PE and ESG: More than a box check

Thomas Kristensen has just spent an hour on the phone with the sustainability officer of a Nordic pension plan discussing environmental, social and governance (ESG) issues. The purpose was to break down into its constituent parts the process by which LGT Capital Partners assesses the credentials of GPs entering its fund-of-funds program. It was a consuming and detail-oriented exchange.

As LGT's ESG officer for private markets, it is Kristensen's job to have these conversations, but rewind just a few years and there probably wasn't a dedicated sustainability officer at most pension plans to talk to at all. The conversation is symptomatic of a tougher approach now filtering down the chain from LPs to GPs. While LGT's backing of a fund or co-investment opportunity hinges on whether the GP can deliver the required returns, how ESG might alter the risk-return profile is increasingly important.

"Four years ago it was ‘Are you doing anything?' and we would explain what we were doing and that would be fine," says Kristensen. "We still have some clients that either are not interested or just want to get comfortable that there's something we do. But the number taking it seriously and asking more detailed questions is increasing substantially. It is no longer a box-ticking exercise."

We have been getting more interested in the understanding of ESG issues at the portfolio level, including visits to portfolio companies with managers to discuss specific ESG topics. We plan to do this more in the future - Marta Jankovic

As such, GPs can no longer get away with box-ticking themselves. For many, ESG has traditionally been a factor in pre-deal due diligence: before completing an investment, they want to know if there are potential liabilities - a company might be dumping hazardous waste, falling short on commitments made to employees, or paying off regulators to turn a blind eye - in order to minimize downside risk.

But ESG is also relevant to operational improvements made during the investment process, which can translate into higher exit value. LPs increasingly want to see how ESG is woven into strategic thinking, from sourcing through sale. GPs are under pressure not only to have a boilerplate policy but also to invest time and money in ensuring it is properly executed. And on top of that, they must demonstrate to LPs how activities are having a material impact.

Increased activism

"Managers must demonstrate a focus on ESG matters during the holding period of the asset," says Marta Jankovic, senior sustainability and governance specialist, APG Asset Management. "We have been getting more interested in the understanding of ESG issues at the portfolio level, including visits to portfolio companies with managers to discuss specific ESG topics. We plan to do this more in the future."

APG insists on side letters that go beyond typical ESG provisions. Fund commitments are only signed off at investment committee level once there is satisfaction with requirements pertaining to ESG. This stance is seen as typical of the European pension funds and development finance institutions that led the way on responsible investment in the LP community. For others, it has been a combination of internal initiative and external pressure.

A significant step came as private equity guidelines were developed under the UN-backed Principles for Responsible Investment (PRI) framework in 2008-2009. This was followed in 2013 by the ESG Disclosure Framework for Private Equity, devised by a broad base of LPs, GPs and industry associations. As a result, the last 2-3 years have seen a significant uptick in interest and engagement from institutional investors.

This shift is reflected in the results of a PwC survey of LPs published earlier this year. Of the institutional investors polled, 83% believe better management of ESG issues will either improve returns or reduce risk, while 71% said they would turn down a fund or co-investment opportunity on ESG grounds.

As to what is driving the increased focus on responsible investment, reputational risk and corporate values were both highlighted in the survey, but an overwhelming majority of respondents identified fiduciary duty as one of the top three drivers. Indeed, there are expectations that the fiduciary duty argument will be strengthened by pending legal action in the UK.

"We anticipate a landmark case in the UK around fiduciary duty," says Hannah Routh, Hong Kong-based director of sustainability and climate change with PwC. "Ten years ago, there was a belief that anything that distracted from financial returns - like ESG - would be a violation of fiduciary duty. But now there are legal opinions that it is within fiduciary duty to consider ESG because there is a link to value."

Starting points

The connection between ESG and value goes to the heart of a broader debate about how GPs approach investments. However, private equity firms are on different points of an evolutionary scale in this respect, based on geography, strategy, internal resources and longevity.

Adam Black joined Europe-based Doughty Hanson in 2008 as one of the first in-house hires to focus on ESG. The firm had become a PRI signatory the previous year, but it was recognized internally that this was still "playing around the edges," as Black puts it. "They saw the risks and opportunities at portfolio level, but this hadn't really been considered beyond pre-deal due diligence. They realized that during the holding period they were missing a trick and they wanted an in house expert embedded within the team to have a look."

