Integrating ESG factors into the investment process

Actions a GP can take to develop frameworks for integrating ESG factors into their investment cycle.

Including ESG information relevant to the company fs industry, geography, and business model in the investment analysis and post-acquisition management helps a GP to:

holistically account for material risks and potential opportunities which may make the business more or less attractive for investment;
identify and develop action plans for strengthening the target business;
ensure that their investments are aligned with their LPs’ interests.

This will help GPs and their LPs create and maintain the value of their investments.

GPs will have their own systems for integrating ESG considerations into their investment process. In practice, effective systems typically exhibit the following characteristics:

They are practical and can be adapted for different investment strategies and portfolio companies.
They are aligned with existing tools and standards.
They allow GPs to compare risks and opportunities across a diverse portfolio.
They allow for prioritisation of the most important topics per company and for the portfolio.

“A good policy is never a substitute for actual behaviour.”

1. General tips

1.1 Align a GP’s framework for ESG integration with existing tools and standards

A GP could draw ideas for its framework for ESG integration from toolkits made by DFIs, NGOs and also from their peers. Appendix A contains examples of various toolkits which can assist the development of a due diligence tool. Using these toolkits is one way to ensure that a GP’s framework for ESG integration is based on international standards and on good industry practices. A GP can also draw upon established and industry specific standards (e.g. LEED12) in their analyses and target-setting.

“We have tailored the CDC toolkit to our specific needs.”

In practice

When Capman Russia, an investment partnership of the Finlandbased PE fund manager CapMan Group, started building its framework for ESG integration, they reviewed previous work conducted by some of their DFI LPs on the subject. They used this as a basis for their own system. DFI LPs such as the IFC and EBRD set high performance requirements for ESG issues and have been an important driver for increased attention to ESG issues in Russia and Eastern Europe over recent years. The standards which they set can provide the basis for exclusion lists, post-investment action plans and reporting templates.

Kendall Court, a Singaporebased GP, has built its framework for ESG integration by reviewing the international standards recommended by DFI toolkits and the local rules that are applicable to their regions of operation. Between international and local standards, Kendall Court will endeavour to select the one with the highest standard.

1.2 Ensure access to ESG expertise

It is important that GPs fully consider the spectrum of relevant ESG issues in their investment decision-making by ensuring that they have access to expertise on ESG matters.

As suggested previously, a GP can develop a separate work stream to focus on ESG analysis and management or integrate ESG-related skills and knowledge within the investment team. As referred to in the due diligence section below, a GP can consider using external expertise and/ or existing industry resources to supplement its internal capabilities. The allocation of human resources will depend on the GP’s business strategy and model. With either approach, the GP should ensure that ESG analysis and management are not isolated from the other investment processes such as commercial, financial and legal due diligence and portfolio company oversight.

1.3 Be sensitive to regional differences

When integrating ESG considerations into the investment process it is important to be sensitive to regional differences. For example, in some markets deals may involve very competitive bidding processes with very limited exposure to the target companies. In such cases, the depth of ESG due diligence is limited because only a high-level screening can be performed. In addition, certain regional characteristics, such as the predominance of minority PE transactions in emerging markets, will influence how a GP can engage with and monitor a portfolio company.

1.4 Pilot your framework for ESG integration

A GP could perform a pilot run of their framework for ESG integration with existing portfolio companies instead of trialling their framework with new investment opportunities. This is a good opportunity for a GP to collaborate with their portfolio companies to identify and subsequently adapt their processes for monitoring ESG developments.

There are three key benefits of a pilot run. Firstly, by applying the framework for ESG integration to the existing portfolio, the GP can verify whether any improvements are needed. Secondly, a GP will gain experience in considering ESG information when reviewing a business; this experience will be helpful for integrating ESG factors in the due diligence stage. Finally, a GP could use examples from the pilot to demonstrate the practical application of the framework to its investment team. This can help to “demystify” ESG factors for investment teams by revealing new opportunities and/or improved risk management without creating an unnecessary burden.

“After we had used the toolkit for the first time we had an example we could share; it led to demystification, showing it is not bureaucratic and probably is a value-added process.”

In practice

Egeria used an ESG pilot run to help with identifying whether their current portfolios contain any hidden ESG risks. These pilot runs helped them gain experience in examining a business through an ESG lens, instead of through a solely financial and commercial one, before applying ESG criteria to due diligence. Among other things, these pilot runs helped the firm’s

investment managers to become more familiar with the issues associated with ESG.