Integrating ESG factors into the investment process: due diligence

Actions a GP can take to integrate ESG factors into due diligence

2. Due diligence

2.1 Screening

The initial screening of an investment opportunity can provide an early stage assessment on how it aligns with a GP’s ESG objectives.

A GP could:

Compile a checklist to screen for high-level ESG risks before embarking on detailed due diligence. The content of this checklist will be dependent on both LP demands and on the GP’s own strategy. High-level checks may also look at the sectoral and geographic-related ESG risks and opportunities. A GP could periodically review this list to incorporate new developments or insights which may significantly influence its composition.
Exclude controversial industries and activities (e.g. cluster munitions) or follow the UN and EU guidelines on country exclusions.

Publicly available toolkits
The Dutch DFI FMO offers an easy-to-use tool which provides the GP with an initial assessment of E&S risk against IFC Performance Standards regarding a particular investment. The assessment is based on the sector and geography where the company is active. The tool also provides E&S opportunities/value add for the GP to look into.	The SASB standards can be used to identify the relevant ESG issues for a company by industry and the GRI Sustainability Reporting framework includes sector guidance to identify ESG issues. A GP can review the issues highlighted in these frameworks and incorporate the consideration of these into its due diligence process, as relevant.
The IFC ES-Toolkit offers GPs an extensive overview of templates and tools which can be deployed during the due diligence phase of the investment process. For example, the toolkit includes an overview of the eco-labels which are available in the industry. This sort of information can help GPs develop a better understanding of existing initiatives and a general sense of where a particular industry is heading with regard to environmental trends. This can in turn help focus the due diligence process.	The CDC toolkit provides a comprehensive overview of issues related to geography, sector and industry and supplies frameworks for GPs to map these out during due diligence. During the interviews, this toolkit was repeatedly referred to as a helpful resource for GPs integrating ESG into the due diligence process and their operations.

A GP may find, however, that dedicated training of staff on integrating ESG considerations into due diligence can have more impact than using elaborate formats and frameworks.

“We apply the WSJ-test: we ask ourselves how we would feel if a certain issue or deal made the front page of the Wall Street Journal.”

In practice

Bridges Ventures, a UK private investment firm, has devised a comprehensive impact methodology to assess its investments, throughout the deal cycle and across all fund types. Due diligence analysis always includes an initial review of whether the potential investment is aligned with Bridges Ventures’ envisioned target outcomes, i.e. using investment to address pressing social and environmental challenges. Whilst impact analysis is tailored to each of Bridges’ three funds, there are certain key impact features that are common to all investments. Bridges Ventures will look primarily at these three areas during analysis: thematic impact (linking the investment output with the target societal outcomes), additionality (whether the investment will create positive change relative to what is likely to happen otherwise) and ESG factors (identifying other environmental, social and governance factors that signal both risk and opportunity for value creation). Bridges Ventures uses tailored, practical indicators for impact measurement and puts an emphasis on consistency and comparability of results. Impact returns and risks are analysed at both the portfolio and investment levels in order to understand the overall impact risk/returns profile of each fund.

2.2 Company deep dive

Due diligence on ESG factors (through desk research and site visits) is an iterative process with repeated interaction between the different actors (the portfolio company, investment manager, external ESG consultant and/or internal dedicated team of ESG operational specialists).

“Management of ESG issues is not necessarily different from managing other aspects of the investment; you just have to have the will.”

On the whole, repeated interaction helps to unearth the information necessary to obtain a full understanding of all relevant ESG issues.

A GP could:

Hire an external advisor to conduct detailed ESG due diligence. GPs, particularly smaller GPs, may find it difficult to have in place a fully dedicated ESG professional or team due to resource constraints. Making use of external support services is one way of overcoming resource challenges whilst ensuring access to expertise on ESG matters during due diligence. For example, rather than just hiring a chemicals expert, a GP can additionally (or instead) hire an external advisor to understand the environmental risk associated with the chemicals used at the production facilities of a target company.
Tailor its approach for due diligence on ESG matters to the industry sector, geographical region and business model of the target company. The relevance and materiality of ESG factors for an investment will vary depending on its characteristics. Industry toolkits can help a GP to identify relevant ESG regulations, standards and risks and opportunities specific to a geographical region and industry sector. A GP can then adapt this guidance to the specific target. Please see Appendix A for a list of publicly available industry toolkits.

“GPs complaining about the cost of hiring an ESG consultant should reconsider their due diligence legal bills. The savings in avoided risks alone are already worth it.”

Observation on costs

Based on the interviews, it appears that the costs associated with ESG analysis during due diligence typically range from US$ 5,000 to US$ 20,000, depending on the size, industry and location of the potential investment. This expenditure is typically for hiring external advisors to map the ESG issues associated with a particular investment. This may include factory site visits, resource utilisation analysis and/or mapping the scope for improvements. The estimated costs put ESG due diligence at less than 10 to 15% of total due diligence expenditure. These findings suggest that conducting in-depth ESG due diligence may not be as costly as perceived by some GPs.