He spent the first year understanding Doughty Hanson and its portfolio - studying how the business operated and interacted with the portfolio companies, what was already being done well on ESG and what wasn't, and coming up with programs to plug the gaps. An ESG policy was devised and training provided to deal team members so they were more attuned as to what to look out for and, with guidance from Black, integrate these considerations into the investment process.

On a portfolio basis, some of the initial focus was on luggage brand Tumi. The company outsourced most of its manufacturing to suppliers across Asia and Black ensured a formal process existed to address supply chain ESG issues. The benefits were not so much EBITDA gains due to factors such as more efficient resource consumption; rather it was a case of reputational risk and enhancing the Tumi brand.

"The argument is if we hadn't looked at child labor risk, worker safety and environmental sourcing in the supply chain, and in the build up to the IPO a scandal broke, what would have happened?" he says. "The offering would probably have been pulled. So therein lies your value." Tumi went public in 2012.

KKR's efforts on ESG also moved up a gear in 2008 with the creation of a green portfolio program (GPP) in conjunction with the Environmental Defense Fund (EDF). The idea was to look at operational improvement from an environmental perspective, introducing initiatives that would have an impact on companies' financial and environmental performance.

"We recognized that in making investments we would be smarter and more effective if we not only thought as shareholders but also engaged with other stakeholders who are affected by those investments," says Ken Mehlman, head of global public affairs at KKR. "We look at areas where better governance can de-risk a company and opportunities where we can provide double bottom-line benefit."

The in-house resources Doughty Hanson and KKR devote to ESG reflect their respective sizes. Black is the ESG specialist in an operating partner team that sits amongst Doughty Hanson's 23 partners overall. At KKR, ESG is covered by the global public affairs team and there are two full-time professionals dedicated to this area. Other individuals also play a role in addressing ESG issues, including designated people in each region within KKR Capstone. Both companies bring in external consultants as required.

Creador and NewQuest Capital Partners - to pick two Asia-based managers - didn't exist in 2008. And with less than $1.5 billion under management between them, they have processes and policies but not extensive ESG-dedicated resources.

Creador has one senior executive with overall responsibility for ESG and then investment professionals look at each company as part of their broader monitoring role. At secondaries specialist NewQuest, two executives - the managing partner and general counsel - oversee ESG activities, and there are plans to add a junior person to the team.

However, there is not necessarily a direct correlation between size and ESG competency. Melissa Brown, a partner at Daobridge Capital, a sustainability-focused investment and advisory firm in Asia, notes that the best work is often done by small teams or partners with skin in the game and ESG deeply imbedded in the way they invest. In some cases this approach is based in a view to risk aversion rather than satisfying LPs.

"I have seen small teams with what we would probably call an ESG process integrated into their strategy but they have to go through the process of realizing, ‘Oh, that is what the ESG people mean,'" she says. "Some firms end up reverse engineering ESG processes so they can have more formal discussions with LPs and with potential portfolio companies."

In this sense, the absence of a formal ESG policy is deal-breaker for some LPs - such as APG - but not for all. However, while allowances are made for firms that have not become attuned to the specific requirements of institutional investors, they must exhibit an appropriate level of governance.

"We are not looking for a perfect answer, but we want to see a willingness to commit an appropriate level of capacity for the nature of the fund we are talking about," adds Sam Lacey, ESG manager at CDC Group.

Due diligence typically falls into four phases. First, GPs are asked to complete questionnaires that focus on the nature of their ESG policy, how it is implemented and who is responsible for it internally. Second, the investment process is scrutinized to establish how ESG considerations are incorporated into due diligence and decision-making all the way up to the investment committee. The third and fourth phases concern how GPs work with portfolio companies on ESG and how they report back to LPs.

"We can have all the questionnaires we like but what really matters is the companies. Are there regular follow-ups? Is there representation at board level?" says LGT's Kristensen, referring to phase three. "We need to know what processes are in place to allow a GP's ESG policy to live within the portfolio companies."

LGT awards managers a rating of between one and four based on its assessments. To achieve a top ranking, a GP must be able to identify ESG opportunities and risks, put in place measures to manage them, and draw up roadmaps for how portfolio companies can improve. In addition to having board representatives overseeing all this at portfolio level, a senior executive within the PE firm should assume responsibility for upholding standards internally.

The latter consideration - specifically having someone at investment committee level who can speak out on ESG issues - was highlighted by every LP and advisor that spoke to AVCJ, while every GP quoted in this article claims to fulfill the criteria.

