Impact Funds

Case study – Blended Finance Vehicle – California Rebuilding Fund

Case Study provided by Morrison & Foerster

Summary

Morrison & Foerster LLP was a founding member of the California Small Enterprise (CASE) Task Force, which was formed in March 2020 to address the needs of small businesses in California amidst the COVID pandemic. The CASE Task Force (comprised of lawyers, academics, CDFIs, and local business leaders) initially gathered to provide a comprehensive county-level handbook to assist small businesses in navigating the pandemic and also (together with a dozen other law firms) to staff a free, weekly hotline. 

The CASE Task Force then also set out to pull together a financing structure to provide recovery loans to small businesses in California, which resulted in the California Rebuilding Fund. The blended finance structure leveraged state guaranty funds (including the California bank guaranty program), philanthropic funds, subordinated loans (from foundations and program related investment (PRI) investors) and senior bank capital to reach underserved small businesses which have been traditionally under-resourced and disproportionately impacted as a result of COVID. The fund used CDFIs to distribute cash, using a coordinated technology platform (run by CRF – another CDFI) and created a new economic model to strengthen and support CDFIs.

The structure is innovative on a number of different levels including: (i) using third party non-profit (Kiva) as the fund manager to allow for donations and PRI investments, (ii) establishing a governance and allocation committee comprised of local leaders, lenders, academics and lawyers to allow for flexible and impartial approvals of changes as the structure progressed, (iii) leveraging government funds and guaranty programs, (iv) bringing loans off balance sheet for CDFIs which is a major limiting factor in their ability to scale and (v) using a technology platform to allow for insight across CDFIs and to ensure fair and equal allocation among all geographies.

1. Beneficiaries

The beneficiaries of the fund are small businesses in California. So far over loans have been made to over 700 small businesses in 36 counties across the state with a total of over $45 million being funded to date. Of the these loans, over 80% have been made to a business owned be a woman or person of color located in a low- or moderate-income community. Indirectly, we are also helping the CDFIs involved in the transaction.

2. Structure

This California Rebuilding Fund structure is innovative on many dimensions: 

  • It blends government money (either a guaranty of small business loans or providing subordinate first loss guaranty funds into the structure) with donations/grants and PRI capital which forms additional subordinated capital and senior bank capital – this allows us to leverage the subordinated capital to crowd in private capital
  • Has a third party owner and management structure which allows for real time changes and decisions to ensure that the mission of the program is achieved – which is helping the smallest of the small businesses which have been most severely affected by the pandemic and left out of other programs such as PPP (ex. the committee is able to ask CDFIs to prioritize certain geographies if we see that small business owners in those areas are falling out of the pipeline) 
  • Creates a homogenous product so that we can create a pool of assets which we can raise capital for – this is significantly more efficient than each CDFI raising capital on its own
  • Creates an off balance sheet structure for the CDFIs – one of the greatest challenges to CDFIs is that they are required to hold significant net assets and as a non-profit growing those net assets is very hard – this structure moves 90-95% of the originated loans off balance sheet for the CDFIs allowing them to do 20x leverage rather than 4x leverage which is typically what they could do 
  • Uses a single platform for loan applicants – Connect to Capital (CRF’s technology platform) allows for us to see in real time the loans being approved, what loans are not being approved (and the reasons for rejection) and allows us to through the fund structure (committee) to adapt to make sure that we’re reaching the most vulnerable populations (ex. we have found that increasing TA assistance is key to making sure that certain applicants don’t fall out of pipeline), or asking CDFIs to prioritize certain zip codes to ensure equal distribution of funds 
  • Reducing client acquisition costs for CDFIs – CDFIs have a high client acquisition cost. Coordinating efforts and leveraging Governor Newsom’s communications infrastructure allowed us to get the message out with no cost to the CDFIs. In this structure they did not have to go out to find new borrowers. 
  • Reaching underserved communities – using the community partners we are able to ensure that we reduce inequalities programs like PPP experienced. They can provide technical assistance and are a trusted resource which encourages under-represented small businesses to apply. These community TA provides (various local chambers) also allowed us to send rejected applicants links to additional resources that could provide assistance even if they did not qualify for a loan through our fund. 

