ESG due diligence in private equity: legal developments and emerging best practices

April 2022  |  SPOTLIGHT | PRIVATE EQUITY

Financier Worldwide Magazine

April 2022 Issue

An increasing number of private equity (PE) general partners (GPs) are incorporating sustainable development, and environmental, social and governance (ESG) factors into their investment strategies. This follows a broader trend of increased capital flows to ESG funds across all asset classes. ESG assets under management (AUM) are expected to reach $53 trillion by 2025, up from $30 trillion in 2018. PE limited partners (LPs) increasingly seek sustainable investment opportunities, and consumers demand that businesses offer products and promote practices that align with their values. As ESG becomes more mainstream, PE firms acknowledge that a successful ESG strategy requires sophisticated due diligence and reporting.

Failure to perform proper due diligence carries three primary risks: (i) reputational harm from the failure to meet the expectations of LPs; (ii) legal and regulatory non-compliance with ESG-related rules; and (iii) financial risk of lost profits caused by reputational and legal risks. Because an ESG-oriented fund’s performance depends on sound diligence practices, it is critical to understand the emerging ESG due diligence best practices, and the legislative and regulatory framework informing and reinforcing these developments.

Legislative developments

Governments are responding to the calls by consumers and investors for increased ESG regulation. In Europe, the European Commission recently introduced a proposed directive that requires companies with significant operations in the European Union (EU) to conduct environmental and human rights due diligence regarding their business practices. The proposed directive, which applies to both EU and non-EU multinational businesses, also requires companies to address ESG risks, and measure and report performance on the risk-mitigating strategies that are implemented.

The proposed directive is part of a broader effort to harmonise the European ESG due diligence legislative framework. For instance, both Germany and France have already implemented measures to require ESG due diligence in companies’ operations and value chains. Against the backdrop of the newly proposed directive are the Sustainable Finance Disclosure Regulation (SFDR) and the EU Taxonomy Regulation, which came into effect last year. The SFDR and the Taxonomy Regulation aim to help investors compare and analyse sustainable investments and the sustainable impacts and objectives of companies.

In the US, the Securities and Exchange Commission (SEC) has recently begun considering ESG rules that would apply to investment funds, including PE firms. Gary Gensler, chairman of the SEC, recently expressed concerns about the rise of ‘impact washing’ or ‘greenwashing’ – the practice of making unsubstantiated or inflated claims about a firm’s environmental or social impact. Although these legislative developments could mean added risk and uncertainty, they could also present an opportunity for innovative GPs to add value by increasing ESG compliance among target and portfolio companies.

Developing an ESG framework

Before diving into the due diligence process, an emerging best practice is to first implement an ESG framework, which begins with determining and defining an ESG focus. In 2015, the UN General Assembly adopted 17 Sustainable Development Goals (SDGs) as a framework for addressing some of the world’s most entrenched problems. The SDGs include ambitious goals such as ‘no poverty’, ‘clean water and sanitation’ and ‘decent work and economic growth’. Rather than specific performance metrics, the SDGs serve as aspirational guidelines for establishing an ESG area of focus. Using the SDGs, GPs can work with internal management and external consultants to conduct ESG materiality assessments to determine which specific ESG issues are most material to the PE’s industry focus and stakeholders.

After conducting the ESG materiality assessment, GPs should consider adopting an ESG framework to manage ESG investment decisions, particularly during the due diligence process. The Principles for Responsible Investment (UNPRI) is a UN-supported framework for implementing ESG investment best practices. The American Investment Council (AIC), formerly the Private Equity Growth Capital Council, coordinated with UNPRI to develop Guidelines for Responsible Investment. An emerging best practice involves combining the AIC and UNPRI guidelines to form the basis of GPs’ overall ESG framework.

For LPs, the UNPRI developed the ESG Assessment Framework to enable LPs to assess GPs’ performance on a variety of ESG metrics. Under the Assessment Framework, LPs can assess GPs’ ESG policies as either basic, intermediate or advanced. At the basic level, ESG diligence is typically outsourced to a third party, and is primarily focused on screening for ESG risks, with only intermittent and ad-hoc involvement of the investment committee. Intermediate strategies include GP-led ESG diligence processes, supported by external experts. Material risks are identified, and the investment committee actively incorporates consideration of such risks in investment decision making. At the advanced level, ESG diligence includes a process for assessing ESG-related value creation opportunities, informed by a materiality assessment. This framework follows an integrated approach, requiring substantial coordination and feedback among investment, legal and human resources teams.

