Is Carried Interest under threat from ESG?

February 16, 2022


As most readers will know, carried interest is part of the Private Equity industry’s DNA.  The concept of carried interest, in reality the more common name for the performance fee that a fund manager receives for successfully managing someone else’s money by investing it in private equity, has been an integral part of the private equity and venture capital industry since its early days in the 1960s and 70s.

It has served the industry well.  But some recent articles have suggested that the model is under threat – because of ESG.  Some are even questioning the longevity of carried interest in light of growing ESG demands.

To us here at MM&K, this suggestion is far-fetched, and that is putting it politely.

We are fully aware that many LPs are looking at the ESG credentials of the funds they are considering investing in.  Inevitably this is even more the case where the fund is a renewable energy fund or an impact fund of some sort.

There is no doubt that some LPS are thinking about whether they can or should insist upon ESG metrics being factored in to the carried interest structures of the funds that they are investing in.  Indeed, there are some actual examples of this having happened.  In one case that we are aware of (an energy fund) the GP has said that it will forfeit 25 per cent. of its carry if it fails to hit its “impact pledge” target over the ten-year life of the fund.

There are other examples out there, another one being the Blue Ocean fund currently being raised by Swen Capital Partners who have openly stated that 50 per cent. of their carried interest on this fund will be subject to the achievement of impact targets.

However, we have only found examples of this sort of ESG – Carry linkage in renewable energy and impact funds.  So far, we have not seen any evidence of this in more traditional PE or VC funds.

Talking to some of our contacts in the industry, it appears that new PE and VC funds are successfully being raised with market standard carry structures, with little or no pressure coming from LPs to make them subject in some way to ESG performance outcomes.

Of course, one of the greatest difficulties for GPs and LPs alike, in more traditional buy-out and venture funds, would be to decide what ESG concepts might be used for this purpose (in terms of linking it to the carry), and in turn then how these ESG concepts can be measured in a meaningful quantitative way.

In reality only time will tell.  Clearly some fund managers have already done it so it does fall within the art of the possible.

However, we are not convinced that the linking of carry to ESG outcomes will become standard practice in the industry at large.  In particular, we do not believe it will become the norm for the more traditional buy out and venture funds.

We expect the fund managers to push back on any suggestion that their performance fees should be linked in any way to ESG targets, arguing that whilst they will be doing all they can within reason to invest and manage their clients’ money in an ESG friendly way, this should not become the be all and end all of their investment committee’s decision-making process.  Successful managers will be able to set out their stall in this area in their investment memoranda and be strong enough to say to potential investors, that is it.  ESG will not be part of our carried interest arrangements.

We may of course be proven wrong, but perhaps more importantly, we absolutely do not subscribe to the idea that the whole concept of carry is under threat because of growing ESG demands in the alternative investment management sector.

As we said at the outset of this article, carried interest is part of the Private Equity industry’s DNA and it will remain so for a long time to come, whatever is thrown at it.

We do accept that there could be changes to the standard 20% carry model, but that possibility is for another day.

For more information contact Nigel Mills.

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