What impact investors can learn from development finance institutions

DFIs often act as lenders of last resort, but also as vital conduits to international capital, where their support and intervention can help fund managers attract third party investors.

Increasingly, there is alignment between the sustainable development goals or other sustainability outcomes that DFIs are working towards and the sustainable investment that investment funds are promoting. We have, however, seen DFIs impose side letter terms as forms of conditions on, and safeguards, around sustainable finance. Those terms incorporate mechanisms for oversight, remediation, and reporting and enable investors to actively monitor and enforce compliance with ESG standards throughout the investment lifecycle.

Impact investors should seek to understand the common terms DFIs include in their side letters as these could inform their own negotiations with fund managers and help them drive positive social and environmental change through their investments.

Excuse rights

Excuse rights are essentially rights extended to investors that allow them to opt out from investments. Excuse rights are often negotiated between limited partners and general partners in investment arrangements to account for the potential misalignment of their investment strategies.

ESG considerations play a pivotal role in shaping DFIs' policies, influencing not only the countries where investments can be made but also encompassing extensive policy documents covering ESG and business integrity (BI) requirements. Some DFIs even impose specific prohibitions, such as opting out of investments associated with private schools. In contrast, non-DFI commercial funds, particularly those managed by large entities, often grant no-excuse rights, placing the burden of determining whether or not to excuse on investors.

The focus for excuse rights in the private sector typically revolves around more conventional limitations like munitions and gambling. Moreover, in the commercial landscape, if excuse rights are invoked, fund managers demand timely investor response, typically within five to 10 business days after issuing a drawdown notice, accompanied with a legal counsel opinion confirming that such investment breaches any particular laws or policies applicable to such investor, reflecting a more streamlined but potentially less comprehensive approach to ESG considerations compared to their DFI counterparts.

Excuse and management fees

DFIs often include an excuse mechanism in the side letter to opt out of a non-compliant investment. This mechanism allows investors the flexibility to selectively allocate their capital to more sustainable opportunities by refraining from contributing to specific investments that do not meet environmental or social requirements.

DFI side letters also often provide for a step-down in management fees where investors exercise their excuse right, where the share of an investor’s management fees is calculated on the basis of invested capital of the fund as opposed to based on total commitments of the fund.

By tying management fees to invested capital, this provision creates a financial disincentive for non-compliance with environmental and social and other sustainability requirements. This sends a strong signal to the general partner and portfolio companies that sustainable and impact investments is not only a moral imperative but also a financial one. It aligns the interests of the investor and the fund management team, emphasising the importance of ESG considerations throughout the investment lifecycle. The management fee step-down provision also provides transparency and accountability, ensuring that investors' capital is deployed responsibly.

Draw stop mechanism

A draw stop mechanism in the side letter serves as a critical safeguard against potential breaches of the fund's ESG policy or failures by portfolio companies to adhere to environmental or social requirements. By having the authority to halt capital contributions in response to non-compliance, investors protect their interests while reinforcing the importance of ESG integrity. This provision not only preserves the integrity of the investment portfolio and mitigates risks associated with non-compliant investments, but also provides investors with the assurance that their capital is deployed in alignment with their ESG objectives.

In contrast to a draw stop mechanism, which provides an immediate response to non-compliance, an excuse provision offers the fund and portfolio companies a chance to remedy the situation before capital is fully withdrawn, potentially fostering a more cooperative approach to addressing ESG concerns. This also ties in with representation and warranties often made by general partners to effectively co-operate in good faith with investors in addressing potential breaches or failures to implement ESG requirements. This promotes transparency and emphasises the aim of achieving mutual objectives. General partners are further required to respond promptly to notifications, providing detailed responses and supporting documents as requested by the investor.

Monitoring and reporting

The general partner is commonly required to report to the investor on the development impact of activities financed by the fund. Each of the DFIs typically include their own development impact indicators in the side letter. These essentially serve to guide the reporting process. Whilst these indicators vary depending on the DFI’s own impact and sustainable development goals, they commonly focus on revenue, direct job creation, and the representation of women in senior management or on the board. Those data points are typically collected at the portfolio level.

Development impact reports often form part of the fund’s quarterly and/or annual reports. This reflects that they are generally delivered within a specific timeframe after the end of the financial quarter or financial year of the fund. These detailed reports allow investors to measure ESG performance, monitor progress towards ESG objectives and evaluate the effectiveness of interventions so that investors can make informed decisions regarding future investments. Prompt reporting of ESG-related issues also allows investors to address concerns in a timely manner and take appropriate actions to mitigate any risks attributed to their investors. Such reporting requirements hold stakeholders accountable for meeting established standards. They therefore enhance investor confidence and enable them to make well-informed decisions about their investments.

Many DFIs also impose side letter rights to have unrestricted access to the fund and the portfolio companies’ premises and management, and to monitor policy compliance. This allows for active oversight and ensures that investors can verify compliance with ESG standards, as well as address any concerns proactively, promoting transparency and accountability throughout the investment process.

Remediation measures and cooperation

DFIs often require the fund and portfolio company to define appropriate remediation measures in the event of a breach of ESG policy, in consultation with investors within an agreed time frame, and to provide regular updates on the ongoing implementation. In essence, this provision ensures that corrective actions are taken promptly to address non-compliance.

Any failure to fulfil such obligation can entitle DFIs to dispose of their investment in the portfolio company under commercially reasonable terms, taking into consideration factors like liquidity, market constraints, fiduciary responsibilities, and the principles of a responsible exit.

Certain DFIs also integrate side letter provisions that allow DFIs to actively participate in addressing ESG-related issues within the fund and/or portfolio companies and enforce remediation measures, which fosters a culture of accountability and continuous improvement.

Governance responsibilities and training

Some DFIs mandate that the general partner designate a specialised officer, whether an employee with specific ESG expertise or an investment staff member, tasked with monitoring, applying, and implementing the environmental and social policy and/or corporate governance framework and ensuring compliance with ESG standards for each target portfolio company. Additionally, the officer may be required to engage with portfolio companies contractually on governance matters.

This requirement serves to enhance governance and accountability within the investment portfolio, ensuring adherence to ESG standards and effective risk mitigation. It also promotes ethical conduct within portfolio companies, thereby safeguarding investor interests and maximising long-term value creation.

The replacement of any such officer is often an approval matter also, emphasising the importance of continuity and stability in governance, minimising disruptions and maintaining investor confidence.

DFIs also often stipulate that the general partner procures ongoing training for the officer on the ESG policy and other principles. This not only equips the fund's personnel with necessary knowledge and skills but also enhances the effectiveness of ESG management systems and fosters a culture of ESG compliance within the fund management team and portfolio companies, setting a standard for other impact investors to follow.