ESG challenges for private funds: steps to address the financial risks and compliance obligations

June 2021 | SPOTLIGHT | PRIVATE EQUITY

Financier Worldwide Magazine

June 2021 Issue

The drive to move environmental, social and governance (ESG) considerations up the agenda of the financial marketplace has continued in earnest in 2021 and very few (if any) sectors have been left out. Most private fund sponsors have had ESG considerations embedded into their processes for a long time, often in reaction to investor requests. However, the increased public focus on ESG and regulatory developments, particularly in Europe, as part of a continuing trend for increasing ESG compliance mean that the pressure on private fund sponsors from an ESG perspective has been and will continue to be accentuated. As the name suggests, private funds, excluding those that have chosen to become publicly listed, generally have operated on the basis of private relationships with their investors, and those investors have served as the principal barometers of their activities. However, the nature of the new ESG regulatory obligations is such that the activities of private funds may not remain so private. Further, it is possible that ESG factors may have a material impact on the returns that private funds may be able to achieve if those factors are not managed properly.

In this article, we explore some of the challenges presented by the ESG landscape and discuss some steps private fund sponsors may want to consider taking to address those challenges.

ESG Regulations

Many investors in private funds have, for some time, requested that the private fund sponsors with whom they invest take ESG factors into account in their investment processes, for example by reference to standards such as the UN’s Principles for Responsible Investment. Now, private fund sponsors also must consider the different regulatory regimes imposing ESG obligations on them. At the forefront of those regulations in Europe is the adoption of the EU Sustainability Related Disclosure Regulation and the Taxonomy Regulation, collectively known as the ESG Regulations. The principle thrust of the ESG Regulations is to impose ESG-related disclosure obligations on financial market participants, including in-scope private fund sponsors. Effectively, any private fund sponsor that is within the scope of the European Alternative Investment Fund Manager Directive also will be in scope for these rules. As well as imposing investor-facing disclosure requirements, many in-scope firms will have to include public disclosures on their websites. The ESG Regulations apply in differing respects to private fund sponsors managing or marketing funds in the EU. There is also an expectation that other jurisdictions, including the UK and the US, will increase ESG-related regulations and private fund sponsors will need to carefully consider the different ESG standards and frameworks to work out their compliance burdens.

The requirements under the ESG Regulations have staggered effective dates, with the first obligations in force since 10 March 2021 and the majority of the remaining requirements becoming mandatory on 1 January 2022. However, beginning 30 June 2021, in-scope private fund sponsors with more than 500 employees will be required to publish a statement on their websites regarding due diligence policies that describes the principal adverse effects of their investment decisions on sustainability factors. By 1 January 2022, all in-scope private fund sponsors will be required to make disclosures regarding the integration of sustainability risks in their investment decision-making process, and by 30 December 2022, all in-scope private fund sponsors will be required to explain how their financial products consider principal adverse impacts on sustainability factors. To the extent that a sponsor does not consider the adverse impacts of investment decisions on sustainability factors to be relevant, it will not be able to remain silent on these issues but rather will be required to provide a clear and concise explanation on its website of the reasons for reaching the conclusion that these factors are not relevant. This ‘comply or explain’ approach is a familiar path for regulators who hope that few private fund sponsors or other financial market participants will want to make a negative ESG disclosure on their websites.

Challenges

Beyond the additional compliance burden that will result from the ESG Regulations, private fund sponsors must also consider the longer-term impact of having public disclosures. It is relatively easy to identify a private fund owner of a business, whether through the advertising of the private fund sponsor itself or through a search of public filings and beneficial ownership registers. While these disclosures are not likely to raise a concern on a day-to-day basis, if a company does face ESG-related issues, it will not take long for media scrutiny to reveal the ownership of the related business and any public statements made by the owner will only be a quick search away. It is a reasonable assumption that regulators are counting on this level of scrutiny, and private fund sponsors should be aware of the implications of the public statements they make.

