Shervin Shameli, Partner at Reed Smith, explains how ESG considerations for private funds are rapidly evolving from standards and disclosures to compensation.
In the not-too-distant past, socially responsible fund management in the private equity sector often consisted of general partners (GPs) implementing investment processes such as screens to prevent investments in certain ethically ‘undesirable’ areas such as those linked to gambling, tobacco or weapons. However, over the last decade, limited partners (LPs) have increasingly encouraged GPs to take a more comprehensive and wide-ranging view of responsible investing.
Some traditionalists, in both industry and finance, argue that focusing on sustainability may come at the expense of running a profitable business. As a result, much has been made of a younger generation of personnel rising through the ranks of institutional investors and family offices, pressuring GPs into a greener outlook on their investment activities. Studies confirm that there is a generational divide at play: a recent study by forex broker HYCM found sustainable investing was important to 60% of investors aged 18–34, but to only 30% of those aged over 55.
However, other factors have been equally important. Public attitudes to, and awareness of, issues such as climate change have advanced significantly in recent years. Regulatory changes (such as EU and UK ESG disclosure rules), pressure from international organisations (e.g., the Task Force on Climate-related Financial Disclosures) and governments have also had an impact: it was over 20 years ago that former UN Secretary General Kofi Annan announced the UN Global Compact – encouraging businesses and firms to adopt sustainable and responsible business practices – at the World Economic Forum.
Recent studies show that the majority of professional investors now hold ESG factors to a similar level of scrutiny as financial, operational and reporting considerations when undertaking due diligence on funds. LPs are now willing to walk away from investments if they sense deficiencies in a GP’s approach to ESG. As a result, GPs that do not have demonstrably applied ESG policies with appropriate levels of disclosure (on how they and the fund impacts ESG and how ESG impacts them) are at risk of being forced to the back of the capital-raising queue, even if their funds do not have ESG as part of the core strategy.
Incorporating industry standards from fund inception
Key challenges raised by GPs include the lack of a uniform framework for evaluating ESG credentials and the absence of alignment between regulatory bodies. Recent developments of industry-wide standards should now give GPs a better toolkit for implementing ESG considerations into their decision-making processes and investor reporting.
Many GPs already adopt standards consistent with a recognised code of conduct, such as the UN Principles for Responsible Investment. GPs can now also use the framework for ESG investors that the Institutional Limited Partners Association (ILPA) issued in 2021 to further develop their investment process and reporting packages. ILPA’s framework gives a standardised structure by which investors can evaluate and benchmark GP practices regarding ESG matters and has found its way into many an LP’s due diligence checklist. By incorporating these industry standards into the fund’s investment thesis from inception, a GP will not only more easily demonstrate its ESG commitment, but also potentially avoid being in the unwanted position of negotiating various LP-specific side letter disclosures and other ESG-related provisions.
ESG disclosure regulations
GPs also need to deal with key ESG-focused regulations, such as the EU’s Sustainable Finance Disclosure Regulation (SFDR), which requires financial market participants and financial advisers to provide investors with certain ESG-related information in connection with the provision of financial services and the marketing of certain financial products. Alongside SFDR, the EU Taxonomy Regulation introduced a framework for an EU-wide classification system for ESG-related investments to help investors identify the extent to which an economic activity is ‘sustainable’.
While the SDFR and the Taxonomy Regulation have not been implemented directly in the UK, they remain relevant for UK managers marketing funds to EU investors. The UK Financial Conduct Authority introduced a climate disclosure regime for large asset managers in January and has announced measures to establish a green taxonomy and ESG disclosure regime for a broader category of asset managers and owners, which will be similar to but not the same as the EU SFDR. Regulators have focused much of their attention on the ‘E’ component of their ESG disclosure rules. Setting clear standards and benchmarks for the ‘S’ and ‘G’ components will be important to establish a uniform approach, which will make comparisons meaningful and understandable to investors.
The regulations are complex and GPs need to ensure that they balance complying with the rules against over-emphasising their ESG credentials to the extent that they are accused of ‘greenwashing’: unsubstantiated or exaggerated claims that an investment is environmentally friendly. GPs should take professional advice to help them establish whether they are within the scope of any of the new disclosure requirements and the steps they need to take to comply with them.
The future: ESG-driven compensation?
Much of the existing focus on ESG links to a GP’s investment decision-making and disclosure process. Some LPs argue that a GP that undertakes to deliver an ESG impact should align its carried interest with achieving that impact. As a result, a new trend is emerging that links ESG performance to GP compensation, particularly if the investment policy of the relevant fund has ESG as a core objective. One example is where a GP forfeits a percentage of its carried interest if it fails to achieve predetermined ESG-based targets. Another is where a GP’s carried interest only becomes payable after a hurdle which includes both a financial return element and a specific ESG-based element, such as achieving a certain percentage reduction in an underlying investment’s carbon emissions.
There are challenges in implementing this concept on a practical level, not least setting effective targets and implementing a system to measure performance against those targets. This is still a developing area, but GPs should be prepared for LPs adding this item to their list of due diligence and commercial requests in the near future, especially for more impact-focused funds.
This article was co-authored by Karen Butler, Partner, and Matthew Evans, Counsel, at Reed Smith.