equivalent structure

Financial alignment of interest is commonly embedded in the structure of a limited partnership or equivalent structure through two levers:

1. Profit sharing. The manager is compensated by a management fee,35 which is not tied to performance, and a share in the profits (or carried interest) of the fund beyond a hurdle rate.36

2. Contribution of capital. The manager is often required to contribute capital (usually about 1 percent) to the fund, thus establishing skin in the game for the manager.

There are limitations to such alignment of interests, however, as discussed in box 4.5.

When the public sponsor has no ownership interest in the management entity of a SIF, oversight responsibilities are also met via a limited partnership advisory committee or similar structure. This advisory committee represents the owners’ interests in the SIF and is usually populated by the public sponsor and other key investors. The advisory committee has a more hands-off relationship to the management of the SIF than a board of directors does because the public sponsor and other investors have no ownership interest in the management entity.37 The committee structure instead collapses the ownership interests in the SIF with the oversight responsibility of the board of directors. The SIF advisory committee provides oversight, serves as a sounding board on strategic matters, weighs in on conflicts, and provides waivers for investment or risk thresholds and other restrictions laid out in the limited partnership agreement, and other key matters.

Management

The third tier of a SIF’s governance structure focuses on the management of the fund, driven primarily by whether the manager is in-house or dedicated

BOX 4.5

Limitations to aligning financial interests in a limited partnership model or equivalent structure

Despite using such financial levers to align interests, the public sponsor cannot fully eliminate the principal-agent problem. For instance, although carried interest helps to provide an incentive by allowing the fund manager to participate in profits, it does not eliminate the possibility that the manager may take excessive risk because, in the downside scenario, the manager may forgo a share in profits but does not give up management fees (Magnuson 2018).

The hurdle rate seeks to partially correct this misalignment at a portfolio level by not permitting the manager to participate in a share of profits until capital plus an agreed rate of return (usually 8 percent) has been remitted to the investors.

However, if the profit-sharing arrangement is not a sufficient motivator for the manager, the public sponsor and other investors may also bear the risk that capital is not fully deployed or is deployed in suboptimal investments. A key risk is that the fund manager may perceive the possibility of never seeing carried interest, so it is important to keep track of fund life and establish an attractive profit-sharing arrangement.

The public sponsor and other investors must therefore pay keen attention to the profile of the manager hired, to ensure that the manager is unlikely to be complacent about its own track record or to focus only on fixed management fees.

Source: World Bank, including interviews with International Finance Corporation (IFC) Private Equity Funds and IFC SME Ventures teams.

to the SIF (an internal manager) or is an external manager selected via a competitive process.38 The selection of the SIF manager sends an important signal to the investment community in which the fund operates about the capacity of the SIF, its expected independence from the public sponsor, and its appeal as an investment partner to prospective co-investors. Whether private investors look to invest at the fund level in a mixed capital SIF, or as co-investors at the project level, the SIF’s human resource capacity is crucial to its credibility as a partner. The options are the following:

• In the internal manager scenario, the public sponsor either assigns management responsibility of the SIF to an internal agency or recruits directly the individual investment professionals who will form the SIF’s fund management team. The employment status of these professionals will vary with the legal setup of the SIF. For instance, they may be employed directly by the line ministry that supervises the SIF or by a new fund management firm set up to manage the SIF. • In the external manager scenario, the public sponsor (1) appoints, through a competitive process, an external fund management firm with the qualifications to successfully implement the SIF’s investment strategy; (2) negotiates a fund management agreement that disciplines the activities of the external manager; and (3) establishes processes to monitor the external manager’s performance. Each of these three steps is discussed in detail later in this chapter.

Several factors affect the public sponsor’s decision to appoint an internal or external fund manager, including the following:

• The SIF’s target investor mix. Commercial investors place high importance on a fund management team’s shared investment track record and proven working dynamics (for example, shared vision, complementarity of skill sets, and agreement among team members over roles, seniority, and remuneration).

A public sponsor that aims to attract commercial investors to a SIF may therefore want to consider appointing an established external manager, rather than assembling the investment team from scratch. Marguerite, whose internal manager lacked a shared track record, highlighted this as one of the factors that hindered its ability to raise commercial capital for its first fund (see the case study in appendix A). • The availability of reputable investment talent in the target sector or geography. A public capital SIF’s sponsor that believes it has the talent in-house (or can organize such a team) within an internal agency may choose to do so, as the government of Ireland did by locating ISIF within the NTMA. If such talent is not easily accessible to the public sponsor, it may choose to seek an external manager. Because the private capital fund (PCF) industry is nascent or developing in many emerging market and developing economies, finding established and reputable external managers based in or interested in investing in these countries may prove difficult. If reputable external managers are already operating in the target sector or geography, they may be conflicted from managing a new fund. In these circumstances, a public sponsor may still prefer to appoint an internal manager, rather than settling for a second-tier external manager. • The extent to which the SIF’s investment strategy diverges from the typical

PCF investment strategy in the target sector or geography. PCFs operate under precise assumptions in terms of investment time horizon, as discussed

in chapter 5. A SIF that plans on longer-than-usual investment horizons may struggle to attract existing PCF managers. Similarly, an infrastructure SIF that targets early-stage greenfield projects may struggle to attract existing infrastructure fund managers, if the focus of the latter is on brownfield projects. Likewise, a SIF that pursues a very broad strategy—targeting, for instance, both direct and indirect investments, and investments in both equity and debt—may not appeal to PCF managers pursuing more specialized strategies. In all these cases, appointing an internal manager may be the best or perhaps the only option. • The procedures for appointing external versus internal managers. It may be easier for a public sponsor to appoint individual investment professionals, under existing public hiring procedures, than an external fund management firm. As discussed later in more detail, the latter’s selection process requires a sound understanding of the fund management industry and its legal and contractual frameworks, which the public sponsor may not have in-house.

