Guide for limited partners: responsible investment in private equity - Section 3

 

Integrating ESG

Figure 7; Integrating ESG into the investment process

 

Module	Explanatory notes
Module I: RI Policy, Beliefs and Goal Setting	Establishing how the organisation views ESG issues and the goals of their responsible investment practice is helpful in sending a consistent message to the organisation and investment partners
Module II: Governance	ESG considerations in specific governance constructs
Module III: Investment Process	The implementation of your responsible investment practice leading up to and executing the investment decision. Challenges, tools and resources are highlighted in this module
Module IV: Monitoring and Reporting	Monitoring and reporting of performance and initiatives at portfolio companies and GPs

Module I: Responsible investment policy, beliefs and goals

Policy

As discussed earlier in the Section 2, an investor may have multiple drivers for introducing an RI policy – materiality, clients, risk management and regulation. These drivers may result in policies relating to “responsible investment”, “sustainability”, or “ESG”.

Clarity on why your organisation is interested in responsible investing is key for developing an organisations’ approaches and criteria for decision-making. This can then be articulated in the investment policy and/or as a separate investment process. Additionally, clear policies allow for consistent messaging to key internal and external stakeholders such as investment teams, GPs, co-investment partners, beneficiaries and clients. This is helpful for GPs where they are fielding requests from LPs on RI issues. Here are three recommendations on how to establish and integrate ESG policies:

Recommendation 1
Define and integrate RI beliefs into a broader set of investment policies or approaches. Steps and considerations may include:

• Promoting organisational clarity on why these matters are important.
• Developing definitions of what ESG means for your investment mandate, strategy and products.
• Defining a principle-based approach as these definitions may change as your understanding changes.
• Identifying different objectives throughout your organisation, such as risk mitigation or investment opportunities

Recommendation 2
Develop ESG policies early in the process which can:

• Drive implementation and enable your organisation to quickly and effectively implement responsible investing practices.
• Build consensus and clarity amongst the investment team.
• Be used to establish the scope of a specific policy.

Recommendation 3 
Invest in internal education and capacity building for the investment team which can:

• Ensure investment teams always ask consistent questions which are focused on material ESG issues.
• Provide Ideas for internal education and capacity building which could include a speaker series and use of off-the-shelf courses.

Goal setting

Setting goals (aspirational, interim, qualitative or quantitative) is an important part of developing a coherent responsible investment strategy. Setting of goals remains an exercise in judgement to find ones that are consistent with the LP’s corporate beliefs, and are realistic and acceptable across both management and board teams. Goals might be set using 1) existing standards from industry organisations and/or 2) following industry peers. Leveraging off existing industry goals or practices has the advantage of:

• Being able to position your organisation as a “fast follower”
• Leveraging work that has clear reasoning and credibility
• Alignment with industry consensus

In either case, the LP will usually have to adapt existing resources and standards to their investing strategy, products, client requirements and internal systems.

Module II: Governance

LPs are encouraged to seek guidance on private equity fund governance best practice from the Institutional Limited Partners Association’s (ILPA) recently published Private Equity Principles 3.0 (2019).⁹ The third edition of the ILPA Principles now reflects ESG considerations as a standard part of LPAC procedure and fund disclosures. Areas covered include:

Notifications and Policy Disclosures:
Among the notifications and disclosures that GPs should provide to investors on material developments that impact the fund, the ILPA Principles includes a section on ESG Policies and Reporting. It states that an ESG policy “should include information sufficient to enable an LP to assess the degree to which the GP’s investment strategy and operations are aligned with an individual LP institution’s ESG policies, including how ESG is factored into due diligence as well as incident disclosures and performance reporting. The policy should identify procedures and protocols that can be verified and/or documented, rather than a vague commitment of behaviour”. The ILPA Principles also includes “incidents presenting potential breach of ESG policy or code of conduct” in the list of notifications that should be provided to LPs on occurrence or disclosed upon request.

Limited Partner Advisory Committee:
The ILPA Principles propose a list of matters which fall under the mandate of the LPAC, including “Reviews of any material ESG incidents and/or risks to the fund’s portfolio” and includes “ESG reporting” on the list of recommended elements of an LPAC agenda (although this is subject to the GP’s discretion).

Figure 8; The role of the LPAC

Expenses Fully Offset or Covered Under the Management Fee:
The ILPA Principles note that, as a general rule, any thirdparty expenses incurred in the provision of services that typically would be provided by the GP to similar funds should be offset against the management fee. ESG-related expenses are included under this rule, and are regarded in the same way as general due diligence consulting costs. It is noted that if specialised consultants are required to fulfil specific LP requirements, any resulting fees should be paid by the requesting LPs.

