Private equity players are taking a range of approaches to implementing environmental, social and governance initiatives, but some nudging from limited partners could lead the industry toward more standardization.
Cebile Capital LLP Managing Partner Sunaina Sinha, who advises private equity firms on fundraising, believes LPs have the ability to raise the ESG bar for the entire industry. For example, Sinha noted that LPs can place stipulations on their allocations, with the goal of mandating that general partners take such steps as refine their ESG policies or improve monitoring.
However, LPs have little sway in enforcing such requests in the current white-hot fundraising environment in which private equity firms have been able to raise an abundance of dry powder. While the investors want a minimum threshold for responsible investment performance, they are also very concerned about maintaining access to top-quartile oversubscribed funds, said Natasha Buckley, senior manager at Principles for Responsible Investment, or PRI, the United Nations-supported organization that aims to help investors incorporate ESG.
Pushing for more defined terms around ESG is not always a top-line agenda item for LPs when speaking with GPs about fundraising. “It’s about preserving access,” Buckley said.
But once the cycle turns, GPs will likely face more fundraising roadblocks, and the leverage will shift toward LPs. When that occurs, investors will find themselves in a better position to push for improved ESG standards, Sinha said.
“LPs will say [to their GPs] ‘tell me how you monitor your portfolio for compliance, how you ensure compliance with your ESG framework, and show that to me retrospectively. Have you done that in the last portfolio, and how?’” she said.
LPs have already helped the industry move toward greater adoption of ESG. The initial push for private equity firms to sign up to PRI came from LPs asking whether their managers were signatories and sending out questionnaires. A decade ago, PRI had a handful of private equity members, and that has now grown to a membership of 400 GPs.
The first hurdle for private equity firms was dealing with the burdens of different requests from LPs. In some cases, questionnaires were asking for the same thing in slightly different ways. PRI has since created its own due diligence questionnaire to streamline the process.
Five years ago, Sinha said the demand and implementation of ESG in private equity was “hit-and-miss,” existing in some due diligence but not all. Today, it exists in most due diligence carried out by both GPs and LPs, and the majority of GPs have an ESG policy written down and quantified.
No one size fits all
But even now, different LPs will pursue ESG initiatives in different ways. In terms of portfolio monitoring, the capacity for LPs to absorb, or want, ESG information ranges widely. Some LPs will carry out due diligence on a firm’s ESG approach at the point of each fundraise, while other LPs may collect portfolio-level key performance indicator information so they can verify the GP’s approach.
Likewise, there is “definitely no one size fits all” across all private equity funds when it comes to implementing ESG initiatives, said PRI’s Buckley. The success of a firm’s ESG approach has “very much to do” with a firm’s investment strategy as well as how hands-on it is.
Larger funds tend to score better on annual reporting assessments, but this might be reflective of the fact that they have more resources internally to deal with reporting. “It’s absolutely not to say that small firms aren’t doing great work,” Buckley said, adding that small to mid-market firms with funds that own 10 or 12 companies, have a deal team focused on ESG, and board seats or significant control in their portfolio companies should “absolutely have the bandwidth to focus on these issues,” Buckley said.
A push for standards
While some GPs have the resources to hire internal teams or bring in external parties to conduct an ESG audit of their portfolios, many mid-market and smaller firms struggle to do this type of ESG compliance on an annual basis, Sinha said.
Still, LPs are asking smaller managers whether they are ESG compliant. One lower mid-market manager said it will always flag any ESG questions with their largest investors. If something is particularly controversial, the manager will bring the issue to the limited partner advisory committee. Even though it may not have the same resources as its larger competitors, ESG is still important to LPs. “I think, in the current environment, with ESG being such a high-profile issue, you’d be very nervous about doing anything with any kind of disquiet in the investor base, to be honest,” the manager said.
Sinha said she expects the LPs who are more advanced on ESG issues will spearhead the shift toward standardization by seeking ESG-related terms when committing funds. The industry could even see a boom in third-party ESG advisers who will fill the gap for those GPs that do not have the resources to establish their own internal capacity. They will be required to pick “their favorite ESG adviser” to check over deals and the portfolio just as they would hire someone to do commercial or legal due diligence.
“It will just become one of the processes that you have to do that investors insist on,” Sinha said. “It’s not the case today, as we know, but it definitely can be.”
Source: S&P Global Market Intelligence