PRI Awards 2019 case study: Green Fund of Fund – Innovative ESG Strategy with China Characteristics

Overview of the firm’s approach to ESG incorporation

Starquest Capital was the first renminbi fund of funds to sign up to the PRI and has since spearheaded ESG practices across China. The firm has established a ‘five-element ecosystem’ that provides value-added services to general partners (GPs), portfolio companies, limited partners (LPs), service providers and regulators. This ecosystem helps the outreach and adoption of ESG practices in China and beyond.

At the heart of Starquest’s comprehensive firm-wide ESG framework lies the ESG Committee, which aims to involve all the employees in the front, middle and back offices. Each ESG Committee member is assigned a portfolio and key performance indicators. Steered by this ESG Committee, Starquest has put in place an ESG investment process. Once the GP has provided the information needed for initial fund review, the Starquest team evaluates the ESG practices of the GP via a five-step process:

1. Preliminary assessment: The investment team collects ESG information about the GP through a short ESG questionnaire and GP interviews.
2. Due diligence: the Starquest team distributes a detailed ESG questionnaire to GPs. Meanwhile, middle and back office teams will agree potential ESG issues or risks.
3. Investment decision: the team prepares a comprehensive ESG report for the ESG Committee.
4. Terms of contract: Starquest’s in-house legal counsel drafts legal papers that address ESG issues identified during due diligence.
5. Post-investment management: Through quantitative assessment and ongoing ESG seminars, Starquest continues to share ESG know-how through the GP with its portfolio companies.

In the post-investment stage, Starquest assesses GP performance on ESG quantitatively. It does this in two ways:

1. ESG KPIs: the firm has developed a KPI matrix to evaluate the ESG performance of the GP’s portfolio. The matrix consists of four dimensions: general, environmental, social and governance. General KPIs are used on GPs, especially those without a clear ESG strategy, to assess their overall understanding of ESG principles.
2. Analytic Models: The firm also uses different analytic tools such as the analytic hierarchy process combined with dynamic weighted matrix.

In addition to this process, Starquest has worked with the Green Finance Committee of the China Society for Finance and Banking to develop a set of green investment principles for the Belt and Road Initiative. The firm has also conducted academic research on ESG in collaboration with the National Institute of Financial Research at Tsinghua University and experts at MSCI.

Why this approach stands out in the market

The Starquest approach stands out in the market for several reasons. First, because of the influence it has had in encouraging ESG principles more broadly across China. It has done this in three ways:

• Partnership with the government: Starquest represents private equity firms on the Green Finance Committee of the China Society for Finance and Banking on the green Belt and Road Initiative.
• ESG exchanges: The firm is in frequent talks with leading firms such as LGT Capital and Actis to gain insights on ESG practices.
• In-house ESG seminars: Starquest encourages local companies to join organisations such as PRI. It also recently hosted an LP/GP seminar where Madame LUO, PRI China head, was invited to share thoughts on ESG.

The second reason Starquest’s approach stands out is the firm-wide makeup of the ESG Committee, which operates a 1+2+1 model. That is: one managing partner, plus two investment-team members, plus one middle-and-back-office member.

The third reason Starquest’s approach stands out is because of the step-by-step approach to its questionnaires for GPs. The initial questionnaire is designed to be simple with only multiple choices. As the due diligence progresses, a more detailed questionnaire requires the GP to give essay-style answers on each ESG KPI that has tangible investment examples.

Finally, in order to minimise subjectivity and improve accuracy, Starquest has chosen analytic tools that are best at solving various non-deterministic problems. For instance, a weighted matrix is applied to count for all the relevant factors and arrive at more accurate ESG scores.

Practical examples of how the approach was applied, and challenges overcome

Starquest assessed ABC Capital using its five-step ESG investment process. This was how it worked:

Screening and preliminary assessment: After receiving its pitch book, the firm sent out a short ESG questionnaire and set up a meeting.

Due diligence: Starquest asked ABC Capital to fill out a more detailed questionnaire and the middle-and-back-office team prepared legal papers to incorporate ESG-related terms.

Investment decision: In the investment committee meeting, committee members, the investment team and middle-and-back-office team assessed ABC Capital thoroughly and found no significant conflict with its ESG principles.

Terms of contract: Starquest proposed, and managed to include, ESG-related terms in the contract with the GP.

Post-investment management: The firm conducted quantitative analysis on ABC Capital’s ESG practices on a quarterly basis.

In the quantitative assessment, ABC Capital received an ESG score of 7.2, which is above the mean of score 6.1 in Starquest’s wider sample. This was largely because ABC Capital has the management buy-in on ESG practices and has experience in incorporating ESG terms in legal documents.

However, during the assessment, challenges arose in collecting ESG information from the portfolio companies of ABC Capital. In China, most companies are generally unwilling to take the ESG assessment requested by the GP. ABC Capital was no exception. To solve this issue, ABC Capital assisted in progressively implementing ESG practices in its portfolio companies. In particular, Starquest suggested that ABC Capital groom ESG specialists in its portfolio companies and monitor their ESG progress regularly. Additionally, the firm recommended that ABC Capital use questionnaires to collect useful information.

Measurements for success and lessons learned

Starquest’s in-depth ESG analysis arrived at the following conclusions:

• The awareness of ESG is very low in the PE/VC market in China. 50% of the respondents in its sample have limited exposure to ESG principles while 13% have never heard of it.
• The recognition and understanding of ESG varies among GPs. Around 20% of the local Chinese GPs in the sample had no idea about ESG, whereas US-dollar GPs in China generally have ESG exposure thanks to their international LPs who insist on ESG practices.
• The implementation of ESG principles in the investment process is the biggest challenge in China. In the Starquest sample, no GP had a complete or clear process to assess ESG factors. In the sample, 63% of them provided less convincing ESG investment stories while the rest could not provide any example.
• Legal enforcement should be strengthened. Enforcement is crucial to ensure GPs’ compliance with ESG principles. However, many LPs do not include ESG components in their legal documents.

Starquest believes its approach can be applied more broadly across China because:

• Its step-by-step ESG methodology is systematic and easy to replicate.
• The methodology can be quantified, making it easier to compare ESG performance across different firms.
• Growing ESG problems in the emerging world provide a compelling case for local firms to establish an ESG assessment system as soon as possible.
• The firm’s ESG approach is a good start for companies to shape their own ESG strategies.

Starquest constantly adapts and improves its approach for emerging markets through twoway exchanges with local and international firms. It is extending its influence on ESG by expanding its five-elements ecosystem. Importantly, because of its association with the Green Finance Committee of the China Society for Finance and Banking, Starquest is also mobilising organisations involved in the Belt and Road Initiative to apply its ESG approach more broadly.