Integrating ESG factors into the investment process: ownership

Actions a GP can take to integrate ESG factors into the investment decision and investment agreement

5. Ownership

5.1 Engagement

The way that a GP engages with portfolio company management during ownership will depend on its investment strategy and governance model. For example, GPs which are majority shareholders with active board positions may be better positioned to influence portfolio company management compared with GPs which are minority shareholders. Additionally, GPs will experience varying levels of support from portfolio companies on ESG initiatives depending on the company’s culture or region of operations. Regardless of the approach taken, GPs are encouraged to find the right balance between stimulating active management of ESG factors and placing unrealistic expectations on portfolio companies.

A GP could:

Persuade its portfolio companies to implement ESG initiatives by helping senior company executives and management better understand the potential impact of ESG risks and opportunities on the value of their business. It may also be the case that the GP can learn from a portfolio company’s practices and share these practices with other companies in their portfolio.
Work with its portfolio companies to set up an ESG programme, which could include drafting a policy, assigning responsibility for ESG operations and setting up processes to manage ESG activities. The company could also engage internal or external technical consultants to achieve operational ESG improvements. The company will be responsible for day-to-day management and as such it is important that they have the systems and resources in place to effectively manage ESG risks and bring to fruition the identified opportunities.
Make the portfolio company’s board explicitly accountable for ESG initiatives. This could be achieved by placing a representative on the portfolio company’s board who is responsible for overseeing ESG initiatives. Alternatively, a GP could form an ESG committee within the individual portfolio companies.
Leverage expertise and experience on ESG matters across the portfolio by encouraging sharing of knowledge and good practices between different companies. A GP could organise periodic meetings with representatives from all of its portfolio companies to discuss ESG topics. Similarly, a GP may organise dedicated sessions or webinars for portfolio companies around particular themes and topics.
Conduct periodic site visits. Site visits can help GPs to verify the portfolio company’s reported information, reveal the full extent of the company’s ESG activities, and demonstrate to the company that the GP is fully committed to working with them on ESG activities.

“100% of our portfolio companies have an ESG policy and most have an ESG officer.”

In practice

Global Environment Fund, a GP headquartered in the US, actively takes into consideration the environmental effects of their investments. For example, when it acquired Red Ambiental – a Mexican integrated waste management company – due diligence yielded various opportunities for environmental improvements in its management and footprint, and areas of potential liability, including drainage pumps, additional permits and community engagement. These were discussed with management and incorporated into the ESG action plan.

During the investment agreement stage, Kendall Court will stipulate that the portfolio company forms an ESG committee. This will typically consist of 3-6 people, including the portfolio company’s CEO and CFO whenever possible and at least one Kendall Court employee. The rationale behind this ESG committee is that inter-departmental coordination on ESG matters is crucial to avoid a silo mentality when it comes to ESG implementation. Moreover, meaningful change usually requires human capital and/or resources, which is why Kendall Court endeavours to ensure that the CEO and the CFO are on the committee as they have the necessary decision-making power.

5.2 Monitoring portfolio companies

A GP could:

Define company specific or portfolio wide ESG indicators, depending on the characteristics of the portfolio companies, and monitor these on a regular basis. A GP could perform a pilot run with a subset of their portfolio companies to determine the most relevant ESG metrics to monitor.
Prioritise the relevant ESG issues and focus on the most important issues in the short or medium term. The CDC toolkit – see Appendix A – contains an overview of what are considered to be the more pressing issues for various industries. Likewise, the SASB standards focus on the determination of materiality. Both tools can assist GPs in determining which the important or material issues are for their portfolio companies and what (if anything) they should consequently be targeting in the short or medium term.
Ensure that ESG developments are consistently on the portfolio company board’s agenda. The underlying logic here is that these developments capture, to some extent, how a business is performing overall. When a company is experiencing ESG issues, it generally means that other operational issues are also at play which the board should be aware of. Additionally, it is the board’s ultimate responsibility to review all the relevant information to enable them to make informed decisions.
Provide tools to help portfolio companies monitor and measure ESG practices. For example, a GP could provide templates for calculating potential cost savings and upside from ESG practices.
Collect information on ESG developments from portfolio companies using structured reporting templates. Such templates can range from simple questionnaires with yes/no questions to complex matrices of quantitative metrics. A GP could also leverage templates and guidance from industry toolkits. The CDC toolkit offers templates for reporting from portfolio companies to GPs.
Integrate the discussion of ESG developments into existing annual reviews with portfolio companies. This will help provide a holistic view of the company and reinforce the fact that ESG issues are an integral part of the company’s strategy and operations.
Monitor ESG developments in its internal portfolio review meetings (i.e. investment team meetings, operational team meetings, internal investment committee meetings and/or the meetings with LPs, possibly with the ESG team and/or selected external speakers/advisors).