In places, the ILPA Principles reflect aspirations as well as existing market practice for fund governance. In setting out Principles 3.0, ILPA puts forth that careful consideration of each of these preferred private equity terms and best practices will result in better investment returns and a healthier private equity industry. ILPA outlines it is “imperative to the health of the private equity ecosystem that market actors adhere to the highest ethical and professional standards, deal fairly and honestly, invest responsibly and act with integrity and transparency”.

ILPA has also incorporated responsible investment considerations into their core reporting guidance documents:

Due Diligence Questionnaire:
The ILPA Due Diligence Questionnaire (DDQ) standardises the most frequent and important diligence questions posed by investors. Under Section 10, the ILPA DDQ incorporates the PRI Limited Partners’ Responsible Investment Due Diligence Questionnaire as the industry standard for ESGrelated fund due diligence.

Portfolio Company Metrics Template:
The ILPA PortCo Metrics Template proposes an efficient and comprehensive format for reporting details about individual companies held by an LP’s fund investments. It includes a voluntary ESG section, which is aligned with PRI’s own work on ESG reporting over the lifetime of a fund. If the GP is following PRI guidelines on reporting, they should have the suggested “framing” data for each portfolio company in place. For example: Does the company have an ESG/ sustainability policy? Is it being monitored on ESG by the GP? Is there a resource in place at the portfolio company to implement the policy?

Module III: Investment processes

The PRI has developed dedicated resources to support LPs and GPs with incorporating responsible investment considerations across three investment stages: fund due diligence, fund commitment and fund reporting.

Figure 9; Three Stages of Private Equity Investment Process

Fund due diligence

An LP is a passive partner in the management of a fund. After an LP has committed capital to a fund, the GP has sole discretion for investment and ownership decisions. Therefore, before investing in a fund, an LP should assess the degree to which a GP has clear policies, strong governance systems and sufficient resources in place needed to integrate ESG considerations into its investment practices. Prior to investing, an LP should also discuss ESGrelated disclosures that the GP will provide during the life of the fund.

An LP may consider investing with a GP that does not provide adequate responses during the due diligence process if they believe the GP has the willingness and capacity to elevate their efforts during the life of the fund. In such cases, recognition by the GP of the importance of ESG issues and/or a formal commitment to improve its approach to responsible investment, and report on its progress to the LP, might be expected before making a capital commitment to a fund.

Beginning Due Diligence
A GP’s Private Placement Memorandum, Offering Memorandum, or any introductory marketing materials may allow an LP to establish whether a GP’s fund mandate addresses ESG considerations.

LPs may want to review any publicly available information on the GP’s approach to responsible investment at this initial stage or, if the GP is a PRI signatory, LPs can review their latest public Transparency Report on the PRI website. Initial stages might also include consideration of the investment approach or process undertaken by the GP; for instance, does the fund target specific sectors or geographies that are associated with specific ESG risks such as energy or utilities.

Detailed Due Diligence
The PRI recommends that LPs use the PRI Limited Partners’ Responsible Investment Due Diligence Questionnaire as a starting point for assessment. The PRI proposes this questionnaire as a standard format for ESG due diligence and it has been incorporated into the ILPA Due Diligence Questionnaire. The DDQ is not intended to be used as a checklist, but as a tool to establish dialogue and that the approach used might depend on the GP’s strategy, size, experience and resources. The questions or responses may form a basis for engagement, either pre- or postcommitment and GPs have reported that receiving feedback from an LP on the answers provided in the DDQ would be helpful. The PRI DDQ has an accompanying guidance document which guides both LPs and GPs on how to enhance discussions during due diligence.

Considering the diverse nature of the private equity asset class, an LP should also discuss with the GP how their approach to ESG integration is influenced by their investment strategy, by establishing responses to the following types of questions: How does your approach to integrating ESG factors vary depending:

• On whether you make a minority or control investment?
• Upon the sector or stage of company growth cycle that you might target?

Different funds will have different exposures to ESGrelated risks and opportunities, and different GPs will have different capacities, leverage and management approaches for addressing ESG issues. An LP should take these considerations into account when assessing the GP’s responses to the LP Responsible Investment DDQ and during the ensuing dialogue. 

Fundraising cycles
Private equity is a relationship-based business and GPs typically rely on existing investor relationships when raising successor funds. Private equity funds, on average, return to market to raise successor funds three to four years after closing a predecessor fund. Many typically secure capital at the same rate as deploying it.¹⁰ This may present a challenge to LPs looking for prior examples of how the GP has fulfilled their responsible investment commitment in prior funds.

Incorporation into operating plans 
The post-transaction plan, typically called the “100day plan”, is a critical period to determine whether the investment evolves from potential to performance. It is also an excellent opportunity for material ESG risks and opportunities to be prioritised. However, ESG issues that are not immediate concerns may be integrated into the longerterm business strategy for the portfolio company. LPs should seek to understand the GP’s approach to integrating ESG into both plans.

