Overview

The information and analysis needed to identify and manage material ESG risks and opportunities is the same in public and private equity. While LPs have not traditionally asked GPs for ESG-related information on portfolio companies, such information may be available on request, or the GP may be willing to collect it over time.

Governance challenges

Private equity has a long-term investment horizon, with the GP bridging the gap between company management and its beneficial owners. At its best, private equity is a stewardship-based style of investment and should benefit from increased focus on ESG issues. Responsible investment should be seen as a natural step for private equity investors.

However, an LP should inform itself of the differences between public and private equity. One key difference is the role of the GP and the different governance challenges this creates. Private equity does not face the governance challenges that largely define investors’ work on responsible investment in public equities (i.e. aligning the interests of company managers and a diverse pool of shareholders).

However, the industry still faces a governance challenge: how to align the interests of asset managers (GPs) with a diverse pool of capital providers (LPs).

Just as investors have advocated changes to corporate governance and disclosure practices to be able to more effectively act as stewards of publicly-owned companies, so too must an LP consider fund governance and disclosure practices to act effectively as a steward in private equity. An LP is encouraged to seek guidance on private equity fund governance best practice from the Institutional Limited Partners Association’s (ILPA) Private Equity Principles 2.0.

Characteristics of private equity with implications for ESG integration

The key characteristics of private equity that should inform an LP’s approach to integrating ESG factors are:

Private equity funds are normally structured as limited partnerships. These limited partnerships are managed by a GP, who is responsible for sourcing and analysing investments, executing investment decisions, monitoring and advising the fund fs investments, and eventually selling portfolio companies. An LP provides capital to the limited partnership.

Private equity fund investments are long-term, with an LP typically committing capital for 10-15 years. Capital is invested during an investment period that may last five years or more, with the remaining life of the fund spent disposing of investments and winding down the fund.

Private equity is a buy-to-sell model, not buy-to-own. The average holding period for a portfolio company is 3-7 years, and all investments must be sold within the life of the fund.

Investing in a fund generally involves a blind pool commitment. While an LP commits capital to a fund with a defined investment strategy (typically including geographic, sector and company size restrictions), the underlying assets (portfolio companies) are not known until after the fund is operational. Therefore, an LP fs investment decisions are based significantly on the nature of the fund fs investment mandate, the GP fs track record, and the LP fs assessment of the fund terms, conditions and governance to ensure an alignment of interest between the LP and GP.

Private equity investments are relatively illiquid. Although the secondary market has matured in recent years, an LP cannot easily sell its interests, and such sales generally require permission from the GP. In addition, changes to the investment mandate may require negotiating with other fund investors.

GPs have complete discretion over investment decision-making and ownership activities for both legal and practical reasons. An LP typically invests in funds on the basis of a GP fs ability and judgement, and therefore delegates managerial functions to a GP. While a GP may obtain an LP fs input on various issues relating to a fund, an LP that provides input beyond being consultative in nature may undermine its limited liability status, depending on the jurisdiction and the particular facts involved.

While an LP cannot make, or materially influence, specific investment decisions, a distinction can be made between influencing a decision and influencing a decision-making process. As a result, in dispatching its fiduciary duties, an LP should monitor and, where necessary, engage a GP about the policies, systems and resources used to identify, assess and make investment decisions, including ESG risk management.

Communication between GPs and LPs. There are four main channels a GP uses to communicate, or engage with, its LPs:

• Limited partner advisory committee (LPAC): The LPAC is generally comprised of the largest LPs in a fund, who represent their own interests. LPAC practice and mandate differs widely between funds, but often includes consents or waivers with respect to transactions involving conflicts of interest, valuation policies, investment period extensions, and other issues on which a GP seeks LP input. If LPAC members have a commitment to, and a competence in, ESG integration, it may be an effective body for addressing ESG integration.
• Annual general meeting (AGM): During the AGM, a GP generally reports on fund investment and performance during the previous year to all LPs. AGM practice differs across funds, but is generally for sharing information and not for seeking formal input on decisions.
• Periodic GP reports: The frequency and content of a GP’s reporting obligations is generally set in the fund’s governing documents. ILPA has developed standardised reporting templates, which an LP may consider when defining its expectations. An LP with specific reporting requirements will sometimes seek additional commitments from the GP in a side letter. 
• Meetings: GPs and LPs may arrange telephone or in-person meetings. Unless otherwise stated in a fund’s governing documents, such meetings take place at a GP’s discretion.

