March 20, 2019
Private equity, with its appetite for risk and ability to quickly access industry expertise, represents an increasingly promising source of capital for socially conscious and environmentally sustainable enterprises. In fact, “impact” or “social” investment funds are carving out a growing segment of the private equity market in terms of both size and number of funds. The World Bank estimates that assets under management allocated to impact-focused private equity has increased by 19 percent annually over the past five years, with private equity and venture capital investors placing approximately $79 billion globally in sustainable technology alone over the last 12 years. Recent years have seen impact investment move from smaller, issue-driven funds to mainstream private equity firms. With this move into the mainstream, potential investment targets and private equity professionals are developing novel solutions to some of the putative challenges to conventional private equity impact investment.
One of the principal challenges is that the modest size and liquidity of the sectors in which impact investors work increase the risk of a longer hold period and uncertain exit opportunities. According to GIIN’s 2018 Annual Impact Investor Survey, approximately 39 percent of private equity investors characterize the liquidity and exit risk in the sectors commonly considered for impact investing as “severe,” while traditional exits, such as M&A or an IPO, remain relatively infrequent across most of these sectors. A majority of private equity investors also express a desire to identify “responsible exits”—i.e., exits that do not compromise the enterprise’s social mission—which further narrows the pool of potential exits. This experience has led certain commentators to caution that the traditional exit-oriented approach of conventional private equity funds favoring high-risk, high-growth enterprises can compromise either the social enterprise’s mission or its natural growth trajectory.
Pre-Investment Diligence Considerations
Despite such skepticism for the compatibility of the conventional private funds’ approach and impact enterprises, some private equity investors have used a narrow focus in pre-investment diligence to mitigate the exit risk and secure a responsible exit. The liquidity risk in established sectors with a strong technology focus, such as health-tech, finance-tech and medicine, is often more acceptable than in other sectors of the impact space, such as education, environment and public policy. According to a study conducted by McKinsey, financially viable exits are also becoming more common in microfinancing, as well as the agriculture and clean energy sectors.
At an enterprise level, a private equity investor may also focus pre-investment diligence efforts on identifying enterprises where the social mission is core to their business model and linked to their financial success. In such instances, the enterprise’s social mission also contributes to its commercial viability, and a potential buyer is therefore more likely to perceive the social mission as a driver of growth rather than an impediment or additional cost which may otherwise deter acquisition.
Re-Thinking Traditional Exits—A Revenue-Based Approach
For private equity firms eager to place capital across a broader spectrum of sectors, conventional exit models may unduly restrict both the scope of potential investment opportunities as well as the accompanying investment rationale. Certain private equity investors have begun to rethink their exit models, favoring smoother returns through progressive liquidity over riskier efforts to capture higher return multiples.
A revenue-based approach to exits represents one such alternative. With this approach, investors are able to realize their returns through built-in redemptions or dividends paid on an agreed-upon financial metric, such as revenue, free cash flow, profitability, etc. These financial metrics are typically designed to approximate growth of the social enterprise. For instance, an equity investment may be structured so that mandatory cash dividends are paid based on either enterprise’s free cash-flow. Once aggregate dividends paid to the private equity investor reach a certain multiple of the original investment, the enterprise may redeem the underlying shares at their original price or a multiple thereof. In this way, the private equity investor obtains downside risk protection for invested capital if a “full” liquidity event is not feasible during the time-frame required by the investor. This hybrid approach is also less burdensome for the social enterprise than debt instruments would be, as payments are required only in times of economic growth and typically then only from “surplus capital,” and do not encumber assets that may otherwise be used to secure debt financing.
Alternatively, a private equity investor may achieve smooth returns and, over time, a full exit without a traditional buyer through mandatory redemption of its shares. Such redemption or put/call rights are sometimes structured in increments over the investment period at a predetermined price and frequency based on the enterprise’s cash flow. For instance, a 2016 investment of $460,000 by Acumen, a U.S.-based social investment fund, in Gigante Central Wet Mill (GCWM), was structured as a combination of debt and equity. Under the investment terms, GCWM placed all cash generated over an agreed working capital amount in a reserve account, with a certain percentage allocated to repurchasing Acumen’s equity stake at an agreed price equal to Acumen’s invested capital plus a preferred return, and another percentage allocated to debt repayment, after a two-year grace period. From Acumen’s perspective, this structure not only addressed the exit challenge, but also provided down-side protection and a modest return with a high(er) degree of exit certainty. For less risk-averse investors seeking to capture more of the up-side participation in a minority investment, options such as a responsibly tailored forced-sale right or default-rate dividend preference could also be considered.
Regardless of how it is structured, tying liquidity rights to financial performance not only allows minority equity investors to obtain their return on investment in the absence of a robust M&A market for the social enterprise, but it also alleviates much of the timing pressure for both the investor and the issuer. Furthermore, by linking financial performance and liquidity, the investor is obtaining its “exit” without unduly burdening the enterprise with a cyclical financing regime which can distract management from its core business and social goals.
The ‘Multiplier Effect’
It should be noted that the exit risk is likely to become less pronounced in certain sectors as more private equity funds and permanent capital enter the impact investment sectors. As described in a report by Openwell, “if investee companies have demonstrative success, this will lead both to increased demand for the company and for the sector as a whole;” its strong performance not only has the effect of attracting more investors for itself and boosting its own performance, but it also boosts confidence more generally in the idea that a company can be simultaneously socially impactful and financially profitable. This, in turn, should lead to a more fluid market for liquidity. There is growing empirical evidence that market-rate returns are achievable in private equity impact investing in a number of marketwide studies. As conventional sources of capital venture further into impact investment sectors, social entrepreneurs and private equity professionals are finding creative solutions to fit private equity exit modeling into these historically capital-scarce sectors.
With this in mind, impact investors are well-advised to focus internal training efforts on developing a team that knows what to look for when sourcing impact investing opportunities, both from an entry and exit perspective. Such investors are also well-advised to partner with third-party advisers who can bring creativity to bear in structuring these investments. If done properly, this can facilitate alignment of the social mission and a smooth and predictable path to liquidity, benefiting both the investor and the social enterprise with which it partners.
Alex Purtill is counsel in Weil, Gotshal & Manges’ Silicon Valley office. He participates in the representation of financial and strategic clients in various acquisition transactions, including public and private mergers and acquisitions, divestitures and cross-border matters.
Cristina Passoni is an associate at the firm in Silicon Valley. She participates in the representation of public and private companies in a variety of transactional matters, including domestic and cross-border mergers and acquisitions, equity investments and divestitures.
Reprinted with permission from the March 20, 2019 edition of The Recorder© 2019 ALM Media Properties, LLC. Further duplication without permission is prohibited. All rights reserved.