Each one of these features requires significant and creative legal thinking and structuring to ensure that they work for all parties involved – and never losing sight of the ultimate mission to provide capital to the smallest of the small businesses with an emphasis on traditionally underserved and under-resourced communities.

3. Impact

The CASE Task Force expect to serve at least 3,000 small businesses with an affordable loan product (4.25% interest with interest only payments for the first 12 months) and hopefully many more as the facility has the ability to upsize to $500 million. We expect to reach due to our intentionality and the partners that we have chosen to work with (CDFIs) businesses and communities which have traditionally been underserved and under-resourced.

In May 2020 Calvert Impact Capital launched the NY Forward Loan Fund. This model was replicated (with modifications) for the California Rebuilding Fund which was launched in November 2020. In early 2021, Calvert also replicated this structure to launch the Southern Opportunity and Resilience (SOAR) Fund which includes 13 states in the South East. Additionally, Governor Inslee has announced state commitment to launch a fund in WA state in spring 2021. 

The number of these funds clearly indicates that it can be replicated and each fund contains an accordion feature which allows for it to scale as more capital is committed. The major barrier to scale is finding subordinate capital – state/government funds are key in getting the structure launched quickly. However, the structure does work even without state guaranty (ex. the second CA fund and the SOAR Fund which will have no government money).

4. Goals

The goals of the CASE Task Force is for people, organizations and government to dream big. CASE Task Force would love to see a $10 billion federally funded national program. Initially when we embarked on forming the California Rebuilding Fund, we wanted to launch one or two to prove that this could work and then launch a national program. Unfortunately, since in many circumstances subordinate capital comes from the states, there are geographical restrictions on its use. It is inefficient and costly to create multiple loan funds based upon geography, and our hope is that the Biden administration considers providing loss reserves to support this type of lending. The California Rebuilding Fund and other similar funds have demonstrated that it is effective and easy to scale. A national public-private partnership would enable drastic increases in access to affordable and flexible working capital for small businesses and non-profits owned by women and people of color, those located in LMI communities and who are otherwise un- or under-banked, a population that we think will grow much larger as banks pull back.

5. Case members

The following is a list of participating members of the CASE Task Force:

  • Kiva, Calvert Impact Capital, Morrison & Foerster LLP, California Ibank 
  • CDFIs (CRF, 3Core, Access+Capital, Accion, CDC, ICA, Main Street Launch, Meda, NAAC, Opportunity Fund, PACE, PCV, Working Solutions and others) 
  • Business support organizations (CA black chamber of commerce, CAMEO, CalAsian, CA Hispanic Chambers, SBDC California, Small Business Majority) 
  • Lenders and Investors (some have chosen to remain anonymous so this is not a comprehensive list – Wells Fargo, First Republic, Grove Foundation, Kapor, Panta Rhea, All Home, Self Help) 
  • Other supporters (Berkeley Haas, Berkeley Law, California Governor’s office of business and economic development)

Case Study provided by Morrison & Foerster

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.

Resources

Morrison Foerster – Carried Interest by Verified Impact Calculations PPM and Fund Agreement terms

Collective Investment Vehicles

Collective Investment Vehicles aggregate capital from multiple investors into a single investment entity. Generally, the purpose of Collective Investment Vehicles is to invest in a portfolio of companies or projects, although, in some instances, special purpose vehicles are created for a single investment whose capital requirements exceed the available capital that a single investor is willing to commit.


Collective Investment Vehicles are managed by professional investment managers in order to leverage their professional experience, full time dedication, and comprehensive risk management practices.

The aggregation of capital in a single vehicle also improves economies of scale by spreading transaction costs (such as due diligence costs) over a larger pool of capital, as well as the risk return profile by diversifying the assets of the vehicle through a portfolio of investments.

Fund Managers’ view

Collective Investment Vehicles are managed by professional asset managers, who are the agents of the firm. The managers take investment decisions on behalf of the collective investment vehicle, and are remunerated for the management of the vehicle as well as for the performance of the investments.

In the impact investing industry, impact fund managers often have relevant industry investment and thematic experience, ability to operate in frontier or undercapitalized markets, and relevant professional networks which they can make available to investors in an investment vehicle.