“We only hold companies for 3 to 5 years. Thus you only have 1 to 2 years wherein you can actually work on ESG in the sense that management is receptive for ESG-based changes.”

In practice

UK-based GP Actis’ Africa Real Estate Fund incorporates environmental building measures into its greenfield developments. These include: One Airport Square and The Exchange in Ghana, Heritage Place in Nigeria, and Garden City in Nairobi. The ESG and real estate teams worked closely to benchmark each development against internationally recognised rating schemes (LEED and Green Star). All the developments mentioned above are on course to be LEED or Green Star certified. The team has ensured that all developments are at least 25% more energy efficient than similar buildings in the locality.

Permira has a team dedicated to monitoring and reviewing its investment KPIs, including those related to ESG. In the event that this team identifies a potential or actual problem within a portfolio company (i.e. a red flag), the team increases monitoring levels with increased requests (i.e. every two weeks) for feedback. Where relevant, these can include specific ESG KPIs from the company.

5.3 Reporting to LPs

As previously mentioned, GPs are increasingly indicating that LPs are asking them to demonstrate a structured approach to managing ESG risks and opportunities, which also includes reporting on ESG matters. In some cases, LPs are themselves under increasing pressure from their stakeholders to provide greater transparency on how ESG considerations are integrated into their investment processes, and these LPs, in turn, have elevated expectations regarding reporting on ESG developments.

Well-developed monitoring practices can help a GP to report on ESG matters to its stakeholders. This section provides high-level guidance on how GPs may report ESG matters to their LPs. This is an evolving topic and today, no universal, industry-wide LP reporting templates exist. GPs and LPs are therefore encouraged to work together to develop a framework for reporting which allows the GP to disclose the information that is relevant to its LPs.

If LPs indicate a desire for regular reporting, it may be best for the GP and the LPs to agree in advance upon the form and frequency of reporting. GPs should be aware that, in certain cases, LPs could look for disclosures outside of the regular reporting cycle, for example if there is a material incident at a portfolio company. Amongst the many variables that affect the frequency of reporting are the type of fund, geographical and industrial coverage, and LPs’ expectations. GPs could work with their peers, industry associations, the PRI and other constituencies to find a blend that is optimal for them and their LPs. In addition to regular reporting requirements, LPs have also indicated that amongst the key items they focus on are whether ESG topics will be a discussion point at LP advisory committee meetings or at the annual LP meetings, as well as the circumstances under which an LP could discuss ESG considerations more broadly with a GP and its affiliates.

In some cases, the LP’s need to implement its responsible investment policy and/or provide transparency into its portfolio may lead an LP to try and understand key ESG developments at specific portfolio companies and/or across the fund. A GP could (subject to any confidentiality obligations) use information collected during the monitoring of portfolio companies to input into its fund level reporting to LPs. Reporting at the fund level also allows for the disclosure of confidential and more granular information, as most fund documents provide for confidential treatment of information communicated to LPs.

“Reporting creates its own reality… it helps to embed ESG into the daily practice and thinking of both management and the investment team.”

ESG disclosure framework for private equity

The ESG Disclosure Framework for Private Equity is a tool developed by an international group of LPs, GPs and private equity associations to provide guidance on the disclosure of ESG considerations between LPs and GPs. By applying this guidance, GPs can provide LPs with clarity that (i) the fund is being managed in accordance with ESG policies agreed at fund formation, (ii) be informed of any material changes to the ESG risks and opportunities facing the portfolio, and (iii) be informed of any material incidents and how these were addressed.