Alternative Insight – September 2017

Are you ESG ready?

Asset managers typically evaluate a broad range of factors when determining the merits and long-term potential of any investment, whether it’s an LP doing due diligence on a fund or a GP scouting out target companies. Environmental, social and governance (ESG) factors are one such set of factors, and an increasingly important set.

What’s in a name?

‘ESG’ is a very big tent. It covers environmental challenges as diverse as pollution, energy efficiency and animal welfare; social factors like workers’ rights, occupational safety and community integration; and corporate governance issues like transparency, political donations and anti-corruption policy.

What constitutes an acceptable set of ESG criteria will vary from business to business, but one can identify consistent ESG themes – sustainability, high standards, good stewardship – which sit at the heart of socially responsible investing.

Old, yet new

Responsible investing isn’t a novel idea. In the late 19th century, religious groups like the Quakers became known for investing in and running businesses on firmly ethical principles. In the second half of the 20th century, as pension funds became major players in the equity markets, they began to develop investment policies in-house which reflected their own origins and political, social or ethical considerations.

Initially, private equity managers may have regarded ESG as an unwelcome distraction from their core activity of sourcing and managing high-return investments. ESG might then be relegated to a couple of paragraphs in a fund’s marketing prospectus. Its main impact was in the framing of the fund’s investment mandate. For the most part, GPs ticked the ESG box by “negative screening” – an investing strategy which essentially involves steering clear of “vice” industries like tobacco, gambling or armaments. But there was little proactive engagement with ESG beyond the investment mandate or after the fundraising period.

In the last decade, however, the PE sector has vaulted into the vanguard of responsible investing. Much of this has been LP-driven. In 2005 a large group of investment professionals and civil society leaders got together under the aegis of the UN to promulgate the Principles for Responsible Investment (PRI). The PRI concerns investing in general, rather than private equity investing in particular, but its founding signatories included many of the largest institutional investors in private equity funds, a fact which attracted the attention of PE fund managers keen to attract and retain their capital. Quite a few managers have since become PRI signatories themselves.

How and why ESG pays off

Paying close attention to ESG will often have conventional financial advantages too. An ethical investing strategy can lower overall portfolio risk by mitigating at least one set of risks, while also lowering the probability of incidents (for example, workplace accidents, unsafe disposal of chemical waste, abuse of market power) which, if they were to reach the ears and eyes of the media, would cause serious reputational harm to both the portfolio company, the fund that owns it, and the fund’s own LPs. In the long run, it should mean less volatile returns for GP, portfolio company and LP alike, to say nothing of the broader benefits to society.

Others have begun to see and sell ESG as value-add, rather than just value protection. Specialist impact funds have mushroomed off the back of the growing band of investors willing to back up talk with capital commitments. Impact funds actively seek to deliver more than a purely monetary return – the so-called “double bottom line”, in which investment activity is rated both financially and for its environmental and local community impact.

Impact on re-upping

As institutional investors (and their own stakeholders) become more sophisticated in their understanding of ESG, they have started to pressure GPs to become more serious and systematic in their approach to ESG. Some LPs say that ESG is now a significant enough factor that they will often decline to re-up with a manager if it cannot demonstrate real improvements in its portfolio’s track record on ESG.

An early booster of ESG-focused investing, APG Asset Management, which manages the giant Dutch pension fund ABP, has been one of the first major investors to adopt this approach to the funds it evaluates. APG now requires GPs to evidence their green credentials before deciding whether or not to reinvest with them. Managers with a strong ESG track record may soon find themselves speaking to a larger, more receptive and loyal audience of LPs.

Effective implementation

For both GPs and LPs, the heavy lifting starts at the due diligence stage. For instance, Adveq recently disclosed that a quarter of its fund DD questionnaire is ESG-related.

The PRI have a reporting framework that provides a good overview of the information that LPs should consider requesting from GPs that they want to invest with. These reporting obligations ensure that agreed restrictions and activities are correctly implemented.

GPs can rapidly improve their ESG scoring by “positive screening” – purposely seeking out portfolio companies with a good ESG track record of their own. There is some evidence that this is already influencing acquisition decisions. A 2016 PwC study of responsible investing reported that 40% of GPs said they had turned down an investment or demanded a discount to reflect a target’s poor ESG track record. A similar proportion in the same study claim to be willing to pay a premium for a company with strong ESG performance.

Cynics may counter that this is more marketing strategy than investment strategy, with GPs tailoring their narratives to what they believe LPs want to hear. But if they are willing to ‘talk the talk’, then it may not be long before they want (or are pushed) to ‘walk the walk’, too.

Ongoing engagement

The effort shouldn’t tail off at the point of investment. In this regard, development finance institutions (DFIs) have been notably assiduous and innovative at following through on ESG undertakings and policies.

DFIs now commonly insist on ongoing LPAC oversight of ESG compliance, require the manager to prepare regular reports on ESG at the portfolio company level, and set long-term improvement targets, which sometimes may carry consequences for the fund (for instance, via LP excuse or drawstop rights) if there is a sustained failure to fulfil ESG undertakings. CDC, the UK DFI, has developed a template for annual ESG reports, part of a toolkit of ESG-related resources that it has posted to its website.

Don’t look back in anger

It is one thing for an LP to make sure that commitments to new funds are ESG-compliant. But problems can also arise in legacy funds. It is advisable for ESG-minded institutional investors to undertake a thorough review of exposure across their portfolio of funds.

A very public example of how this can play out came in 2013, when the Archbishop of Canterbury’s strident criticism of the practices of Wonga, a payday lender, was followed soon after by the revelation that the Church of England’s investment arm had an indirect investment in Wonga through one of its legacy fund commitments.

Metrics

At present, it is difficult to objectively compare different companies, managers, funds and jurisdictions on what are highly customizable ESG criteria and uneven disclosure standards. Benchmarking against broad standards like the PRI or the BVCA’s Responsible Investment guide offers one route out of the confusion.

Attempts are also being made to develop a standardized rating system to evaluate the key ESG risks and opportunities of investing with particular fund managers. The MJ Hudson Private Equity ESG Policy Level Framework is an example of a ratings system that is simple to implement and easy to integrate into more complex and sophisticated frameworks.


 

USEFUL GUIDES

ESG Factors in Private Equity Investing

The Guide aims to assist fund managers and investors in understanding how the private equity market is treating ESG issues and how to quickly evaluate which policies meet specific requirements.

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Alternative Insight is produced by MJ Hudson’s private funds lawyers. We provide expert legal advice to fund managers, other financial sponsors, investors and advisers on the formation, structuring, investment into and regulation of private funds, managed accounts and similar vehicles. Our practice covers the full spectrum of alternative assets, including private equity, venture capital, hedge funds, private debt, real estate and infrastructure. Clients praise our entrepreneurial approach, commercial outlook and dedication to helping them achieve their objectives, regardless of the obstacles.