Emerging markets vs developed markets
An LP should consider factors specific to emerging markets such as:

• 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.
• There may also be differences in the regulatory regimes for ESG issues requiring compliance above legal requirements.

While emerging markets may have risks not common in developed markets, GPs investing there may also have more experience with ESG factors. Development finance institutions (DFIs), for example, play an important role in the emerging market LP community. DFIs have historically used detailed ESG-related performance requirements and engaged with GPs on ESG factors and are often regarded by other LPs as an anchor investor in the fund. The presence of a DFI may give a level of assurance that ESG factors are being duly considered by the GP.

Different Private equity structures
Below are three common private equity structures with ESG considerations. This is by no means exhaustive but serves to demonstrate the different implications for the due diligence process.

Figure 10; Considerations for select private equity structures

Funds of funds	Secondaries	Co-investments
Funds of funds are typically wellresourced and very experienced at investing in private equity, and therefore have the potential to more effectively oversee and influence a GP’s approach to ESG integration. When investing in a fund of funds, an LP should have assurance that there is a thorough process in place to assess and monitor the underlying funds on their approach to responsible investment. An LP could ask that the fund of funds manager uses or completes the LP Responsible Investment DDQ as a basis for ESG due diligence on the underlying funds or during fund raising.	ESG due diligence can be undertaken on underlying portfolio companies prior to investment because, unlike a primary fund investment, – where capital is committed to a blind pool– the portfolio is already known. When investing in PE secondary funds, an LP should have assurance that there is an appropriate process in place to screen for any material ESG risks before the secondary fund acquires stakes in existing portfolios, and that the secondary fund has a process in place to monitor its underlying investments on ESG risk. An LP could also ask secondaries fund managers to complete the LP Responsible Investment DDQ during fundraising (noting that Section 3 may not be applicable).	Co-investments give an investor increased direct exposure to both the upside and downside of a private investment, and offer a greater level of insight and direct influence over ESG integration. The LP may participate directly in the due diligence process, may be able to appoint a board member and have better access to portfolio company information.

Fund commitment and terms

The Limited Partnership Agreement (LPA) and associated legal documents outline the fundamental terms governing the operations of the fund, including the rights and responsibilities of the parties. In addition to partnership economics, the LPA covers several important aspects affecting the alignment of interests between the LP and the GP, such as control and governance, conflicts of interest and transparency. LPs are increasingly seeking a more formal, structured and binding approach to ensure their own understanding of the GP’s commitments to responsible investment is upheld.

Whilst some GPs will include ESG provisions in their fund terms as standard, others may not do so unless requested by LPs. However, a lack of consistency in requests from LPs results in a proliferation of side letters, which are difficult to manage and prolongs negotiation. If external counsel is not adequately briefed or is unfamiliar with the LP’s RI objectives, this may result in ESG provisions being simplified, misinterpreted or diluted. The PRI has provided guidance on incorporating RI guidance into PE terms. Published in 2017, the guidance identifies current and emerging best practice, as well as potential constraints, and offers practical options to LPs and GPs reconsidering how they might incorporate responsible investment into fund terms.

Despite constraints, if a GP has made a formal commitment to responsible investment then it can be argued that they should be prepared to reflect this in the fund terms. It demonstrates the seriousness of the GP’s commitment and should assist the GP to achieve systematic uptake of ESG by the whole firm.

Though unusual, some LPs have negotiated separate side letter agreements with certain investors. This can be made available to other LPs in the fund through the most favoured nation provision found in many LPAs, though it may only be available to those with the same or greater levels of capital commitment. There is a range of approaches to this in the market and the PRI guidance outlines the advantages of either approach.

Figure 11; PRI guidance and Legal opinion benefits¹¹

Bespoke provisions (such as on reporting requirements, certain investment restrictions or opt-out provisions) could be negotiated with the specific LP through a side letter and renegotiate if required.

Whichever approach is taken, ESG provisions could be split into these overlapping categories to inform dialogue with external counsel:

• Commitments to ESG policy or standards, and compliance with ESG-specific regulation
• Investment restrictions, and/or excuse or opt-out rights
• Investment decision-making processes
• Providing ESG reporting and incident reporting to investors

Module IV: Investment processes

This Module summarises the guidance in PRI’s ESG Monitoring, Reporting and Dialogue in Private Equity guide. which aims to:

• Support LPs in developing their own monitoring practices and enhance their effectiveness
• Support GPs to anticipate and respond to increasing ESG-related monitoring requests from LPs
• Help facilitate dialogue and improve understanding between GPs and LPs on the topic of ESG disclosure through case studies and good practice examples

Many funds establish an LP Advisory Committee (LPAC) to enable a GP to effectively engage and communicate with LPs with overall responsibility for decision-making remaining with the GP. LPs often monitor GPs on ESG integration to better understand portfolio operations and to gain assurance that the GP is fulfilling its commitments to responsible investment practices made during all stages of the investment, fundraising and exit process. This mechanism might be through the LPAC.

