R EVISING THE CONTROL MECHANISMS CENTRAL IN AGENCY THEORY FROM A SOCIAL

investment (ibid). Also, in cases of poor venture performance, the principal can change the management of that venture, whereas in extreme cases, the principal will be able to replace the whole management (Iliev, Lins, Miller & Roth, 2015). Hence, the greatest protection that equity holders have is their vote. Negotiating such board control and management replacement rights into investment contracts provide investors with two main advantages:

1. When an entrepreneur/manager is willing to give up power through board control, that manager is indicating quality and portrays a commitment not to behave opportunistically (Bellavitis et al., 2017).

2. In case the prospects of the venture deteriorate, investors will be entitled to intervene (Hart & Moore, 1999).

Control rights thus contribute to constraining certain agent behaviours and reduce the possibility of agency problems.

4.2 Revising the control mechanisms central in agency theory

in the investment process, where limitations and necessary adjustments of the theory are taken into consideration.

4.2.1 Screening and due diligence

As previously discussed, agency problems are caused by moral hazard and adverse selection. Adverse selection arises when it is difficult for the investor to evaluate the quality of the investment, and therefore it typically appears in the pre-investing phase (Bellavits et al., 2017). The venture usually has access to more information about the business model and growth prospects than the investor has, and might have different goals and incentives with the investment. A thorough pre-screening and due diligence is therefore crucial for investors to evaluate the potential of the venture and to make sure that goals are aligned.

In terms of impact investing, pre-screening and due diligence are conducted the same way as for conventional investments, but with an additional focus on the social aspect of the investments (Grabenwarter & Liechtenstein, 2011). The pre-screening phase is further used to search for prioritised sectors and to exclude investments that do not fulfil the requirements of impact investing (ibid). Pre-investment screening can, in addition to evaluate risk profile and return expectations, be used to measure an investment’s potential for creating impact (Loveridge, 2016).

O’Donohoe et al. (2010) point out that due diligence is important for impact investors to assess the investees’ values and growth targets to decide whether their social impact expectations are met or not. Furthermore, Schiff & Dithrich (2018) find that most impact investors consider their exit opportunities during the due diligence as well, in order to decide whether or not to make the investment based on the impact motives and strategy of the investee. According to The GIIN (2019c), due diligence in an impact investing setting has four core functions: 1) as a risk management tool; 2) as a way to identify the social or environmental impact; 3) as a means to identify ways to add value to improve the impact of an investee; and4) as a way to respond to limited partner expectations.

Jackson & Harji (2012) claim that due diligence is often held closely within institutions and that there is a lack of incentives to share these tools, which can potentially amplify the process of an accurate assessment of investees that deliver both financial and social returns.

4.2.2 Contracting

As mentioned previously, contracting is a well-known tool to prevent agency problems.

However, the challenge with aligning incentives between principals and agents gets even more complicated by adding a social impact objective. In contrast to the extensive literature about the contractual relationship between investors and entrepreneurs in traditional finance, the literature on social impact contracts is limited. Evans (2013, p.

139) addresses the need for a theoretical basis for impact investing and states that:

“Such a framework would enable the design of investment approaches to better fit investors’ desired combination of financial returns and impact as well as provide a ‘tool-box’ for understanding and adjusting the investment contract or environment in the case

where outcomes deviate from target performance.”

Geczy, Jeffers, Musto & Tucker (2018) address this challenge and claim to be the first to analyse the effect of impact goals on contracts and how to add the impact aspect to the traditional contracts. In their paper, they examine several different contract forms to evaluate how contracting practices within this setting adapt.

Saltuk & Idrissi (2015) state that the contractual relationship depends on investor preferences; some investors prefer to allow more flexibility for the investee by keeping impact goals out of legal documentation, while other investors prefer to utilise legal contracts. Hence, an important consideration is whether to include the social objectives directly in the contract. When evaluating this, literature by Hart & More (2008) will be applied, as it evaluates the appropriateness of rigid versus flexible contracts in situations characterised by uncertainty, which is somewhat the case in impact investing. Moreover, Holmstrom & Milgrom (1991) have explored the problem of multi-tasking in contracts,

and since multiple objectives are a core feature of an impact investor’s investment process, it would be natural to look at how contracting practices vary when the agent is responsible for multiple tasks. Furthermore, when assessing how the contract should be structured, literature by Kaplan & Strömberg (2001;2003), which examine contractual designs, i.e. the allocation of cash-flow and control rights, and incentives will be used.

Nevertheless, clearly defined goals and preferred outcomes are undoubtedly of importance in an impact investing process, not only for the investors, but also for the investees. The decisions by managers of social enterprises are difficult to communicate and hence formulate into contracts since the impact of the different measures can have a variety of outcomes.

4.2.3 Monitoring and control

Monitoring of managers is essential to prevent the agents from maximising their own welfare and not that of the principal (Panda & Leepsa, 2017). Specification of the rights of the agent as well as the performance criteria on which the agent is evaluated are usually incorporated in the contract. Thus, monitoring includes a review of the managerial decisions of the agent along with an assessment of output (performance measures) through internal audits to ensure contract enforcement (Namazi, 2014). The principal therefore engages in monitoring and control of the agent to see if the agent is behaving as planned and to measure the performance of the entrepreneur to see if the originally agreed-upon goals are being met.

In an impact investment, the principal must also consider to monitor, control and measure the progress made on achieving the social objectives agreed on. The need for monitoring in order to enforce agency contracts or as a basis for negotiation of an incomplete contract, calls attention to the difficulty of such monitoring due to the issues of measuring impact. According to Jackson (2013) the quantification of social value has been proven to be a complicated and time-consuming process. Godsall & Sanghvi (2016) state that the lack of frameworks to measure impact makes it difficult to measure and benchmark impact. For principals to be able to closely monitor and enforce their control rights if the

investee is not behaving as planned, principals need to find a way to incorporate the social aspect into their post-investment process and establish routines for how they measure and monitor the progress.

Impact investors can thus apply the same monitoring and control mechanisms as conventional investors; however, the inclusion of social objectives must be taken into consideration along the way.