Perhaps more significant is the potential financial impact that ESG can have on a private fund portfolio. On the fundraising side, fund sponsors with negative ESG profiles may find it more difficult to raise capital. On the downstream side, it is likely to become increasingly important for a private fund’s portfolio companies to have positive ESG profiles to ensure there is not an impact on potential valuations or sale prices.

ESG is likely to remain in the spotlight for a long time. While historically there has been much focus on the environmental aspect of ESG, the pandemic has brought an increased focus on social concerns through matters such as employee relations and treatment. Meanwhile, the governance aspect may present private fund sponsors with their best line of defence.

Steps to be taken

To prepare for compliance with the requirements under the ESG Regulations, private fund sponsors should begin by gathering data on their existing portfolio companies and other underlying investments. The data gathered should be sufficient for the sponsor to conduct a risk assessment of the sustainability risks that may arise in these underlying investments. When carrying out these assessments, private fund sponsors, in scope of the EU Taxonomy Regulation, should utilise the environmentally sustainable activities criteria under the EU Taxonomy Regulation. Any assessment should also consider social and governance factors, including, but not limited to, labour relations, board diversity, modern slavery, employee pay and social cohesion, staff and management remuneration, and tax compliance. To the extent that the risk assessments identify any issues, sponsors should consider preparing a roadmap to compliance, to take appropriate action to resolve such issues.

One important area of compliance is in relation to the corporate governance framework adopted by private fund sponsors and their underlying investments. Steps that may be taken by businesses seeking to improve their corporate governance framework include: (i) increasing board diversity and representation; (ii) strengthening reporting lines and risk management procedures; (iii) heightening shareholder and investor engagement through increased reporting; and (iv) embedding and maintaining a strong compliance function that can oversee the business.

In relation to the downstream investment and acquisition processes, private equity sponsors should also consider adopting best practices for compliance and monitoring of ESG on a forward-looking basis. One way of implementing this approach is for private fund sponsors to review and evaluate, on a periodic basis, whether to update or modify their internal policies and procedures to incorporate or enhance ESG factors, to further integrate ESG factors into investment committee decision-making processes, for example. ESG due diligence should form an integral part of the broader due diligence process, and sponsors may want to consider whether it is possible to score or ‘price’ sustainability and other ESG risk factors into any investment decision. Furthermore, private fund sponsors should also consider adopting ongoing monitoring and reporting practices, such that any sustainability-related issues that arise are appropriately escalated and resolved.

Although these practices may raise concerns due to their associated cost and time commitment, the potential risks of failing to implement some or all these steps are likely to significantly outweigh any such cost. As a starting point, it is likely that businesses that suffer from a failure to achieve compliance with ESG standards, particularly where they are made public, will suffer a loss of value at some stage of the investment period, whether during the hold period, for example as a result of a loss of customers and therefore revenue, or on an exit, such as an initial public offering (IPO) where investors are increasingly aware of ESG compliance. In addition, an adverse ESG-related incident is likely to bring pressure from investors and other stakeholders, especially considering the level of public disclosure that private fund sponsors will be required to make. There are numerous examples in the last 12 months of public fallout resulting from ESG-related issues, including consumer boycotts and high-profile resignations.

On the flipside is the positive impact that can be made by private fund sponsors adopting and implementing robust ESG policies and strategies. There are numerous studies that evidence the strong financial returns that can come from sustainable investment practices. For private fund sponsors, there also is the importance of being able to demonstrate such practices to investors. ESG compliance should not be considered only as a means of preventing a negative impact – it can, if implemented properly, result in a very positive impact as well.

Greg Norman and Steven Hannah are partners and Abigail Reeves is an associate at Skadden, Arps, Slate, Meagher & Flom LLP. Mr Norman can be contacted on +44 (0)20 7519 7192 or by email: greg.p.norman@skadden.com. Mr Hannah can be contacted on +44 (0)20 7519 7090 or by email: steven.hannah@skadden.com. Ms Reeves can be contacted on +44 (0)20 7519 7282 or by email: abigail.reeves@skadden.com.

Greg Norman, Steven Hannah and Abigail Reeves

Skadden, Arps, Slate, Meagher & Flom LLP