As private equity is a trust-based system, LPs rely on GPs to monitor ESG issues within the portfolio, and furthermore that the responsibility and knowledge to manage these issues lies largely with the portfolio company management. But as stewards of their capital, LPs are entitled to monitor GPs’ performance in line with their responsible investment strategies and beliefs.

Preparing to monitor 

When preparing to monitor a GP, LPs may want to consider:

• Purpose - What information do I need to monitor ESG within my fund(s)’ portfolio(s)? Why is it important; What ESG information matters to my stakeholders?
• Frequency – what reporting frequency do I require from the GP?
• Feasibility - Is the ESG information requested unique? What additional resources might be required?
• Impact - How will the information be used for future investment decisions? What feedback will I provide to GPs?
• Change - How might expectations have changed since making the fund commitment?
• Published information - How will the information be published and reported?

Key monitoring practices

Eight key LP monitoring practices emerged as recurring themes during the research for the PRI-ERM guidance and during the research for this guide. These themes cover:

1. Exception-based reporting
   For more static information, some LPs would prefer that the GP reports any changes on a by-exception basis rather than on a regular schedule.
2. Using the LPAC and the Annual Investor Meeting
   LPs may use governance structures already in place to monitor GPs on ESG integration. This practice has the added advantage of engaging other investors in the fund on the topic of ESG integration.
3. Using monitoring templates
   Some LPs and funds of funds send proprietary standardised reporting templates annually to their GPs. This allows them to consistently collect information and track progress.
4. Assessment and scoring of GPs
   In assessing GP practices, many LPs use the information disclosed to them to rate or rank GPs annually on their ESG practices.
5. Using the PRI Reporting Framework
   PRI Reporting Framework combines mandatory and voluntary reporting. LPs can request a GP’s private Transparency Report and Assessment Report.
6. ESG incident monitoring
   Most LPs expect to be notified by their GPs in an open and timely manner about incidents that could have serious reputational or financial implications for their organisation.
7. Reviewing GPs’ internal ESG/CSR management and initiatives
   Some LPs monitor GPs on their internal commitment to management of ESG issues or corporate responsibility.
8. GP Feedback
   GPs have emphasised the value of having LP feedback on the ESG information that they report to give them a better understanding of their performance, support internal objective-setting and help them to better understand the LP’s responsible investment objectives and priorities

Underlying all these themes is the importance of dialogue; whether this is through systematic tracking, in-person dialogue, LPAC, through investment consultants or a deep-dive discussion into specific ESG issues or material incidents. 

Monitoring and reporting framework

The PRI has published extensive guidance on monitoring and reporting¹² ESG issues. The main areas are covered in the figure below.

Figure 12; ESG Disclosure Framework for Private Equity

There was also an industry initiative in 2013 which provided a broad framework for disclosure. This is outlined in figure 13.

Figure 13; ESG Disclosure Framework for Private Equity¹³

Principles of disclosure
The PRI has identified some principles that may guide disclosure of ESG performance that LPs might make to GPs. These include:

• Reporting on a ‘whole fund’ basis.
• Alignment with existing financial reporting cycles.
• Disclosed information should be; accurate & credible; balanced & objective; comparable & consistent; complete & timely.
• Clear allocation of responsibilities and oversight for ESG reporting.
• Built on GP/LP dialogue to reflect changing LP reporting requirements.

There are other initiatives that cover monitoring and reporting. These include frameworks on disclosure from ILPA and PRI.

Figure 14; PE reporting initiatives 

ESG considerations for exit strategies

Addressing ESG issues throughout the investment cycle can reduce the risks and enhance company value at exit.

• Identification and management of material ESG issues reduces the possibility a buyer will negotiate a lower price due to unforeseen risks
• Setting KPIs at the beginning of the holding period generates data to track improvements
• Thorough management of ESG issues can indicate a well governed business

In the case of an IPO exit, public market expectations for shareholder rights, board structure and ESG reporting have developed and better management of ESG issues during private ownership can help reduce issues during the IPO. For a trade exit, sound ESG management - ideally in line with the trade buyer’s own standards - of a potential acquisition can increase the incentive for a deal. Integrating poor ESG performers can be burdensome for buyers with established corporate ESG practices and policies. On the other hand, good ESG performers can be seen to contribute to intangible corporate assets such as reputation and brand.¹⁴

Figure 15; PRI snapshot – exit strategy benefits