ESG & secondaries: Finer filters

LPs are recognized as a driving force in the integration of environmental, social, and governance (ESG) policies in private equity, especially in primary fund commitments and direct asset-level investments where they have the most sway. Secondary investments, by comparison, have so far appeared a less natural fit for this kind of diligence and value-add work. That’s changing.

ESG has always been an area of concern for secondary buyers but as more of them sign up to the UN’s Principles for Responsible Investment (PRI) and more stock exchanges adopt higher standards of compliance, it is becoming an increasingly indispensable aspect of portfolio analysis. LPs with significant secondaries agendas are responding by building out more in-house capabilities in ESG and formalizing ESG strategies for these types of investments.

However, the greatest driver for uptake within the secondaries market has been the blurring of the line between secondary and primary transactions in complex deals such as fund restructurings and single-asset portfolio carve-outs. These transactions lend themselves to ESG not only by virtue of their primary components but because they usually occur later in the investment horizon, which by default requires parties to reset the economics and reassess risk. 

They are also increasingly prevalent. According to Lazard, sponsor secondaries as a portion of the total secondaries market have increased from 19% to 34% between 2016 and 2019. Absolute volumes have fallen dramatically this year due to COVID-19, but the relative traction of non-traditional secondaries has persisted, with Setter Capital estimating direct deals went from 37% of the overall market in the first half of 2019 to 38.7% in the first half of 2020.

“Primary investors are much better placed to do a better job working on ESG, and as secondaries investors we believe we will ultimately see better investments in the secondaries market as a result,” says Adam Black, head of ESG and sustainability at Coller Capital.

“The more people there are asking about these issues, helping underlying GPs think about them and helping companies tackle them, the better run the investee companies will be and so the better secondary opportunities we’ll see. Secondaries firms need to adopt a hybrid LP-GP approach, not too hands-on, not too hands-off, and naturally risk-adjusted according to where they can influence most.”

Know your managers

Coller was an early-mover in the adoption of ESG practices in secondaries, having formally established its policy in 2011 and joined PRI in 2014. Black, who has 28 years’ experience in primarily asset-level sustainability consulting, joined in 2016. Sitting on the investment team rather than the investor relations team, he reviews deals with an ESG lens in the early stages and leveraging external resources including the RepRisk platform as well as an in-house database of GP behavior and policy moves built up since 1990.

Visibility on GPs is the key to this strategy. LPs taking secondary positions in existing portfolios must rely on the ESG credibility of the managers, which means knowing what makes them tick. Coller achieves this through an annual survey, which primarily informs an ESG report and guidance notes for the industry at large, but also provides Coller a window into GPs’ various cultures in terms of counterparty responsiveness. Most importantly, this reveals when a sound ESG policy on paper does not translate into openness about discussing issues.

GP-level ESG diligence in this vein is most critical in traditional secondary transactions, where fund positions can encompass hundreds of underlying companies and LP influence will be limited, especially post-deal. The only effective approach here is to take a helicopter view of portfolio risk, usually through a broad screening process including keyword searches for red flag areas. This is not an utterly new secondaries protocol, but heretofore it has rarely been pursued with ESG professionals taking the lead and using specialized ESG tools. 

It is difficult to take diligence any further than this with traditional portfolio positions, especially if the secondary investor is dealing with high levels of deal flow. If investment committee meetings are convened every week, hard decisions will have to be made about where to allocate ESG resources, and fund commitments may have to be deprioritized. This is simply because ESG efforts will be less likely to have a meaningful impact in these kinds of deals than they would in a more direct secondary scenario. 

More ESG resources can be applied to traditional secondaries if they are delivered efficiently. That means knowing what to look for and nailing down internal ESG policies before asking a GP about its approach. Once the respective processes of the LP and GP have been delineated, relevant data points will begin to emerge in process areas such as implementation consistency, the rigor with which planned post-transaction work is carried out, and how heavily various ESG factors are weighed relative to each other.

Jason Sambanju, who has covered Asia secondaries at Paul Capital and Deutsche Bank, says that when he struck out on his own with Foundation Private Equity in 2017, the new firm’s underlying investors had significant ESG sensitivities. As a result, a policy was built into the investment process from day one. 

“You can’t come into this thinking you have the gold standard in ESG policy, and every GP needs to abide by that. In some cases, they might have a higher standard than you do,” Sambanju says. “You need to understand where your perspective and their perspective might be different, and then you can have a discussion about where the gaps might be and how they can be reconciled during the time of the transaction you’re looking at. Sometimes you’re able to close those gaps, and sometimes you’re not because, ultimately, you must answer to your investors.”

Levels of influence

The core difference between ESG in secondary versus primary transactions is the dual nature of the diligence, which is required at both the manager and asset levels. The catch is that mobilizing technical experts and independent consultants to assess GPs and companies for primary investments is routine, whereas in secondaries, there is much more reliance on the GP. The rise of portfolio management devices such as GP-led and stapled secondaries – which combine primary and secondary commitments – has done much to reverse this status quo. 