Man at the top

The challenge is one of integration: a well-resourced private equity firm can hire a dedicated ESG team and produce countless memos, but if their findings are not being factored into ultimate decision-making then the effort is futile; and where potential deals are run by the investment committee on multiple occasions, if there is no senior figure tasked with asking the relevant questions, ongoing due diligence loses focus rather than honing in on the key issues.

"If you just have someone at a junior level responsible for the checks and balances, and no one asking those questions at the investment committee, the program is never going to be terribly effective," says CDC's Lacey. "At the end of the day, there is a general atmosphere in the fund that ESG is not taken terribly seriously at a senior level."

As a frequent backer of small managers in frontier markets, CDC is used to seeing situations in which the ESG designee combines those duties with another role. A GP raising a first-time fund in a challenging market may also struggle to find the budget for any meaningful additional resources in this area.

The general LP view is that even a sub-$100 million fund should be able to build processes adequate for its scale. Reluctance to allocate resources to conducting ESG due diligence on a potential deal is often a red flag. If the risks are large enough that a consultant is required, yet the manager claims there is no room in the budget to pay for one, this essentially means the manager is not in a position to get comfortable with the risk involved. As such, should the GP be pursuing the deal at all?

After speaking to AVCJ, Lacey was due to meet with one of the partners from a relatively small PE firm operating in a difficult geography. The goal was to come up with an ESG framework that would fit the GP's strategy, and the basis of the discussion was CDC's ESG toolkit. This toolkit is intended to help answer questions like when, why and how external consultants should be brought in.

CDC's objective was to augment existing information on the technical side of ESG, such as the International Finance Corporation's (IFC) performance standards, with practical advice on setting up a program. In telling GPs what it wanted to see in terms responsible investment, the DFI is contributing to a growing body of work on industry best practice.

The combination of PRI's LP due diligence questionnaire - still in its draft phase - the ESG Disclosure Framework, and various other guidelines suggests the way LPs and GPs interact on ESG is going to become increasingly standardized. "When I look back at the world of sustainability, it invariably it starts out with something relatively light touch and eventually you are obliged to meet certain targets and there will be verification," says PwC's Routh. "I think the PE Industry is now embarking on the journey that other sectors have taken at various times over the last 20 years."

Much like the Institutional Limited Partners' Association's (ILPA) efforts to introduce templates to codify other aspects of the GP-LP relationship, it would save time and paper. ESG reporting in its most basic form addresses what goals were set for a portfolio company the past year, whether they were achieved and if not why not, and what can be done better over the coming 12 months. Yet there are already complaints about multiple LPs in a fund asking a different set of questions for each company.

Flexibility issues

At this nascent stage it is unclear what will emerge, but one issue to arise from the ILPA process concerns flexibility. It is relevant in an ESG context too. "There needs to be some standardization but also a level of flexibility so that GPs who invest in different things and different places to us can reflect the myriad of differences that occur at portfolio company level," says Doughty Hanson's Black.

Private equity firms that have already established a set of key performance indicators (KPIs) and cleared them with LPs are not particularly worried about regulators trying to redraw the map. However, within Asia there is some uncertainty as to the treatment of minority investments, in which the GP may have limited influence over a portfolio company's approach to ESG.

APG already has special provisions for such transactions, with PE firms asked to produce investment agreements that include ESG requirements and rights. "It is possible that a GP would say it will do what it can on ESG but in practice, without explicit ESG requirements placed on the portfolio company, it is not really empowered in the legal sense because it doesn't own the company," says Jankovic.

These situations can become complicated when an LP requires transparency on ESG performance at portfolio company level but the GP does not raise the issue with the majority shareholder. Stipulated rights minimize the risk involved, but in terms of value creation, the size of the stake should not necessarily be that relevant.

If the GP's strategy is to identify ways in which a company can become financially successful and environmentally and socially sustainable then there is an alignment of interest with the owner or management team. The payoff is an easier ride with the regulators en route to an IPO or a higher valuation at trade sale because multinationals pay a premium for ESG compliance.

The onus is on GPs to develop end-to-end ESG policies as opposed to covering the bases during initial due diligence and risk management, and then ignoring the issue during the holding period.

"Some GPs probably still view it as a cost rather than a business opportunity, and so they may be tempted to go for a tick-box exercise," adds Doughty Hanson's Black. "But that is a false economy because they are going to have to prove that what they say in their policy is happening in practice - and they will be put under closer scrutiny in the coming years."

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• Topics
• Investments
• GPs
• LPs
• Portfolio management
• ESG
• GPs
• LPs
• LGT Capital Partners
• APG
• KKR
• NewQuest Capital Partners
• Creador
• CDC Group