GPs generally make large investments in a relatively small number of companies. The concentration risk associated with this investment style may be mitigated by a number of factors, including: the amount of due diligence undertaken by a GP before investing in a company; a GP’s complete access to full management accounts of a portfolio company, both before and after investment; a GP’s significant influence or control over a company after an investment has been made, which could include board representation, access to management, ability to add or replace management, or the timing of an exit.

GPs generally seek a degree of influence over their portfolio companies. In the case of buyouts, GPs frequently purchase a full or majority stake in the portfolio company. In other cases, even with a minority investment, the GP may nominate one or more board members. This allows GPs to exert influence both as a significant equity investor and through their board representative(s), as company director (gaining influence over corporate strategy, governance and senior management).

The private equity ownership and governance model is based on the close alignment of LP, GP and portfolio company management interests. This increases investors f ability to influence how ESG issues are addressed within portfolio companies.

LPs within a fund are likely to differ in their approach to responsible investing. LPs that engage with GPs on ESG issues may not necessarily have the support of other LPs that may have a different perception of whether or how ESG factors can impact risk-adjusted returns.

GPs generally have full access to management accounts within their portfolio companies. As a result, while portfolio company reports often include less information than those of publicly listed companies, significant additional information is likely to be available upon request. This may include information on strategy, risk management and key performance indicators (KPIs).

Characteristics of particular forms of private equity

Funds of funds

Many institutional investors choose to invest in private equity through a fund of funds. Funds of funds manage the relationship with GPs on behalf of several LPs. Funds of funds often have better resources and are more experienced at investing in private equity, and therefore have the potential to more effectively oversee and influence a GP’s approach to ESG integration. However, unless a fund of funds is running a managed account, it must adopt an investment strategy that serves all LP interests. Funds of funds may find it difficult to give a level of attention to ESG factors that some LPs believe is consistent with fiduciary duty if only a minority of LPs express an interest in ESG integration.

Co-investments

Many institutional investors seek more direct exposure through co-investments, where they invest alongside a GP in a specific portfolio company. Co-investors are usually an LP in the fund from which the GP makes the portfolio company investment. A co-investment may give an LP the opportunity to participate directly in the due diligence process. Depending on the relative size of the stake, a co-investor may also have the right to appoint a board member. The co-investor’s role may require different types of expertise and internal resources. In comparison with other LPs, co-investors may have more and better access to portfolio company information. Co-investments may also provide investors with opportunities for more detailed assessment of ESG-related risks and opportunities, both before investing and throughout ownership.

Secondary investments

Unlike primary fund investments, where capital is being committed to a blind pool, a secondary investment involves the purchase of an LP’s position, either in an existing fund (secondary fund investment) or in specific private companies (secondary direct investments). Secondary investments provide a selling LP with liquidity and the opportunity to rebalance its portfolio. ESG due diligence can in theory be undertaken on underlying portfolio companies prior to investment because, unlike a primary fund investment, the portfolio is known. However, these transactions generally do not give an LP the opportunity to renegotiate existing documentation to include any ESG issues.

Emerging markets

As more LPs commit to emerging market private equity funds, an LP should consider factors that may differ from developed market strategies, including:

• Private equity investments in emerging markets often do not involve the same level of ownership and control, increasing the importance of aligning interests with other investors and company management.
• A GP may not be able to access the same scope and volume of audited information in its due diligence process. Many legal processes may take longer in emerging markets, which often means that enforcement actions may stretch beyond the terms of the fund itself.
• There may also be differences in the regulatory regimes for a variety of ESG factors. As a result, additional legal compliance may be required, and legal compliance is not always a sufficient baseline for performance expectations.

While emerging markets may have risks not common in developed markets, GPs investing in emerging markets may also have more experience with ESG factors. Development finance institutions play an important role in the emerging market LP community. They have used detailed ESG-related performance requirements and been engaging with GPs on ESG factors for several years.