ESG (Environmental, Social and Governance) issues have been steadily moving up the agenda for GPs in recent years. However, following the COVID pandemic and a greater focus on climate change, the spotlight is now clearly on making sure that GPs properly consider ESG issues, both for themselves and their portfolio companies. Although the concentration on “ESG” has packaged these three topics together, there is, of course, a great difference between the issues relating to environmental policies and the drivers behind the two separate areas of social issues and governance principles. In this Mainspring Insight Article, we cover some of the developing requirements and examine how GPs can adopt these new ESG requirements and potential opportunities for the benefit of the fund and the GP.
What if the government introduced a carbon tax?
Would you understand the impact on a portfolio company? If the management team and company strategy have been prepared upfront it may not be negative. However, what is the GP’s level of confidence in the ability to answer investors ESG questions about the current investments, or during the next fundraising?
Some investors are anxious to be seen to be doing the right thing, for many, however, particularly pension funds, ESG is now seen as a “must-do” – there is no option. This is because many investors, particularly European pension funds, have signed up to the UN Principles for Responsible Investing, (the “UN PRI”). Early in 2005, the then UN Secretary General, Kofi Annan, invited certain
individuals, drawn from the world’s largest investors, to develop these principles, which were first issued in April 2006. There are now over 3,000 signatories, in over 60 countries, representing over US$80 trillion of assets. The first paragraph of the PRI’s mission statement states:
“We believe that an economically efficient, sustainable global financial system is a necessity for long-term value creation. Such a system will reward long-term, responsible investment and benefit the environment and society as a whole.”
There are six Principles, which are voluntary and aspirational, offering a menu of possible actions for incorporating ESG issues into investment practice. The main ones require signatories to incorporate ESG issues into investment analysis and decision-making processes as well as being active owners of businesses in order to incorporate ESG issues into ownership policies and practices.
Making appropriate ESG disclosures and reporting on progress is also required. As a result, investors are keen to find managers which promote sustainability and demonstrate an appropriate level of commitment to being carbon neutral as well as following other ESG policies. The PRI has set out particular examples of ESG factors in each of these three categories – although it recognises that these are ever-shifting. The PRI also gives examples of possible actions which could be taken to implement its six Principles.
ESG, what should a GP do?
Every GP needs to consider its position in relation to its own particular in-house policies as well as the obligations imposed on it through the regulatory regime to which is it subject. It also needs to think about how to embed appropriate ESG criteria into its investment process to ensure that each investee company is aware of these issues and adopts appropriate policies.
ESG Internal policies
Each GP needs to look at its existing practices and consider how they can be improved to reflect better ESG practice. Not all factors suggested by the PRI will be relevant. GPs should probably focus on two or three particular areas such as reducing single-use plastic, becoming carbon neutral and ensuring that an appropriate compensation strategy is pursued. It may also want to review its employee relations, board diversity and structure, as well as looking at how to improve its governance.
There are several independent ESG professional service specialist organisations that can assist with this type of review, assisting with GP specific policies for ‘what good looks like’ and a flexible plan to set out goals.
Introducing ESG to the investment process
Since the PRI emphasises stewardship and close contact between a GP and a portfolio company, private equity is naturally suited to responsible investment. The investment process can be adapted – ESG questions/policies can be included in the initial screening process, the due diligence questionnaire, the investment memorandum and term sheet as well as in the investment agreement/shareholders agreement.
With more investors adopting ESG as a core investment principle, those GPs who have incorporated ESG into their investment process and portfolio management and can demonstrate a genuine commitment to the issues will find themselves better positioned when it comes to the next fund raise.
The new ESG regulatory landscape
The EU’s Capital Markets Union Project includes a number of reforms in the ESG area which affect managers of private funds. The EU is keen to prevent “greenwashing” – so marketing products that appear to have an ESG component, when in reality ESG considerations were not taken into account in the investment process.
There are four new principal provisions that came into force in March 2021:
- Sustainable Finance Disclosure Regulation (“SFDR”) – this imposes transparency and disclosure requirements on AIFMs at both a product and manager level;
- Taxonomy Regulation – this creates criteria for determining whether an economic activity is environmentally sustainable and includes product-level reporting requirements for products that promote environmental characteristics;
- Low Carbon Benchmark Regulations – introduces a framework for climate-related benchmarks; and
- Amendments to AIFMD and MiFID. These will require AIFMs to integrate sustainability parameters into their risk management processes and requires sustainability factors to be taken into account in the product governance and sustainability processes of MiFID firms. These provisions will also apply to products marketed into the EU, including those managed by non-EU funds, so by UK managers. There are heavier disclosure requirements for firms with more than 500 employees, but all firms are required to describe their “sustainability risks” and explain how they are integrated into their investment process.
In addition, post-Brexit, the UK may well introduce its own measures around greenwashing and ESG disclosures – so depending on whether they are marketing into the EU, some UK managers may have to comply with both sets of rules. Notwithstanding Brexit, the UK government has committed to complying with the new EU rules since ESG is being treated as part of the UK Government Clean Growth Strategy.
Life is changing. More information will need to be gathered and reported upon. Every GP needs to be alert and make sure it complies with the new ESG requirements to which it is subject – otherwise, it may find that it is in breach of regulatory requirements and that investors are no longer ready to support it.