactful Exit, European Venture Philanthropy Association (EVPA)
The Art of the Responsible Exit in Microfinance Equity Sales, Consultative Group to Assist the Poor (CGAP)
Great Expectations: Mission Preservation and Financial Performance in Impact Investing, Wharton Social Impact Initiative (WSII)
The resources below have been developed by the GIIN to help you integrate impact considerations into your investment management:
- Set goals and expectations: The GIIN has coordinated with a variety of stakeholders through The Impact Management Project, facilitated by Bridges+, to identify shared fundamentals for understanding impact and more clearly articulating goals and expectations.
- Define impact strategies and search for evidence: The GIIN’s Navigating Impact project provides a simple means to align impact goals and expectations to credible, evidence-backed investment strategies – such as those targeting housing, clean energy, or smallholder agriculture – and use metrics that indicate performance toward their goals.
- Select metrics and set targets: IRIS is the GIIN’s catalog of generally accepted performance metrics that the majority of leading impact investors use to measure and manage social, environmental, and financial performance and evaluate deals. The GIIN manages IRIS, and offers it as a free public good to support transparency, credibility, and accountability in impact measurement & management practices across the impact investment industry.
- Measure, track, use the data, and report: The Impact Toolkit is a digital database designed to help impact investors identify otherwise fragmented supporting resources across the web that are fit-for-purpose to one's impact measurement and management (IMM) needs.

[1] Abhilash Mudaliar, Hannah Schiff, and Rachel Bass, Annual Impact Investor Survey 2016 (New York: The GIIN, May 2016), 44, https://thegiin.org/research/publication/annualsurvey2016.
[2] Mudaliar et al., Annual Impact Investor Survey 2017, 49.
[3] Mudaliar et al., Annual Impact Investor Survey 2017, 52.
[4] Mudaliar et al., State of Impact Measurement and Management, 47.
[5] Hannah Schiff and Hannah Dithrich, Lasting Impact: The Need for Responsible Exits (New York: The GIIN, January 2018), 20–23, https://thegiin.org/research/publication/responsible-exits.

A Guide for Impact Investment Fund Managers