King & Wood Mallesons
Mark McNamara, Mark McFarlane, Michael Barker, Jason Watts,
Lee Horan and Alex Elser
European Union, USA
December 11, 2013
Many private equity sponsors are now proactively managing the environmental, social and governance (ESG) risks in their investment portfolios. This greater focus results not only from a desire to undertake sensible risk management but also from the realisation that such an approach can increase the underlying value of their portfolios. Some private equity sponsors are even going the step beyond and using proactive responsible investing as a way to differentiate themselves in the fundraising market.
In this article we highlight some of the market-leading practices in relation to responsible investing, outline what constitutes responsible investing and the benefits of taking active steps to address ESG issues, and discuss some of the challenges for private equity sponsors in quantifying and reporting on the benefits of their responsible investing programmes.
What is responsible investing?
‘Responsible investing’ refers to the incorporation of ESG issues into investment decision-making and ownership practices. It differs from so-called ‘ethical investment’. Ethical investment is a deliberate strategy of investing for the social good. It often involves applying an ethical screen to investment decisions and investing only in certain sectors or companies that are seen to be socially beneficial (or not investing in other ‘not socially beneficial’ sectors or companies).
In contrast, responsible investing involves an investor making investment decisions primarily with a financial motivation but also incorporating ESG considerations into the investment decision-making process and the way in which it then manages the investment under its ownership.
The drivers of responsible investing in the private equity industry
George Roberts, co-founder of Kohlberg Kravis & Roberts (KKR) stated at the 2012 Private Equity International Responsible Investment Forum, “ESG activity is more important than it’s ever been, and it is going to continue to get more important… it’s the right thing to do, it’s good for business, its profitable and your investors like it. I think you’ll see more firms do this…”
- LP requirements: investor interest and, in some cases, absolute requirements. Many public pension funds now have fixed requirements that the funds in which they invest adequately address ESG issues in their investment programmes.
- Fundraising: way to differentiate a new fund in the competitive fundraising market.
- Risk management: the cost of an ESG-related incident at a portfolio company can be high, especially when indirect costs such as remedial actions, higher insurance fees, manufacturing stoppages and loss of working time and reputational damage are factored in.
- Cost-savings: through ESG initiatives which both improve operations and performance and reduce use of resources such as power, water and fuel.
- Value creation: new products and innovation designed to address social and environmental needs:
o growth in customers or market share as a result of enhanced reputation and greater public support; and
o supply chain improvements; and
o ability to secure sustainable access to high-quality manufactured raw materials and inputs by engaging with suppliers on social and community issues; and
o possibility of enhanced valuations and exit attractiveness.
- UN and industry principles: in 2006 the United Nations-backed Principles for Responsible Investment (UNPRI) were formulated. Since that time, over 1100 institutional asset owners, investment managers and professional service partners have signed up to the UNPRI – including a large number of private equity sponsors from Europe, Asia and the U.S. The catalyst for this has been, in no small part, the growing interest shown by investors in ESG issues. In addition to the UNPRI, many industry associations, including the Private Equity Growth Capital Council and British Private Equity & Venture Capital Association (BVCA) have adopted guidelines on responsible investment which inform the practices of their member private equity sponsors. The Australian Private Equity & Venture Capital Association was involved in the development of the UNPRI and the ESG Disclosure Framework and has urged Australian private equity sponsors to sign-up to the UNPRI.
Current Market Practices
Despite the UNPRI principles being adopted in 2006, the investing practices of a significant number of private equity sponsors have really only started to evolve meaningfully more recently.
The leading current approaches to responsible investing are strategic, structured and documented. Optimally, ESG issues are addressed at all stages of the investment cycle and not just at the time of making an investment.
That said, there remains a lot of diversity in the responsible investing practices of private equity sponsors reflecting the sponsors’ fund size, market position, limited partner requirements, geographical and sectoral areas of operation and internal capacity.
- Compliance with environmental laws
- Environmental risk management
- Environmental track record
- Chemical use
- Production of effluents and emissions
- Resource conservation and water use
- Waste management
- Land use
- Land clearance and impact on
- Compliance with local labour laws
- Health & safety track record
- Impact on local communities
- Use of child labour and other
- Minimum wages
- Human resources
- Sensitive local or cultural issues
- Use of security forces
- Anti-corruption and bribery measures
- Accounting and compliance
- Corporate governance structure
- Controls and risk management
- Transparency and disclosure
- Treatment of the broader group of stakeholders, including community members
The aspects of the leading current approaches to ESG management include:
- Policies and procedures: A formal responsible investing policy and supporting procedures. These are seen as important features for fundraising and implementing a private equity sponsor’s commitment to responsible investing and enabling it to meet investor expectations for monitoring and reporting. Many leading private equity sponsors have also developed standardised internal documentation for their deal teams (and portfolio companies) to facilitate best practice across their investments. These include such documents as due diligence checklists, sample codes of conduct and supplier assessment checklists.
- Pre-acquisition due diligence: In the U.S. and Europe, the vast majority of medium to large private equity sponsors consider ESG issues as part of their investment decision-making process. To support this process, a number of sponsors have specific ESG due diligence frameworks which are followed for their investments.
- Investment committee review: A number of sponsors now include ESG considerations (including any ESG ‘redflag’ issues identified in due diligence) as mandatory items in the investment committee approval process.