These types of transactions increase secondary investors’ influence over GPs and offer more immediate exposure to underlying assets. More granular questions about policy, implementation, and operational specifics can be asked. Deals can be crafted through more primary-style negotiations, with individual companies of concern potentially excluded from a basket of assets. Collaborative post-deal engagement is more feasible in terms of site visits, workshops, and networking support.

Post-deal, the problem is control in terms of ESG influence, especially in Asia where secondary investors are mostly working with minority stakes. Secondary buyers are often acquiring investments that predate widespread ESG awareness in private equity, meaning that LP rights around the relevant reporting and action plans are not in place. This can be difficult to rectify because exposure gained through secondaries often comes without a board seat or other contractual means for imposing an ESG agenda.

“You don’t want to get into a situation where there could be meaningful ESG issues and you don’t have influence on the board or meaningful contractual rights,” says Darren Massara, a managing partner at NewQuest Capital Partners. “Occasionally, ESG issues present themselves post-acquisition, and if you don’t have direct influence, your only recourse is to make a compelling case to the company’s stakeholders. In such a situation, it may fall upon secondary investors like us to lay out the risks and issues in a way that will resonate with them.”

NewQuest operates exclusively in direct and complex secondaries, with a significant ESG overlay that includes sending annual questionnaires to GPs and portfolio companies and using an International Finance Corporation-developed framework for categorizing the severity of ESG risks in the deal pipeline. The firm became a PRI signatory in 2011 and formalized its ESG policy the following year. Massara, who was the Asian representative on PRI’s global steering committee on private equity for three years, adds that secondary investors seeking company-level access can also experience headwinds in pre-deal talks.

“Even if you are buying a meaningful secondary stake, you may not be able to perform the ESG due diligence you require,” he says. “Unlike a primary investment, where new money is invested into a company to fuel growth, a secondary transaction effectively just replaces one financial investor with another. In certain instances, company management or founders may not be supportive of due diligence that goes beyond standard legal and commercial items. If ESG is a critical factor for you, and you don’t feel you are getting the access you need, you will likely have to decline the transaction.”

Changing priorities

As is the case across asset classes, secondaries investors note that ESG priorities are shifting with the digital age, effectively meaning that despite growing awareness of climate change, social concerns such as data privacy are gaining ground on environmental concerns. In the COVID-19 era, employee safety has come to the fore, as have social themes around work-from-home arrangements. Cybersecurity and demographics-linked healthcare issues such as standards for elderly care homes are also emerging themes.

Developments on this front that are most uniquely interesting to secondary investors, however, may have less to do with the E and S and more to do with the G. Governance issues around alignment between GP, LP and portfolio company founders are a familiar hurdle in secondary transactions but the challenge is intensifying. This has been driven by the rise in single-asset transactions and complex deal structures as well as a growing presence of high-growth tech companies prone to shaking up traditional expectations about exit timelines. 

“You need to think about all the same ESG issues in a secondary as you would in a primary but with an extra layer of consideration around governance of the fund and alignment of interest,” says Jie Gong, a partner at Pantheon. “Is the GP aligned with the LP? Is the GP internally aligned with its own team to maximize resources? More attention will also need to be paid to incentive alignment as GP-led restructurings become a bigger part of the market. Negotiating and evaluating governance by re-incentivizing GPs is the crux of those types of deals.”

These issues might be exaggerated in Asian private equity if the views of regional LPs are to some extent informed by the realities of their home markets. Coller’s latest survey for example found that only 48% of Asia Pacific LPs were happy with the allocation of LP advisory committee seats versus 58% for North American LPs and 72% for European LPs. Meanwhile, 77% of LPs in the region said GPs were not taking climate change seriously enough, compared to 47% and 65% for North American and European LPs, respectively.

“The reality is that you find more companies in Asian private equity portfolios that have historically been recognized as having a higher degree of ESG risk,” says one Asia-based secondary investor. “Whether its garment manufacturing or heavy manufacturing, these are the types of industries that you do find in Asia private equity portfolios but you probably won’t find in Western private equity portfolios.”

There is reason to believe that these discrepancies are fading as the PRI movement continues to bleed into Asia and frontier markets attract more development finance institutions and impact investors as LPs in regional funds. As these trends unfold, secondary investors with few ESG resources and limited access to target assets may be forced into positions where they can only execute cursory diligence and remediation efforts. At worst, this will lead to sub-optimal outcomes, both financially and in ESG terms. At best, it will beget accusations of greenwashing.

“As an ESG practitioner, you can spend your time just looking at energy efficiency, for example, which the investment professionals will love because you’re finding direct cost-saving benefits to the bottom line and linking it back to carbon. We’ve all seen that and there’s nothing wrong with that, but you’ll be missing a trick if you don’t also focus on issues like sustainable production or human rights abuses in the supply chain,” says Coller’s Black. “The more challenging issues like climate change, ecological impact, and pandemics are no longer just long-term – they’re getting much closer to home.” 

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• Topics
• Secondaries
• Secondaries
• ESG
• Coller Capital
• NewQuest Capital Partners
• Pantheon
• Foundation Private Equity