ESG: Policy pitfalls

The progressive viewpoint on environmental, social and governance (ESG) protocols is now mainstream – organizing an indispensable subset of operational risk management concerns allows for value accretion and even innovation. The fact remains, however, that introducing an ESG policy means adding another layer of administration and due diligence that entails new potential for miscalculation. 

Furthermore, this equation of operational future-proofing and practical application risk extends across the private equity stakeholder chain. ESG is increasingly recognized as a critical aspect of every area of the industry, from fundraising to portfolio management. 

The ubiquity requires an approach from multiple angles with an understanding that ESG will be interpreted as either a bureaucratic drag or a value driver depending on both individual personalities and more quantitative variables around implementation. Decision making along these lines will need to be an ongoing process in order to adjust to evolving market conditions. 

“With so many factors impacting business today outside a CEO’s control – from growing populism and nationalism to social media to stakeholder activism – ESG must be seen from both a risk and opportunity perspective, including how these factors can impact a company’s operations and reputation,” says Steve Okun, CEO at APAC Advisors. “What constitutes a material ESG factor changes all the time. The only way to address these factors is by having a top-down and bottom-up approach simultaneously.” 

GP-LP

Impact investment represents a good example of how poor ESG implementation can be damaging. It is typically seen as a low cost of capital strategy, but if the reporting burden is too heavy, the economic rationale for an investment may no longer stack up. From this perspective, ESG risk is more pertinent at the GP-LP level than at the company level. 

“I don’t think that LPs are generally concerned that GP returns are going to be dragged down by an ESG agenda, but there are parallel issues that need to be watched,” says Niklas Amundsson, a partner at placement agent Monument Group. “For example, there are GPs and funds that may have suboptimal returns, and their way of securing financing for their products is to profile themselves as ESG investors. Playing to that ESG bucket of capital that needs to be deployed when you have a track record of lower returns – I think that’s something that happens.”

The greatest point of consideration for LPs, however, is ensuring that GPs’ professed ESG polices are being implemented in the most effective way possible. This involves verifying that proper processes are in place and that the fund manager has the capacity to execute. Also, steps must be taken to confirm GPs are instilling an ESG mindset in portfolio companies. 

Managers, by contrast, are more obliged to consider factors with a tighter focus, including personal bias. This is because the private equity industry’s lingering ESG skeptics are most likely to take the form of highly individual fund manager counterparties such as family offices and high net worth individuals. 

Founders fall under this category as well, so GPs will need to exercise sensitivity when deciding what ESG-related changes are reasonable to impose on portfolio companies. Important considerations include the fact that mitigation of long-term operational risks requires gradual cultural changes that are initiated early in a company’s growth story. Too much meddling at an early stage, however, can be problematic.  

“From an investors’ standpoint, you can’t just come in and say, ‘Here’s the ESG manual. We need a report every week as a condition of our investment,’” says Leonard Cohen, a partner at Lakeshore Capital responsible for ESG. “GPs have to balance that so they’re not slowing companies down and creating problems from the outside. At Lakeshore, we try to gradually get what we need without distracting companies from their core business. The reporting requirements are just once a quarter.”

Cohen adds that although younger companies have the ability to make ESG part of their DNA from the beginning, they must not lose track of far more important survival drivers. Businesses in their early stages benefit from a greater general flexibility, but ranking the most immediately critical spot fires and growth opportunities with limited resources remains a key challenge. 

“When you’re in the early days in that acceleration moment, the importance of prioritization is higher,” says Ben McCarron, a managing director at Asia Research & Engagement. “You have to decide what will be on the long-term health check that you don’t need to invest right now. Prioritization matters for large companies as well, but the ability of a small business to cope with a mistake in prioritization is lower, so it matters a bit more at that end.”

Strong foundations

Industry participants agree that while a comprehensive and operationally active ESG policy is usually an unnecessary burden for young companies, the essential themes should be integrated into growth strategy at a conceptual level. This is because legacy systems developed via a flawed initial trajectory become expensive to retrofit in an established corporate machine. 

The clutch decision point in both the cultural integration and prioritization processes is defining what constitutes a material or immaterial business development factor at any given stage of a company’s growth. The crossover of various industry-specific and personality denominators in such an equation can make ESG planning more art than science. However, the logic behind even instinctually forged polices must be articulated between all stakeholders in order to head off the dangers of mishandling best intentions.   

“The question is how does the reporting help mitigate operational risks such that the portfolio company is able to grow its business and the GP goes back to the LP with a better return,” says James Pearson, CEO at Pacific Risk Advisors. “If that doesn’t get communicated and understood down the chain between LPs and GPs and portfolio companies, that’s when you get pushback because people don’t see the value of what they’re doing.”   

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• Topics
• GPs
• Advisory
• Fundraising
• Asia
• ESG