- 100 day plan: ESG issues identified in pre-acquisition due diligence should be included in the portfolio company’s 100 day post-acquisition action plan. Ideally, agreement on any required ESG plans should be reached as soon as practicable with the portfolio company’s management, both so that action items can be explicitly identified and so that baseline performance (and the metrics by which progress will be judged) can be determined.
- Establishing long-term action plans and targets: Some private equity sponsors are now setting yearly and longer term goals for their ESG programs and reporting on their progress against those goals. Some have also been encouraging their individual portfolio companies to implement their own ESG management plans and review their operations against those plans and relevant guidelines.
- Deal team training: Many private equity sponsors are now conducting training for their deal teams so that they can ensure the integration of ESG considerations into their investment decision-making. The BVCA’s responsible investment guidelines recommend that deal team training should include ‘an understanding of where a higher level of expertise is required – that is, when to bring in a competent ESG professional – which should not only be confined to situations where the law requires it’.
- Portfolio programs: Several of the leading global private equity sponsors (including KKR, Blackstone and Carlyle) have established ESG programs for their portfolio companies. For example, KKR’s ‘Green Portfolio Program’ is an operational improvement program through which KKR portfolio companies strategically measure and manage their key environmental impacts and commit to strategies to reduce those impacts. KKR has also implemented an employee wellness program across a number of its portfolio companies.
- Knowledge sharing between portfolio companies: TPG, Blackstone, KKR and Apollo are among a group of private equity sponsors that have hosted portfolio company events to share knowledge on common ESG issues. At these conferences, portfolio companies have showcased their most successful ecoefficiency initiatives, thereby encouraging the deployment of proven solutions across the firms’ portfolio. Some sponsors have also hosted web-based training events for multiple companies in their portfolio group covering issues such as reporting and communicating ESG issues.
- Communication: Several private equity sponsors are actively communicating their commitment to responsible investing to their relevant constituencies. Many now include responsible investing sections on their websites. Some also have ESG management included in the agendas for their annual limited partner conferences and quarterly updates to limited partners. Several of the larger global private equity sponsors have also more recently started producing detailed annual ESG reports.
- Expertise: Certain of the larger private equity sponsors have formed specialist ESG teams to oversee implementation and reporting of their ESG policies across their portfolios
- Partnerships: A wide range of private equity sponsors have formed partnerships and other forms of working relationships with non-profit environmental and social organisations to develop programmes and resources for their portfolio companies.
Measuring and reporting the benefits of responsible investment
There remains a large degree of variability in the quality of formal ESG reporting. While a majority of private equity sponsors do not publicly provide any information beyond a high level commitment to managing ESG issues, often larger private equity sponsors produce detailed and specific responsible investing reports. Reasons often given for this variability include a limited common understanding of best practices and a nervousness about a lack of formal procedures.
To date, much of the reporting by private equity sponsors on the benefits of responsible investing has also been qualitative rather than quantitative. Qualitative reporting enables a private equity sponsor to track ESG progress both between portfolio companies and over time, as well as at least go some way to satisfy its limited partner’s requirements. However, it does not enable it to easily demonstrate value growth from its ESG activities.
Even measuring the benefits of responsible investing in a meaningful way has proven to be difficult for many private equity sponsors. Identifying metrics to quantify the intangible benefits of certain ESG activities and standardising the measurement of ESG practices is fundamentally challenging. Indeed, simply determining which ESG factors to measure is often a difficult task.
One area where quantitative reporting has proven easier is in the area of eco- efficiencies. Private equity sponsors have been more readily able to calculate and report on both the environmental and financial savings of their environmental focused practices. The Global Reporting Initiative (a non-profit organisation that promotes economic, environmental and social sustainability) has produced guidelines for general sustainability reporting which are proving useful for those sponsors measuring and reporting on such issues.
While the UNPRI has always had a Reporting Framework, until two months ago there was no mandatory public reporting. The most recent changes to the UNPRI Reporting Framework in October 2013 introduced mandatory public reporting for signatories across a limited range of reporting indicators depending on the relevant asset class of the signatory. The UNPRI Reporting Framework comprises both mandatory and voluntary indicators. Signatories only have to complete the modules and indicators that are relevant to their organisation and asset allocation mix. In addition, they only have to complete indicators that are ‘mandatory’ within each module. Not all indicators that are ‘mandatory’ are mandatory to disclose to the public. Unless a signatory otherwise agrees to voluntarily publicly disclose additional responses, only a subset of responses will be publicly published in the individual RI Transparency Report for each signatory on the UNPRI website.
In March 2013 the UNPRI also published the ESG Disclosure Framework for Private Equity (www.unpri.org/whatsnew/3600). The UNPRI states that the ESG Disclosure Framework was “developed to help GPs better understand why LPs want ESG- related information and to help rationalise the types of questions LPs are increasingly asking GPs on ESG”. The ESG Disclosure Framework outlines eight objectives common to many limited partners who want more structured ESG disclosures in relation to their investments and sets out a series of investigative ESG-related questions which limited partners may consider asking private equity sponsors both during fundraising and over the life of a fund.
This article is being provided for informational purposes only and not for the purposes of providing legal advice or creating an attorney-client relationship. You should contact an attorney to obtain advice with respect to any particular issue or problem you may have. In addition, the opinions expressed herein are the opinions of Mr. McNamara, Mr. McFarlane, Mr. Barker, Mr. Watts, Mr. Horan and Mr. Elserand may not reflect the opinions of Synergy Environmental, Inc., King & Wood Mallesons or either of those firms’ clients.