Conversely, an external manager, once hired, may facilitate the operations and reduce the running costs of a SIF through its established procedures and administrative infrastructure, as also noted in the generally accepted principles and practices (GAPPs), or Santiago Principles.39

SIFs sponsored by a national government generally opt for an internal manager (whether through an existing agency or by recruiting a new team), whereas SIFs sponsored by a development institution may often opt for an external manager. SIFs sponsored by development institutions often have the express mandate to attract commercial investors at the fund level, and have more targeted strategies in line with PCF standards; several development institutions also customarily invest in private equity (directly or indirectly) and therefore have the technical expertise required to appoint an external manager.

The SIF’s principal-agent problem extends to remuneration for the fund manager, whether internal or external: incentives must drive both financial and economic returns. Performance-based pay for a SIF may need to be designed differently from the compensation structure generally used in the investment industry to reflect the SIF’s dual objective mandate. Given the long-term investment horizon of SIF investing, for instance, the governance structure of the SIF must contemplate long-term incentives that drive individuals to perform in the interest of both the financial and the economic objectives of the fund. For an internal manager, public sector compensation schemes may impede the ability to flexibly remedy the principal-agent challenge through financial incentives (see discussion in the next subsection). For an external manager, long-term incentives could be achieved, for instance, by delaying the manager’s right to carry (share in profits) until longer-term financial returns and economic returns are evident; by basing carry on the overall portfolio of the fund, rather than individual projects; or by allowing staff and managers to benefit from carry even after they leave the fund, which is likely when longer-term impact is discernible. At the same time, incentive structures should not deviate so radically from private sector fund management standards that they make it impossible to attract qualified fund managers to the SIF.

Internal fund manager selection When the public sponsor has chosen for the SIF to have a dedicated or in-house management team, the CEO is ideally appointed by the SIF’s board, not the

public sponsor.40 If the public sponsor retains the authority to hire and fire the CEO, it takes away one of the board’s most important powers and dilutes its responsibilities. It also limits the accountability of the CEO to the board, and risks making the CEO beholden to the ownership entity or ministry (World Bank 2014). The public sponsor should instead establish the qualifications, criteria, and guidelines41 for nominating, selecting, and appointing the CEO. It should also outline the criteria to remove the CEO from office.

Governments of developing countries and emerging markets often recruit SIF management (and staff) from their diaspora members working in international financial centers or reputed global organizations, and pair them with public sector technocrats who can manage the government apparatus. This is the case, for example, with the CEOs of FONSIS, NIIF, and NSIA, all of whom come from their respective country’s diaspora. Diaspora members with global experience are thought to bring dynamic corporate backgrounds, create meritocratic cultures and opportunity for talented young professionals, and have low tolerance for politically motivated hiring. Having built their careers outside the country, however, diaspora members typically do not have a deep understanding of government networks and bureaucracy. Therefore, such recruits are frequently paired with senior public servants with extensive public sector experience and access to the ministries and government entities that are SIF partners. Such public sector recruits can bolster the SIF’s value proposition of acting as a bridge for foreign investors to access local government networks. Even nongovernment public sponsors may value public policy experience in addition to investment experience.

The SIF CEO should be permitted to select his or her own senior executives and team. How senior executives and the SIF’s team are selected and appointed has a strong bearing on the SIF’s eventual efficacy. Given the importance of staffing, CEOs should ideally be allowed to select their own management team and staff, with the board reviewing the terms under which the CEO selects top management (World Bank 2014). NIIF’s CEO, for example, was selected through a global search process, and among the core priorities he established to ensure manager independence was that NIIF Limited would be able to recruit its staff and executives without involvement from the government. Involving the public sponsor in the process would risk establishing a direct relationship between the public sponsor and SIF staff, thus allowing the CEO’s authority to be undermined.

SIFs are highly skills-intensive organizations, requiring high-capacity management teams and staff with a range of experience, as demonstrated by the skill sets recruited by the various case study SIFs in this book. As investment organizations, SIFs must recruit on the basis of criteria that characterize staff of well-performing investment firms. Generally, these criteria encompass financial expertise, investment or operating expertise, and people skills, including access to broad networks.42 Typical backgrounds include investment banking, fund management, consulting, infrastructure and project finance, multilateral development finance institutions, and sector-specific experience corresponding to the SIF’s investment focus (see box 4.6 on staffing at NIIF). Although SIFs recruit heavily from the private sector, they also recruit talent from public sector backgrounds, for example, to staff economic impact teams. SIFs generally follow standard hiring processes of the investment industry, such as engaging well-reputed headhunters.