Among the most important factors for managers are that the Collective Investment Vehicle be adequately capitalized and that the managers have the time and flexibility to execute their investment strategy.

Investors’ view

For the investors in the Collective Investment Vehicles, it is important that the investment thesis implemented by the manager delivers the expected financial returns and social and environmental impact, while maintaining adequate risk mitigation practices.


The benefits of pooling capital into a single Collective Investment Vehicle include:

  • Having access to a portfolio of investments
  • Diversification
  • Professional management team dedicated to managing investments

Traditional impact fund structure

Limited Partnership Closed Ended Fund

The most common structure for Collective Investment Vehicles in venture and private equity is the limited partnership. This structure separates the fund managers, the General Partners (GPs), who manage the fund and take investment decisions. The GPs bear unlimited liability for the obligations of the fund. They raise capital from investors in the fund known as Limited Partners (LPs), who are not involved in the investment decisions and have limited liability (for the amount the invested in the fund?). The limited partnership is a closed ended fund with a fixed life, and standard provisions that regulate the distribution of capital to protect the invested capital of Limited Partners before capital distributions are made to the General Partners.

https://www.investopedia.com/articles/investing/093015/understanding-private-equity-funds-structure.asp

“A Limited Partnership Agreement regulates the relationship between the General Partners and the Limited Partners, 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.”
(Source: GIIN Developing a Private Equity Fund Foundation and Structure)

Compensation of the General Partners

Carried interest

Carried interest, also known as “carry” or “profit participation,” is the share in the profits generated through the investments that the general partner receives from the fund. The terms of the Carried Interest vary, and may or may not be payable to the GP only after achieving a Hurdle Rate.

Management fee

The management fee is the fee charged by the General Partner to the fund for running the day-to-day operation of the fund, and is paid from the paid in capital annually.

Alternative Structures

Even though Limited Partnerships are the most common vehicle to structure funds in impact investing (GIIN), alternative terms or collective investment vehicles structures have emerged In impact investing to overcome intrinsic features of the Limited Partnership model.

Alternative performance incentives

In a conventional limited partnership, the Limited Partners handle all the investment decisions and management of the investment portfolio over to the General Partners. As a result of this delegation, the Limited Partners have no control over the impact management of the portfolio investment.


In order to better align the financial incentives of the General Partners to the impact expectations of the Limited Partners, innovative structures to align the financial remuneration of the General Partners to the impact results have emerged.

The Carried Interest is the profit participation of the General Partner in the fund, which is calculated on the returns of the fund that exceed the invested capital. The Carried Interest can be tiered or unlocked based on the achievement of specific social impact metrics.

Holding Company Structures

Holding Companies (HoldCos, or permanent capital vehicles, or evergreen investment structures) are deployed to extend the lifetime of an investment vehicle beyond the traditional 10 years plus extension of a close ended fund (limited partnership investment fund).

The longer lifetime of the investment vehicle gives additional flexibility to the fund manager in investing patiently in a social enterprise, and does not require exiting the investment within the closed ended lifetime of a traditional limited partnership structure. Patient capital and a longer investment period can facilitate a mission aligned exit of the investment in social enterprises when the company has fewer prospective target buyers and chances of an initial public offering.

Liquidity to investors

  • Liquidity to investors
    While limited partnerships must return the invested capital after returns and fees to the investors throughout the lifetime of the limited partnership, typically HoldCos do not have a limited lifetime. In order to provide liquidity to investors, in addition to providing dividends, HoldCos can redeem and buy back existing shares, facilitate secondary liquidity by transferring shares among investors, or list on the stock market to raise additional capital and provide liquidity to existing investors.

  • Potential for listing on the stock market
    Holding companies are investment vehicles that can offer secondary liquidity to investors, as well as attract new capital from new investors, through an Initial Public Offering.

Budget

While limited partnerships operate through the yearly management fee calculated on committed or invested capital, holding companies typically are managed on an operating budget. Innovative approaches to determine a cost based fee calculation have emerged, which limit the operational expenses to the actual operational expense and is capped to the invested capital.

Contributors

  • Dario Parziale, Toniic