Role

Due diligence and its implications

Before committing to a fund, most LPs assess the GP’s performance history, legal terms, governance structure, and market and operational risks. Incorporating ESG due diligence should be part of every LP’s responsible investing process. By integrating ESG-related due diligence into its manager selection processes, the LP aims to achieve the following:

• Establish clear expectations and an alignment of investment strategy with the GP.
• Demonstrate the weight of its approach to responsible investment.
• Gain assurance of the GP fs ESG risk mitigation processes.
• Understand any reputational risks to the LP and its beneficiaries’ interests on specific ESG issues.
• Make better investment decisions and enhance investment value consistent with its fiduciary duties or investor obligations, where applicable.

The PRI, in consultation with its signatories and industry association partners, has published the PRI Limited Partners’ Responsible Investment Due Diligence Questionnaire and accompanying guidance And How To Use It as the industry standard for LP ESG-related due diligence. It contains an adaptable list of questions designed to enhance LP-GP dialogue on responsible investment and streamline the reporting burden placed on GPs. The GP may have also defined its approach to responsible investment through its Private Placement Memorandum (PPM).

Therefore, when it comes to commitment, the LP should already have a clear idea of the GP’s approach or intentions towards responsible investment which may determine the emphasis placed on ESG provisions in the negotiations on the fund terms. Likewise, the GP should hopefully have a clear understanding of the LP’s expectations and will anticipate the importance that the LP will place on ESG provisions in the negotiations.

“At Adveq we have established a responsible investing due diligence framework for evaluating prospective fund investments. We use this framework to assess a manager’s adoption of ESG principles, which is important to us as an organisation. The outcome of this assessment then frames our investment decision-making, as well as the negotiation of formal ESG terms and conditions in the legal documents and our responsible investing expectations of the manager going forward.”

John Atherton, General Counsel Private Investment Structures, Adveq

Incorporating ESG provisions in fund terms

GPs have discretion over investment decision-making and ownership activities (usually within pre-agreed investment criteria) for both legal and practical reasons. An LP typically invests in funds on the basis of a GP’s ability and judgement, and an LP that contributes to the management of the fund beyond being consultative in nature may undermine its limited liability status. However, an LP will want to understand how investment decisions are going to be made during the lifetime of the fund and to place some parameters around how its capital can be invested.6 The objective of ESG-related provisions in fund terms is to formalise these parameters with the GP and give the LP greater transparency on the operations of the fund.

“With regard to our clients, we believe there is a direct correlation between responsible investing and performance, and we work closely with our clients to ensure that their own responsible investment requirements and policies are met as we build their private markets portfolios. On the GP side, we routinely incorporate ESG-related questions into our overall due diligence questionnaire to analyse responses alongside every other part of an investment opportunity. In addition to the potential benefit of incorporating ESG provisions proactively, there is also major risk to those managers that ignore ESG. So while ESG provisions perhaps used to be seen as burdens to investors, today they are increasingly being seen as a positive that can help mitigate risk.”

Janet Bauman, Managing Director – Fund Investment Team, Hamilton Lane

Ideally, the GP would have a responsible investment policy prepared before fundraising and would have considered how this policy could be appropriately reflected in the fund terms. If a GP does not refer to responsible investment principles, considerations or processes in the first draft of the LPA, the PPM or as part of its due diligence materials, it will be up to the LP to raise the issue with the GP before committing to the fund.

Whether or not the first draft of the LPA contains any ESG-related language, the LP will review the document and negotiate ESG-related provisions with the GP based on its own ESG expectations of its managers and in alignment with its own responsible investment policy. It is important that LPs identify these expectations as early as possible. See Section 3 for an overview of how LPs can formulate their responsible investment expectations of managers in the fund terms.

The process of negotiating with the GP can often result in either the LPA being amended or the GP granting specific ESG provisions in a side letter to that particular LP before its admittance to the fund.7 See Section 2 for a discussion on the placement of ESG provisions in the LPA versus a side letter.

“Since we truly believe that the integration of ESG issues into investment evaluation and governance is an important part of the value creation in any investment, the approach of a GP to responsible investment is always part of our due diligence ahead of committing to a fund. This is in order to ensure that the GP has reached a sufficient maturity and, even more importantly, has an ambition to continuously evolve in that area. “To us, the willingness of the GP to include appropriate ESG provisions in side letters or, preferably, in the LPA is an indication of the GP’s comfort in its internal ESG processes and an important statement of the GP’s intent going forward in what we normally expect to be a long-lasting business relationship.”

Jonas Lidholm, General Counsel, Sixth Swedish National Pension Fund (AP6)

Current market practice and constraints

Before elaborating on how to incorporate ESG provisions into fund terms, it is important to consider that this in not yet standard practice, even for PRI signatories that are considered to be industry-leading. The 2017 PRI reporting data, based on submissions from 219 LPs and 332 GPs on their responsible investment progress, indicates that 63% of PRI LP signatories consider responsible investment in their appointment of private equity managers, whereas 39% of PRI GP signatories are not making commitments to responsible investment in their fund terms, or are not being asked to do so by investors.

