An increasing number of investors are embracing “impact covenants,” or legally enforceable promises, as a tool for maximizing the positive impact of their investments. Jeff Rosen, Chief Financial Officer of the Solidago Foundation and Confluence Board Member, recently moderated a webinar discussion about impact covenants. He spoke with Deborah Frieze, co-founder of the Boston Impact Initiative Fund, an impact fund focused on economic justice, and Chintan Panchal, founder of RPCK Rastegar Panchal, a law firm focused on innovative finance and impactful transactions. The discussion ranged from an overview of how covenants typically function in legal documents to insights about best practices when introducing impact covenants into deal negotiations.
What is an “impact covenant?”
Chintan began by providing background about covenants and the role they play in legal documentation. Simply put, covenants are legally enforceable promises to take, or to refrain from taking, a specified action. For example, in loan agreements, borrowers almost always covenant to provide regular financial reporting to lenders. Deborah noted that while the market is fully accepting of covenants such as financial reporting obligations, which are designed to protect the financial bottom line, investors are just starting to think about using covenants to protect the environmental or social bottom line. Nonetheless, the speakers anticipate that legal documentation will increasingly reflect and protect environmental and social expectations of investors alongside financial expectations—with impact covenants serving as one of many important tools in accomplishing this end.
Chintan and Deborah shared their perspectives about the role impact covenants can play in an impact transaction. They agreed that investors tend to focus on the enforceability of impact terms. In other words, investors focus on whether an investor can take legal action against a business’s failure to live up to its promise. For example, when a covenant obligates a corporation to pay a baseline wage to its employees, and utilizes a redemption right to enforce this covenant, an investor might take the business to court to have its investment returned if the enterprise fails to pay those baseline wages. However, the speakers cautioned, the investor should consider practicalities at the outset, such as whether the investor is likely to enforce such a right in this way and potentially bankrupt the business for the specified failure. Ultimately, Chintan and Deborah encouraged investors to approach enforceability from a proportional perspective, meaning that investors should weigh the seriousness of the covenant breach against the harshness of the remedy.
Chintan and Deborah then posed a perspective-shifting question: What if we stopped thinking about impact covenants in terms of enforcement and instead looked at impact covenants as part of a co-creative process, a means of strategizing to maximize the environmental or social bottom line and as the articulation of what both the investor and business teams value?
A tool for alignment
Chintan emphasized that covenants should be used to drive alignment among various stakeholders. Working through impact covenants at the outset of investment discussions helps to build consensus among stakeholders about the anticipated business outcomes. Furthermore, investors and businesses can use the strategic discussions surrounding investment partnerships to brainstorm productive ways to tie positive outcomes to financial outcomes. For example, Deborah has used financial rewards (such as a step-down in interest rate) to incentivize certain social outcomes.
In answering questions from the webinar participants around real-life experience with enforcement situations, Chintan noted that in his experience, investors and founders have walked away from the negotiating table over disagreements surrounding impact covenants. However, in his view, an incentive-based approach to covenants was less likely to tank a deal than an enforcement-focused approach, particularly in deals with traditional investors that are less mission aligned.
Moreover, impact covenants that focus on building and protecting a strong process—for example, policies and procedures designed to produce a certain outcome—are usually more successful that setting hardline metrics around the outcome itself, particularly if there are factors beyond the enterprise’s control that could affect this outcome. Nonetheless, Deborah added, sometimes it’s right to pull an investment when the business wholly departs from its social purpose.
Regardless of whether investors take the carrot or stick approach, both Deborah and Chintan emphasized that the most important outcome is the conversation those covenants prompt. From the very beginning, impact covenants encourage discussion between all stakeholders about the desired impact of the enterprise. Further, they continue the conversation over the life of the investment, whether through requirements for ongoing social or environmental reporting or as a result of renegotiations following a breach of a covenant. In short, impact covenants serve to elevate intended positive outcomes and to ensure that the importance of ‘impact’ is on the table.
While impact covenants are still both rare and often controversial, they are an increasingly common tool for driving alignment between financial and social outcomes.
Marie Cita, Associate, RPCK Rastegar Panchal.
Marie Cita is an associate in the New York office of RPCK Rastegar Panchal. She has experience advising international and domestic sponsors, portfolio companies, and financial institutions in a range of complex corporate transactions, including M&A transactions, cross-border financings, fund financings, and other secured and unsecured debt structures. She also has advised depository institutions and affiliates on bank regulatory compliance and in enforcement matters. Marie received her J.D. from Harvard Law School where she was lead article editor of the Harvard Civil Rights-Civil Liberties Law Review. She received her B.A. in English Language and Literature from Yale University.
Chintan Panchal, Founding Partner, RPCK, Rastegar Panchal
Chintan Panchal is a Founding Partner at RPCK, Rastegar Panchal, a global boutique law firm, and head of the firm’s New York office. As a corporate advisor, entrepreneur, and sustainability professional, Chintan brings a unique perspective to his practice, counseling private equity, foundation, family office and growth company clients on corporate merger & acquisition, finance, and dispute resolution matters. Under Chintan’s direction, RPCK has developed a dedicated impact investing practice, advising both mission-aligned investors and social enterprises. The firm works closely with clients to execute capital investments in both emerging and developed markets that generate social and environmental impact alongside market rate, risk-adjusted financial returns. Drawing upon deep commercial lending, private equity, and industry specific experience, RPCK helps clients qualify opportunities and structure transactions that achieve long-term, measurable results.
