If you’re engaging in ESG investments (investments in environment, social and governance issues) and investments in larger impact funds, your investment advisor is most likely sourcing these investments for you. However, if you choose to engage in more direct investments, this blog will help demystify the transaction process by breaking down the seven key steps involved in that process.
If you’re engaging in ESG investments (investments in environment, social and governance issues) and investments in larger impact funds, your investment advisor is most likely sourcing these investments for you. However, if you choose to engage in more direct investments, this blog will help demystify the transaction process by breaking down the seven key steps involved in that process. Direct investments are certainly more work than investing through impact funds, but their social impact returns are also usually more directly linked to your investment dollars.
This blog revisits a 2021 CMF Annual Conference session and a subsequent virtual training on how to “do” an impact investment. During the conference session – “Art of the Deal” – a panel of impact investors and their investees discussed actual impact investments, from start to finish. Carolyn Cassin of Michigan Women Forward presented on Belle Capital’s investments in women-owned business, David Contorer discussed Hebrew Free Loan’s revolving loan program to individuals and a real estate attorney outlined the nuances particular to real estate investing.
As you review each of the core steps below, we invite you to make note of your questions and share those with us to support your continued learning. And, please reach out if you have examples of investments and related resources that can be shared as fresh examples for the field!
We talked about this in a blog post from 2022. Many beginning impact investors note that sourcing deals is a challenge, but you likely have more resources at your disposal than you may initially think. You could also consider finding an experienced investor and asking if you can participate in one of their investments to dip your organization’s proverbial toe in the water. As CMF’s Expert in Residence for Impact Investing, I can help with this step, as well.
An NDA is typically executed before the parties start sharing too much information with one another so that one or both parties (in a “mutual NDA”) are prohibited from sharing this information with anyone who’s not a professional advisor needing to know the information to assist in evaluating a potential transaction (who would be bound by a similar duty of confidentiality).
Before you go to the expense of the next steps, you would want to ensure that you and the potential borrower/investee are generally on the same page as to what your investment will fund, on what timetable and on what terms. For example, will you stick to market-rate terms, or do you want to provide “patient capital” at terms that are somewhat more favorable to the investee? (Despite hours of conversations, many realize they don’t truly have an understanding of these critical considerations until they put the information down on paper). In terms of documenting these considerations, in the for-impact world, everyone loves to use the term “Memorandum of Understanding (MOU),” but lawyers prefer “Term Sheet” or “Letter of Intent (LOI).” It needs to be clear (if intended) that such documentation is not binding. In the LOI, you would want to avoid agreeing to terms like the parties “will use best efforts” to come to an agreement, as you don’t want to be overly-bound before due diligence is conducted as a next step. There’s a fine line between spending too much time hashing out details of a term sheet that’s not binding and making sure there’s enough information so that the parties are sure that they are on the same page.
This step involves “looking under the hood and kicking the tires” to determining whether the business in which you’re investing in or making a loan to is sound. There are three main areas of due diligence that typically occur:
Legal: Lawyers conduct due diligence for areas such as governance, review of major contracts, whether there are liens on investee/borrower assets, review of intellectual property (which varies depending upon the product/service offering of the company), potential litigation and the like. Lawyers will also review or prepare “authorizing resolutions” so that both the entity accepting the investment or loan, and the entity making it, have properly authorized the transaction. Since charities don't usually require board-level authority to accept a charitable contribution, they often question why they must do so for a loan. This is necessary in particular because of the legal consequences stemming from the loan.
Depending upon the size of the investment and your familiarity with the organization, it is usually prudent to run background checks on the management team and the organization for things such as prior bankruptcies and litigation matters. There is a certain extent of public records searching that can be done without the consent of the organization or individuals, or you can secure their permission to do an employment-like background search.
Another area of due diligence that is advisable is how the organization runs its business. Unfortunately, just because a business calls itself a social enterprise, and even if it does have a socially impactful mission, it doesn’t mean that all aspects of its business are operated in the same manner. For example, the business may be successful in producing an affordable product that helps people with physical challenges, but it exploits its own workers by not paying them a living wage.
If your investment is in an impact fund, you would want to investigate the fund sponsor (who’s in charge of the fund), as well as its track record of investments and returns and the types of investments it’s traditionally made. Again, not all funds that call themselves “impact funds” are indeed truly impactful, and sometimes they trade one type of impact for another. Real estate investments will require additional due diligence to determine whether there are liens or easements on the property, likely at least a “Phase I” environmental study, and assurances as to zoned uses of the property.
Once you are satisfied with the due diligence, you can then proceed to deal documentation. For equity investments, the National Venture Capital Association has developed model forms with standard terms that can be used for the investment. You may want to add a social impact twist to the documentation, such as impact metrics or impact reporting. These documents don’t have to be heavily negotiated because they’re determined to be generally even-handed forms. For loan transactions, documentation could be as simple as a promissory note, or may include that and a loan agreement, together with any documents regarding security if you’re taking a security interest in the borrower’s assets. (These get filed publicly). Real estate may involve a mortgage agreement, which also gets filed publicly. Whether or not you take a lien on assets (including a mortgage) is up to you as the investor – in the pure, for-profit world, it is the norm; in impact investing, it varies depending upon the risk tolerance of the investor and its reason for making the loan. Some large, international impact investors say they just want to be on par – “pari passu” – with other investors in the organization, and so if others are taking a security interest, they will. Otherwise, though, they’re often comfortable not doing so.
If you’re investing in a deal that has attracted many investors, or in a fund, the investee entity will present you with its form documents for review by your attorney. These documents aren’t usually subject to much negotiation, but depending upon the size of the investment, may include the ability to negotiate a “side letter” which states that no matter what the deal documents say, the letter takes precedence over them with respect to the matters noted therein. Private foundations often have standard terms in their side letter agreements among all their investments, especially if they intend to treat the investment/ loan as a Program Related Investment.
Once everyone agrees that all of the documents are in final form, the documents are signed, and the investment dollars are provided to the investee. If you invest in a fund, the fund sponsor may not “call” (require) the funds immediately, but instead investors must be ready to provide them within a certain time after they’re requested. Sometimes the documents are signed in advance and “held in escrow.” This does not involve an escrow agent but simply the notion that signed documents cannot be used until they’re agreed that everything is finalized, and then a simple communication by email acknowledges that signatures are released from “escrow” and the deal is closed.
If you’ve invested in a fund, you’ll receive updates and information on a regular basis just as with all investors. If you’ve made a more direct investment as the only investor or part of a small group of investors, there is often more opportunity to be in direct contact with the investee, if both investor and investee desire it. Some of the larger, national impact funds have a separate, charitable fund for this sort of “technical assistance” because part of their social impact theme is the education and assistance that goes along with the investment dollars. In other cases, impact investors or their colleagues provide in-kind service and guidance to investees. This often magnifies the social impact of investment dollars. You’ll also want to review the reports on both financial aspects of the business and social impact to spot any potential issues in advance, if possible, so that they may be remedied. Discussion of how to measure social impact (as opposed to output or outcomes) of investments is a robust and constantly evolving area, as it is with measuring the social impact of grant dollars.
If you’re not experienced in business deals, the steps outlined above may seem daunting. However, here are some tips to make it a smoother process:
Although this process is not necessarily intuitive, once you do one or two deals, you will know what to expect and the process should get smoother each time. I’ve often had clients, upon closing their first impact investment, say, “Is that it?” because it was much less stressful than they’d anticipated!
In our next blog, we'll discuss the various types of impact that organizations can have with their assets.
