Authors
Keira McKee
Environmental, social and governance (ESG) considerations in the private fund space will continue to warrant the attention of fund sponsors as they grapple with a) increasing ESG requests from investors, b) patchwork ESG standards and measures and c) the ESG benefit debate (including the U.S. anti-ESG movement). We suspect that ESG-related diligence, disclosure and undertakings of the sponsor are likely here to stay (and will continue increasing); however, as the debate continues in respect of any potential trade-off in investment returns as a result of a focus on ESG-related metrics, fund sponsors (and institutional investors) will be challenged to determine how best to manage.
A solid framework and plan, together with a streamlined process-based approach, can help fund sponsors (and institutional investors) navigate the continuously evolving ESG landscape.
Over the past several years, there has been increasing pressure on fund sponsors to consider and diligence ESG criteria when making portfolio company investment decisions. This increasing pressure has been predominantly driven by institutional investors, particularly pension plans, with internal objectives, mandates and requirements to advance ESG policies and commitments.
More than two-thirds of institutional investor respondents to a recent survey conducted by the Institutional Limited Partner Association (ILPA) and Bain & Company indicated that ESG considerations play a part in organizational private equity investment policies, with approximately 85% of such investors indicating that their policies include at least some ESG initiatives, with 52% having fully implemented ESG-specific policies and 33% having partially implemented such policies1. These ESG policies inform and guide investment decisions and dollar allocations, making ESG an important consideration for fund sponsors who are seeking to attract these investment dollars. As a result, many fund sponsors have recently begun, or have continued to, figure ESG considerations more predominantly into their investment strategies.
Furthermore, as institutional investor ESG policies have developed, investors are seeking more robust, disclosure-based commitments from the funds in which they invest. Fund sponsors are challenged with addressing these requests while ensuring these requests are operationally and strategically achievable over the short-term and the long-term.
Specifically, institutional investors are more commonly seeking the following types of commitments from fund sponsors.
These requests are heavily data-driven and require detailed, comprehensive and evidence-based responses from fund sponsors. With fund sponsors committing to various restrictions and thresholds, it can be daunting for them to navigate and track their ESG undertakings, particularly over the long-term lifespan of a fund (e.g., traditional closed-end model is 10 years). Some of these undertakings may be agreed to by some fund sponsors in fund-wide offering documentation (often as a result of investor pressure and/or to attract more capital), while other fund sponsors may keep the ESG-related language broad in offering documentation and investor side letters to maximize flexibility (sometimes while they work on developing their own ESG policies, often in consultation with external ESG experts).
We would also note that, like many institutional investors, many fund sponsors believe ESG diligence and related disclosures have value in serving as an additional lens for assessing investment risk management.
In addition to increasing investor requests related to ESG metrics, fund sponsors are also faced with navigating the surge in domestic and foreign regulatory developments that attempt, in part, to address the lack of a uniform ESG standard.
While many fund sponsors are monitoring ESG performance in some capacity, the lack of clearly defined standards and definitions of ESG among stakeholders continues to make it difficult to quantify, measure and compare ESG performance of a given investment and across investments. This has led to confusion from a) fund sponsors seeking to diligence ESG aspects of investments and b) investors looking to use ESG disclosure received from fund sponsors to assess investment opportunities. There has been a number of voluntary and benchmark frameworks to ESG reporting that have been developed, but the number of such frameworks has in many ways emphasized rather than resolved the nebulous nature of the current ESG standards environment.
This lack of standardization and uniformity has not gone unnoticed, and efforts are underway by regulators and international standard setters to provide clearer guidance on ESG disclosure and monitoring. Some of the international, U.S. and Canadian initiatives to watch include the following.
Certain perceived operational and strategic burdens and costs associated with ESG-related policies and procedures have contributed to a debate (including a predominately U.S.-based politicization) relating to ESG investing. Some argue the added expense of ESG diligence undermines or is incompatible with the fiduciary duties of a fund’s general partner to act in the best interest of the partnership and its partners; however, on the contrary, others believe that fiduciaries must consider material ESG issues when investing.
In respect of the U.S.-based politicization of ESG, this has been largely driven by concerns raised by the political right that ESG considerations undermine fund sponsor fiduciary duties, arguing they are shortchanging returns and financial objectives in favour of climate and social goals. 2021 and 2022 saw several right-leaning states approving legislation, regulations and policies prohibiting businesses from investing with investment managers who have committed to mandates that restrict investments in certain markets, such as fossil fuel companies.
For instance, in December of 2022, Florida divested $2 billion from BlackRock, Inc. for, in their view, focusing too heavily on ESG at the purported expense of investment returns. Shortly after this, Florida on January 17, 2023, formalized policies and guidelines that prohibit the state’s investment fund sponsors from considering ESG factors when investing state pension funds. These regulations appear to be at odds with the U.S. Department of Labor’s new rule, the “Prudence and Loyalty in Selecting Plan Investments and Exercising Shareholder Rights”, which allows Employee Retirement Income Security Act of 1974 (ERISA) plan fiduciaries to consider climate change and ESG factors when making investments of retirement funds to the extent those factors are relevant to a risk-and-return analysis of the proposed investment. Although the rule came into effect on January 30, 2023, there are currently judicial and legislative efforts to invalidate the rule.
While this level of politicization has not made its way north of border, and many in Canada believe in the value creation of ESG risk assessment, in Canada (and worldwide) the debate in respect of any potential trade-off in investment returns as a result of a focus on ESG-related metrics persists—and it is becoming increasingly difficult and complicated for fund sponsors to remain neutral as they look to appease a diverse base of current and prospective investors in the short and long term.
The current efforts underway to increase the uniformity of ESG requirements may help minimize the abundance of requests from investors as investors gain a clearer picture of what is and is not required.
As ESG considerations continue to evolve, fund sponsors will likely be under increased scrutiny about their ESG practices, efforts, processes and reporting. Here are some tactics that may help guide fund sponsors when faced with burgeoning requests, regulations and uncertain political dynamics.
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