The continuing evolution of ESG diligence for private equity funds

August 2024 | SPOTLIGHT | PRIVATE EQUITY

Financier Worldwide Magazine

August 2024 Issue

It was only a decade or so ago that environmental, social and governance (ESG) was a term bandied about in the industry that few fully understood. It was something businesses were aware needed to be increasingly on their agendas to keep up with societal expectations and the ‘hype’ but they did not necessarily know how to implement a strategy that best encompassed the relevant considerations. Gone are the days when adding a few solar panels to the roof was enough to tick ESG credentials off for the year.

What is becoming increasingly clear is that ESG is no longer being treated as an unknown quantity or a concept that ‘sounds good’, but a fundamental consideration for limited partners (LPs) and general partners alike. When done well, it can be a driver of future value creation within a portfolio and a huge attraction to private equity (PE) bidders (some of which will pay a premium when good practice is demonstrated).

When done badly, this creates opportunity for PE owners to instantly add value to a portfolio by including robust ESG targets in their 100-day plans, contributing to capability for maximising future returns.

Good ESG initiatives could be cost saving in nature. For example, reducing paper usage, using renewables to reduce energy costs and improving compliance to reduce the risk of fines from governmental bodies. Alternatively, such initiatives could be revenue generating. For example, developing and selling ‘green’ products to customers who have their own ESG goals and brand enhancement resulting from such initiatives.

Those who are not giving ESG enough resource will get left behind, and they are realising this. It is not uncommon for PE funds to ask for ‘standard ESG due diligence questionnaires’ to implement on their latest platform deal. However, the answer is not as straightforward as simply sending a pre-prepared questionnaire that could be reported on as part of the usual legal diligence exercise, as the scope of ESG goes well beyond legal considerations.

The ESG diligence expectations on platform deals and differing approaches of PE clients can blur the expectations on legal advisers and begs the question as to whether the responsibility for additional ESG diligence lies with law firms, with the funds or with a third-party provider or, perhaps, a combination of all three.

As imperfect as the conclusion may be, ESG diligence is a combined effort, albeit this is something which is still evolving. Eventually it is expected that this will lead to a ‘market leading’ approach which develops over the next few years. A number of the current prevailing methods are outlined below.

Workstream-based approach, with no specific ESG reporting

The least sophisticated method is simply including questions which touch on the typical limbs of ESG within existing due diligence workstreams – for example, legal due diligence reporting on compliance with regulatory requirements, bribery and corruption, internal policies, environmental due diligence reporting on air pollution and waste, and technical due diligence reporting on cyber security. This method has no separate reporting for ESG purposes and just relies on what has been covered in due diligence reports in respect of current practices of the target group to satisfy that ESG has been considered.

A law firm’s role would, vis-à-vis the legal due diligence scope and questionnaire, remain largely the same (save for the usual updates to reflect changes in the law), which is to cover topics including health and safety, anti-bribery and corruption, regulatory and environmental considerations, the extent of which is typically sector driven.

Although there may be scope for adding additional questions around how often they train on, report on and reflect on their ESG policies and goals in board meetings, PE funds need to do more to satisfy their own criteria – criteria which is more commonly being set out in the provisions of investment documents themselves as part of the positive covenants given to the investor by the management team.

However, this approach misses a trick as it does not delve into opportunities for value creation which a fund could capitalise on during its ownership and probably does not give the LPs the standalone reporting they increasingly desire, while potentially having a knock-on effect for future fund building.

Workstream-based approach, with specific internal ESG reporting

Often well-established PE funds have an in-house ESG team to undertake ESG reporting for their LPs. This is typically coupled with the workstream-based approach. The ‘E’, the ‘S’ and the ‘G’ are dealt with within existing due diligence workstreams on a fragmented basis, then pulled together internally by the PE fund, so that they can prepare whatever report the LPs need. This benefit of this is that they can tailor the format of reporting of the ESG findings exactly to the expectations of their LPs and fund strategy and value expectations accordingly.

In some instances, the element of the diligence which goes to looking at opportunity and value creation rather than known risks is undertaken internally by the PE fund, if their capabilities allow it.

There are several bodies that provide guidance or template due diligence questionnaires to help determine the scope and best practice for PE funds undertaking this exercise internally and reporting to their LPs – Invest Europe and UN PRI, to name only a couple.

In this instance lawyers would, again, continue to operate in the same way as they do in the workstream-based approach, albeit there may be more of a focus by the PE fund on building a 100-day plan with ESG high on the agenda. This will create opportunities for lawyers to get involved with advising on post-completion ESG workstreams resulting from the fund. The granularity of the questions being asked in legal due diligence may also evolve, as funds are beginning to see the requirements of LPs evolve in a similar manner.

Standalone ESG due diligence

Some PE funds will, as a matter of course, engage an external adviser to undertake specific ESG due diligence on every transaction, or adopt this on a case by case basis, having assessed the sector the target is operating in. For example, a software company will typically have less risk from an ESG perspective than an industrial, manufacturing or drug-discovery business. In those instances, this is largely driven by what the investment committee of the fund perceives to be required for the specific deal from a risk management perspective. The cost of this will depend on the size of the business being acquired, its location and sector.

This approach has the same benefits as the workstream-based approach with internal reporting and will inevitably result in duplication of work by the ESG due diligence provider and other due diligence providers who may be required to review the same documentation with slightly different hats on.

It does, however, carry the benefit of cutting down resources and costs needed internally to report on ESG . Third-party providers are likely to provide additional value in terms of expertise from seeing market trends in reporting and experience from doing multiple exercises for different clients, across sectors every year. ESG due diligence providers are becoming more commonplace on deals than they have been historically and lawyers will be expected to work hand in hand with them, just as they do with other deal advisers.

Conclusion

While law firms becoming the next full service ESG diligence provider is highly unlikely, the granularity of legal questions adapting and broadening is anticipated, potentially on a fund-specific basis driven by LP requirements and evolving industry standards.

Firms may see greater opportunities to get involved in ESG focused post-completion workstreams to remedy and improve practices of portfolios going forward, particularly as PE funds increase their focus on achieving growth from tightening up the ESG practices of acquired portfolios soon after completion and having a joined-up approach with other due diligence providers.

Holly Hirst is a partner at Shoosmiths LLP. She can be contacted on +44 (0)20 7282 4035 or by email: holly.hirst@shoosmiths.com.

Holly Hirst

Shoosmiths LLP