ESG climbs limited partners’ due diligence agenda

March 2018  |  FEATURE  |  PRIVATE EQUITY

Financier Worldwide Magazine

March 2018 Issue

Environmental, social and governance (ESG) issues are increasingly important to companies and their stakeholders, particularly in the private equity (PE) industry. “Over the last two years, we have seen a significant uptake in ESG data being analysed and weighed in the PE space, particularly among mainstream investors,” says Nancy Mancilla, the co-founder and managing partner at ISOS Group. “Until recently, this was seen primarily as a niche market; however we are now seeing the value generated from more stringent management practices, in what was traditionally viewed as the intangibles.”

The importance being attached to ESG is being driven by changing attitudes among a number of stakeholders, according to Beth Houghton, a partner at Palatine Private Equity LLP. “Pension holders are increasingly insisting that their pensions are invested and managed responsibly, limited partners (LPs) are responding to this by putting ESG higher on the agenda when selecting general partners (GPs) and GPs are realising that ESG can be a value driver within their portfolio companies and therefore lead to enhanced returns,” she says. At the fund manager level, investment teams are realising that ESG and sensible, sustainable investment should increase returns in the long term. Indeed, ethical investing strategies can, for example, lower overall portfolio risk by mitigating at least one set of risks, while lowering the probability of incidents which cause reputational damage.

For some, this is an interesting shift in thinking. “Where environmental issues weighed heavily on the minds of companies for the last 20 years, they have finally managed to get to a point where they have a basic understanding of how to measure and manage negative impacts,” suggests Ms Mancilla. “Similarly, all companies, regardless of size, type or cultural orientation, are able to produce environmental disclosure pretty consistently. Over the last few years, we have started to see growing pressure from stakeholders, whether investors, boards or employees, ask for greater governance and ethical responsibility. Social impacts tend to remain the last great frontier.”

Long-term horizons

PE is ideally suited to ESG and responsible investing, given the long-term investment horizons common to the industry – in 2015 the average holding period of a portfolio company by a PE firm was around five and a half years, according to Preqin. While negative ESG effects can be felt in that time, the long horizon also allows ESG performance to be comprehensively analysed.

Many industry bodies and organisations are reinforcing the growing importance of ESG too. The United Nations-supported Principles of Responsible Investment, drafted by an international network of investors, provides a framework for incorporating sustainability and ESG management best practices into investment decisions and ownership practices across asset classes. The framework has over 1700 signatories representing around $70 trillion across 50 countries.

As, Peter Mallon, an associate at MJ Hudson, notes, sustainable investment within the PE space is on the rise. “From the legal documents side, ESG policies are becoming more prevalent in PPMs and side letters. In time, we hope to see attitudes toward ESG change further, with more PE managers agreeing to be bound by their own ESG policies, and therefore to including such policies in the LPA,” he adds. A May 2017 survey by BNP Paribas found that asset managers and asset owners plan to double their investment in ESG strategies over the next two years.

Revenue creation?

At the fund manager level, many larger PE houses are appointing dedicated ESG professionals, further indicating the focus on responsible investment. Though to date it is has been LPs driving the ESG push, attitudes are changing. “Increasing numbers of GPs are embracing ESG as a potential source of revenue creation,” says Mr Mallon. “We envisage more GPs and LPs working together going forward to ensure that ESG plays a central part throughout the lifecycle of a fund.”

As investors become more fixated on responsible investing and ESG, GPs must respond. The due diligence stage is where GPs must pick up the mantle. “LPs are asking more of their GPs regarding ESG both in due diligence and also annual reporting metrics,” points out Ms Houghton. “GPs not only need to have a responsible investing document but to demonstrate that they are implementing ESG initiatives across their portfolios. Many firms are producing annual ESG reports on their portfolio companies that highlights important KPIs, ESG activities undertaken in the year and targets for the following year.”

However, doubts still linger over ESG’s ability to drive returns. According to research from Schroders, 44 percent of investors surveyed believe that refocusing their portfolios on sustainable investing could hurt returns going forward. One of the ways in which firms can increase investor awareness and acceptance of ESG is by ensuring that they have access to good quality data.

Increasingly, GPs are being subjected to numerous due diligence requests from their investors during the fundraising process, and initiatives such as the Principles for Responsible Investment’s standardised LPs’ ESG due diligence questionnaire are becoming more common. In the coming years, template questionnaires will likely become less boilerplate and more bespoke, with ESG concerns increasingly prominent.

ESG due diligence may now be considered compulsory. In the pre-investment phase, it would be practically unthinkable for a deal team to neglect ESG due diligence. In tandem with risk assessments to mitigate post-investment risk, ESG due diligence has a key role to play.

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BY

Richard Summerfield