In this Insight, guest contributors Barry Lawson and Charlotte Lawson of The Private Equity Consultancy explain why good due diligence is only one part of an ESG programme that PE fund managers need to develop, and provide a route map that will embed ESG considerations into a fund manager’s DNA
It is now common for investor due diligence questionnaires to ask about a fund manager’s approach to environmental, social and governance (ESG) investment. Fund managers need to use this as an opportunity to demonstrate their responsible business credentials and real commitment to ESG outcomes and distinguish themselves from the ‘Greenwashers’.
Investors themselves are asking these questions because they appreciate that their investment power can be used to drive changes in a fund manager or in a sector. This is motivated by a desire to see social outcomes to their investment as well as financial ones (for example, increased employment, greater diversity or because they seeking ‘Impact Investments’), but also because they too are being pressured to be ‘responsible stewards’, by legislation, international standards and by their members and the wider society in which they operate. A report by RBC Global Asset Management in 2018 noted that more than half of institutional investors said they consider ESG issues to be part of their fiduciary duty.
What is meant by ESG?
ESG is an acronym covering a range of issues, some of which could fit into more than one category:
- Environmental: refers to the environmental impacts of an entity and importantly whether and how it can respond to climate change/drive sustainability within itself and in its supply chain. Is electrical power drawn from renewable sources? Are raw materials sustainably sourced and effectively recycled?
- Social: the ‘s’ deals with softer issues such as employee engagement and welfare, equality and diversity policies, talent attraction and building a ‘responsible brand’. Social also deals with how an entity and its staff engage with their local community;
- Governance: looks at the policies and processes that govern the way a business is managed and how they could be improved: for example, through introducing non-executive director talent, proper board packs or independent audit or remuneration committees.
What does an ESG management system look like?
To be effective, ESG issues need to be approached as an integrated system. Such a system is likely to be made up of at least the following four core elements:
Fund managers need to have developed clear thinking about their own policies, procedures and goals if they are to successfully manage ESG issues in portfolio companies. This internal strategy will include:
- Policy: a clear and unambiguous policy outlining their approach and ESG goals internally (increase recycling? reduce air travel? introduce double sided printing? serve ‘FairTrade’ coffee?) and as part of the investment process. Is it, for example a corporate goal to become carbon neutral or to reduce carbon pollution by 20% in accordance with the 2016 Paris Accord?
- ESG Officer: a partner/director-level appointee will need to lead on implementing the policy and dealing with day-to-day issues or escalating significant If a firm can have a CFO, why not an ESG Officer? Senior appointment is a clear signal of commitment.
- Annual Report: the board or partners group of a fund manager need to be kept informed of progress and problems. An annual report on the impact and effectiveness of ESG policy, both internally and on portfolio companies, focuses attention on the issue. FCA-authorised firms produce an annual MLRO’s report.
- Staff engagement: processes such as training, ESG working groups and ‘catch up’ emails can help to ensure that:
- policy and practices are clearly understood and incorporated into the investment process; and
- there is an informed approach to internal issues such as printing, food wastage and travel.
- Measure, reduce, remediate: establishing key performance indicators (KPIs) can help to measure a manager’s own impact upon the environment through, for example, paper usage, air miles travelled, or electricity consumed. Once answers to those basic questions are known, then progress towards reducing and offsetting can be made.
- Social engagement: how does the fund manager engage with the local community/wider society? Are staff encouraged to undertake charitable activities perhaps, with sponsorship or dress down Fridays?
The greatest ESG impacts will be through portfolio companies and there is a growing expectation that a fund manager’s investment power will be used to drive up ESG standards. The actions that a fund manager could take in relation to portfolio companies include the following:
- Due diligence: fund managers will need to develop a risk-based approach to due diligence, perhaps around a standardised set of core questions to properly identify risk areas and value-drivers. A consistent approach will allow a legal team to identify appropriate warranties and indemnities and for the deal team to formulate the most appropriate financial offer.
- Action plans: problems and risks identified in due diligence should be addressed in an action plan which has been agreed with the portfolio company before investment and ideally incorporated into the legal documents.
- Supply chain liabilities and exposures: it cannot be assumed that ESG issues within a portfolio company's supply chain will not have an impact upon that company and upon the value of an investment. The UK’s Modern Slavery Act, for example, places a positive duty on firms to ‘know their supply chain’. In other areas, the problems experienced by Findus when horsemeat was found in lasagna show the financial cost of supply chain failures. As part of the due diligence process a fund manager needs to thoroughly understand the portfolio company's supply chain.
- Common standards: there should be a common list of ESG policies that are to be adopted across portfolio companies. These could include anti-corruption, whistleblower policies, supplier chain and supplier protection policies such as prompt payment of creditors. Such a consistent approach will help leave behind a legacy of improvement in processes and procedures and will help protect the value of the investment.
- Reporting: A typical investment agreement will grant a fund manager detailed information rights. These rights should be drafted to include data on ESG KPIs identified during due diligence. Investors are increasingly expecting to see reporting on ESG matters in quarterly reports. These will be easier to deliver if the management of a portfolio company clearly understands what is needed and has the opportunity to put in place appropriate systems to create/gather/process the information.
- Progression matrix: a matrix showing how the ESG performance of investments has improved over time creates an important ‘track record’ and provides data to help fund managers demonstrate ‘added value’.
Fund managers should carefully consider how ESG reporting fits into their existing investor management processes. ESG commentary on portfolio companies or on notable achievements at / by the fund manager could be built into quarterly reports. Potential issues raised at investors committees would demonstrate an open approach to investors and examples of good practices, and awards or improvements could be showcased at annual general meetings. Managers will also want to be able to demonstrate proactive approaches to publications such as the recent ILPA proposals for diversity and inclusiveness reporting (see our October 2018 Fund Insight for more detail.)
A long-term goal is to further build trust and engagement with investors, to get them to share experiences and to turn them into ambassadors. Such early engagement will, hopefully, enable the investors to provide a more balanced and informed reaction to any problems that do arise.
The reputation of the private equity industry has suffered greatly in the recent past. Fund managers should consider how their websites and social media presence can develop and publicise their ESG credentials.
Important ESG policies, for example, should be added to websites so that investors, portfolio companies and interested third parties can easily understand their commitment to good ESG standards and how they can raise concerns via complaints or whistleblower procedures. Websites and social media can be used to publicize compliance with international standards such as UNPRI, the ISO family of quality marks or the ‘FairTrade’ or the ‘Ethical Trading’ initiatives.
Barry Lawson and Charlotte Lawson