Diving deeper into ESG due diligence

The four stages in the lifecycle of a PE fund are: (i) fundraising, during which the firm seeks to raise capital from investors; (ii) investment or sourcing, during which the firm locates and performs due diligence on target companies; (iii) holding or portfolio, during which the PE firm manages the portfolio companies by working with the companies’ leadership to create value; and (iv) divestment or exit, during which the PE firm typically seeks to sell the target, ideally generating a return on initial investment.

In the M&A context, deal sourcing is the process by which a PE fund screens out less attractive deals and find deals that will, hopefully, provide a healthy return on investment. Given the vast number of potential investment opportunities in today’s hot deal market, it is imperative that PE firms develop a sophisticated, robust filtering process. This is no less true in the ESG context. Capital allocators must determine whether a particular prospective investment is likely to be worthwhile or turn out to be a bad deal. To the extent that ESG issues can affect deal value, ESG diligence should be incorporated at the deal sourcing stage.

The ESG due diligence process begins with an initial screening to determine whether the potential target company generally aligns with the PE firm’s ESG framework and policies. This traditionally entailed taking a risk-focus approach to determining the level of ESG risk associated with the target company and screen for such risks. An emerging best practice is to consider a hybrid risk-opportunity approach or a holistic integrated approach to determine both ESG risks and opportunities and evaluate such risks and opportunities for alignment with the PE firm’s broader portfolio holdings.

With either approach, deal teams would start by assigning a rating of low, medium or high (or green, yellow or red) in each relevant ESG category, with the primary goal of reducing or eliminating reputational and topline risk. Under a risk-focused approach, deal teams would reject the investment if the assessed risk were very high. Under a risk-opportunity or integrated approach, the deal team might only eliminate the riskiest of poor-performing ESG investments, and for all other poor-rated ESG investments, formulate a comprehensive plan to address those risks during the holding stage. Resource-conscious firms should be aware that higher risks entail higher costs to address such risks down the line.

ESG risk can be assessed by using an ESG questionnaire that asks detailed questions in key ESG areas. During its topline review, deal teams should assess the target company’s ESG policy, if any. An emerging best practice includes working with the target company to craft an ESG policy that avoids inflated claims, provides a framework for assessing and managing risks, and involves a process for oversight and accountability. Significant contribution from legal advisers is key as deal teams get deeper into the due diligence process. Material contracts and policies of the target company should be reviewed for ESG legal risks, such as potential violations under data privacy laws, environmental laws or forced labour laws, such as the recently passed Uyghur Forced Labor Prevention Act.

Rather than being rigid and inflexible, deal teams should customise the ESG questionnaire for each target company on a deal-by-deal basis, considering the industry, maturity and general business practices of the company. For instance, for a target company in the construction industry, labour and working conditions are likely to be greater sources of ESG risk, and therefore opportunity to add value, than data privacy issues. An emerging best practice for PE firms without dedicated ESG staff is to leverage the expertise of industry experts to help assess the relative risk of ESG factors, particularly for target companies that operate across industries and sectors.

During the post-investment phase, measurement and reporting are critical. An emerging best practice is to perform a detailed five-day review of the ESG materiality risks identified during the due diligence phase. Here, an external adviser would review the diligence documentation, affirm or challenge the assigned risk rating, and help formulate a strategy for assessing the risks and crafting a tailored process for measuring improvement. Another emerging best practice is to leverage ESG-focused technology to measure ESG performance of portfolio companies using ESG-related key performance indicators (KPIs). For instance, a target company that makes cooling technology for refrigerators that aims to increase energy efficiency could use KPIs, such as carbon dioxide mitigated over the holding period. Prior to exit, the PE firm could leverage questionnaires, interviews and site visits to develop an ESG report for potential exit buyers that highlights the portfolio company’s performance.

Conclusion

ESG considerations are only going to increase in importance. Enterprising PE firms can create ESG opportunity and reduce risks by leveraging emerging frameworks, industry experts and trusted advisers, and technology to adopt sophisticated due diligence and reporting strategies that inform investment decisions and demonstrate value to the marketplace.

Kareim S. Oliphant and Kathryn White are associates at Baker Donelson. Mr Oliphant can be contacted on +1 (615) 726 5628 or by email: koliphant@bakerdonelson.com. Ms White can be contacted on +1 (615) 726 7344 or by email: kwhite@bakerdonelson.com.

© Financier Worldwide

BY

Kareim S. Oliphant and Kathryn White

Baker Donelson