“Whilst many sponsors have taken significant steps in recent years to integrate ESG considerations into their investment processes, the perception of a number of investors is that, in general, they are only prepared to enter into relevant contractual undertakings in vague terms during the negotiation of fund commitments. This often results in individual investors requesting agreement to their own particular ESG provisions (sometimes verbatim), which is challenging for sponsors. “Achievement of a critical mass of support on both the sponsor and investor side for an independent, principles-based and proportionate ESG framework would be helpful in moving the conversation forwards.”

Amala Ejikeme, Partner, Kirkland & Ellis

This corresponds with findings from the 2017 ESG Research Report by MJ Hudson and Allenbridge, which notes low levels of ESG references in the latest LPAs and PPMs according to the data held by the LP Unit MJ Hudson. The research identifies a link between the quality and maturity of a GP’s publicly available responsible investment policy and the probability of a reference to ESG in its PPM and/ or LPA. Furthermore, ESG references are more commonly found in the PPM rather than the LPA, suggesting that the former is easier for GPs to facilitate (as the PPM is not a legally-binding agreement in the same way as the LPA). Interestingly, not all GPs with reference to ESG factors in the LPA will have made similar references in their PPM.

On the investor side, the research report finds a surprisingly high proportion of investors that do not make ESG requests through side letters. Equally surprisingly, it also notes that most of the LPs analysed do not make use of the most favoured nation (MFN) process to elect ESG provisions that have been negotiated by their fellow investors in the fund, thereby missing the opportunity to strengthen their ESG impact.

“There is currently little contractual footing for LPs, suggesting that ESG integration in private equity funds remains an aspirational endeavour. Our prediction is that the picture will look very different in as little as five years’ time and that ESG policies will be front and centre in LPAs.”

Eamon Devlin, Managing Partner, MJ Hudson Law

The mandating of responsible investment activity through fund terms may therefore be understood as a fairly recent and relatively advanced practice, and not yet widely used within the global LP community. Although this guidance has been developed with this in mind, it anticipates a near future need for comprehensive guidance on this aspect of responsible investment in private equity. As LP and GP recognition of the role of ESG integration evolves, there is growing appetite to understand how fund terms can be adapted to reflect this.

A wider uptake is however impeded by the following typical constraints or arguments:

• The level of responsible investment incorporation in fund terms will often be influenced by the capacity and relevant experience of the GP and, to some extent, the size and strategy of the fund, as well as the position taken on responsible investment in previous funds.
• The realities of negotiating a competitive fund situation can make it difficult to properly prioritise ESG-related provisions. Clear communication is needed across all members of the negotiating team to ensure that the LP fs aims are reflected in the ultimate formulation of these provisions.
• ESG integration in private equity is at an early stage of industry implementation and GPs may be reluctant to commit to any policies or processes that may be subject to significant change during the life of the fund. The GP may be concerned that such commitment would reduce the flexibility it has to moderate its ESG policy or reporting practices as market practice adapts over time.
• ESG integration is driven by the commercial nature and goodwill of the LP-GP relationship and some GPs will view contractual obligations on ESG policy or associated reporting commitments as unnecessary.
• Some responsible investment language may be viewed as incompatible with the glegally enforceable h language in the LPA as it can be principle-driven or value-based.

However, as GPs and LPs seek to increase their integration of responsible investment into the ordinary course of operations, both are likely to benefit from establishing clear expectations around ESG considerations within the fund terms. LPs are likely to embrace proactive approaches by GPs that demonstrate that their responsible investment policies are also reflected in fund terms.

“It is important to move towards more clarity on expectations in relation to responsible investment, and to acknowledge the growing interest that investors have in ESG provisions. Legal advisers can play an instrumental role in guiding clients to seek best practice outcomes.”

Matthew Judd, Partner, Ropes & Gray

“As part of our systematic due diligence process, SWEN CP always negotiates ESG provisions through side letters before committing to a fund. In most cases, it is a very constructive negotiation. It can become a lot more challenging when considering oversubscribed funds who will typically delegate negotiations to external counsel. If external counsel is not adequately briefed or is unfamiliar with the LP’s responsible investment objectives, their tendency will be to homogenise ESG provisions in order to simplify the MFN process. “A key objective should be to raise awareness on ESG integration and its challenges within the legal sector beyond a few leading firms, so that they are better able to negotiate on behalf of LPs.”

Isabelle Combarel, Managing Director, Head of Business Development & ESG, SWEN Capital Partners

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  Incorporating responsible investment requirements into private equity fund terms

  July 2017