Aligning carried interest with sustainability indicators in private debt

The strong development of the private debt market combined with the increasing appetite from stakeholders for impact investing, and the recent EU Regulations have led to a variety of mechanisms ensuring proper alignment of financial interests with Environmental, Social, and Governance (ESG) principles. In this respect, the incorporation of sustainability key performance indicators into the carried interest structures of private debt funds is an evolving practice designed to align financial incentives with social impact goals. This approach is gaining traction in impact investing, especially for funds classified as Article 8 and 9 as per Sustainable Finance Disclosure Regulation (SFDR). However, the expected benefits may not be realized without proper management and verification.

A rising trend among investors 

The private debt market continued its expansion in 2024, solidifying its position as a key asset class for institutional investors. At the beginning of 2024, the total assets under management (AUM) in the private debt market reached approximately USD 1.5 trillion, marking a significant increase from around USD 1 trillion in 2020. Projections from Morgan Stanley suggest that this growth trajectory will continue, with AUM expected to nearly double to USD 2.8 trillion by 2028. In an overall cautious fundraising environment for alternative asset classes, demand for private debt remained stable and resilient, with USD 18 billion raised in the first quarter of 2024. By the end of the third quarter, total fundraising had reached USD 190.6 billion, closely mirroring the USD 193.8 billion raised during the same period in 2023.

At the same time, institutional investors, including pension funds, sovereign wealth funds, and development finance institutions, are increasingly integrating ESG principles and impact investing into their capital allocation strategies. Their focus has expanded beyond financial returns to include measurable social and environmental outcomes, reflecting a growing commitment to sustainable and responsible investment practices. Therefore, integration of ESG principles into private debt has seen a positive market evolution not only through greater allocation to products claiming to target ESG goals — with a record 16% raised last year according to Bloomberg — but also through General Partners incorporating ESG considerations into their lending strategies, especially for funds seeking to comply with Article 8 or 9 of the SFDR. 

The combination of these trends has led more and more fund managers to link part of their carried interests to the attainment of pre-set sustainability KPIs before the end of the fund’s lifetime. Failure to meet those targets will lead to a reduction of the fund managers’ carried interests. For investors, it ensures a strong alignment of interest between their impact objectives and the fund managers’ commitment to improve environmental and/or social indicators of their portfolio. Fund managers are therefore not only incentivized by financial performance but also by their ability to generate meaningful impact alongside competitive returns.

In practical terms, fund managers introducing impact carry in their waterfall structures tend to link 20% to 30% of their carry to the achievement of approximately five social or environmental KPIs mainly linked to themes such a carbon emission, gender diversity, inclusion, recycling, energy consumption etc. The targets of those indicators are defined with the investors and progress is reported to them on a regular basis.

Challenges and consideration 

While linking carried interest to sustainability KPIs offers significant potential benefits, it also introduces a set of challenges and key considerations that must be carefully addressed. We identify the most relevant ones which, if not adequately mitigated, could significantly reduce the expected positive effect of such mechanism.

Measurability and standardization: Assessing non-financial performance presents inherent complexities, as it requires quantifiable and consistent metrics to effectively evaluate outputs and outcomes. Using standardized reporting frameworks and metrics (such as IRIS+, GRI or B Impact Assessment) is essential to ensure transparency, comparability, and accountability across investments. Without clear benchmarks, measurement and validation of social performance might end up inaccurate. 

Balancing impact/financial objectives: Integrating sustainability KPIs into carried interest structures necessitates a careful equilibrium between financial returns and social impact. While impact-driven strategies can generate long-term value, certain initiatives may involve trade-offs that could affect profitability, especially in sectors requiring longer investment horizons or lower-yield strategies. Striking the right balance is critical to maintaining investor confidence while fulfilling broader environmental and social commitments.

Dependence on financial performance: In case of disappointing performance unlikely to trigger any carried interest, the fund manager might stop its efforts towards the achievement of the sustainability KPIs. Funds not expected to be in the carry zone will lose incentive to pursue their impact objectives, making the impact performance dependent on the financial one.

Absence of third-party assurance: The value of sustainability KPIs as well as their evolution against the pre-set targets is typically disclosed to Limited Partners and discussed during advisory board meetings without any form of external validation, which increases the inaccuracy risk. 

A need for independent verification

Linking carried interest to sustainability KPIs represents a significant shift in embedding impact considerations into private debt funds' incentive structures. However, this approach is not the only mechanism available. A range of other tools can be leveraged to align fund manager incentives with impact objectives, including:

• Dual hurdle rate systems: Allowing a lower financial hurdle rate contingent on achieving predefined sustainability objectives.
• Reduced management fees: Implementing fee reductions in cases of consistent non-achievement of impact targets, reinforcing accountability.
• Super carry: Unlocking enhanced carried interest when pre-agreed impact targets are successfully met.
• Milestone-based rewards: Structuring performance fees to be released incrementally as specific impact milestones are achieved.
• Clawback provisions: Recouping bonuses or carried interest if reported impact metrics are later found to be inaccurate or overstated.
• Sustainability-linked incentive plans: Tying a portion of partners' remuneration packages directly to the achievement of sustainability targets.

As each of these tools offers distinct advantages and challenges, a combination of several measures can help build a robust incentive framework that aligns financial and impact outcomes, thereby driving meaningful progress in sustainable investing. However, a crucial mitigant to ensure credibility and transparency is the engagement of independent auditors to verify impact metrics and results.

In this context, the International Standard on Sustainability Assurance (ISSA) 5000, published late 2024 — and expected to be effective for assurance engagements on sustainability information reported for periods beginning on or after 15 December 2026 — is designed to guide the independent assurance of sustainability reports and disclosures by establishing principles and procedures for evaluating sustainability information.

What’s next?

With sustainability becoming a critical consideration for the financial sector, driven by growing awareness of ESG issues and materialized in the EU by various regulations and directives following the EU Sustainable Action Plan, investors increasingly demand accountability and transparency in addressing sustainability matters. For private funds, recent years have seen the emergence of new impact-related terms and conditions crystalizing a new Risk-Return-Impact analysis which is disrupting the way fund managers are managing their portfolio and creating value. As is often the case, changes require adaptation but also create opportunities.