Q2 | Torys QuarterlySpring 2023

Fund sponsors juggling ESG in private market investing

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.

Lauren Hulme (00:05): The business of being a fund sponsor has gained one more layer of complexity over the last several years, with increasing pressure to consider ESG in their investment strategies and operations. Investor requests about ESG are mostly driven by institutional investors, particularly pension plans, with their own internal policies in respect of ESG, and then that impacts their investment considerations. These ESG-related requests create a critical question for fund sponsors: How can they effectively manage those requests?

I'm Lauren Hulme and I'm here with Keira McKee, and we're here to look at what investors are requesting from fund sponsors and how fund sponsors can respond to those requests. Keira, what kind of ESG requests are investors making for the funds in which they're investing?

Keira McKee (01:17): So we're seeing three broad types of ESG requests that investors are making to the funds in which they're investing. And the first that we're going to discuss is around due diligence. We've seen investors more frequently come to the table with due diligence, checklists and questionnaires that they're asking the fund to complete in order to make sure that the funds they’re investing in align with their internal ESG policies and mandates.

Increasingly, we're seeing these become more complex and metric-based. The second type of ESG request that we're commonly seeing are investors looking for certain restrictions to be baked into the fund governing documents. These are either a complete bar on certain types of investments that the fund can make or more commonly different ESG parameters or thresholds that the fund has to abide by in order to make the investments that they want to make.

Commonly, we're seeing these types of requests dealt with in the side letter provisions that govern the relationship between the investor and the fund, and that the fund is seeking commonly excuse rights and certain other provisions that they can help to govern that individual relationship. We have also seen these be baked right into the fund governing documents and that would mean they would apply fund-wide, but that's more rare.

Lauren Hulme (02:11): So Keira, could you perhaps tell us a little bit about what kind of investment restrictions the investors are looking for?

Keira McKee (02:17): Absolutely. So commonly we're seeing these investment restrictions be industry-based. So the fund is barred from investing in certain industries, including tobacco, cannabis, alcohol, gambling, certain energy industries, but more commonly than an absolute bar, we're seeing ESG-related disclosure requirements for those types of investments or investment restrictions up to a certain threshold. You know, another type we're seeing is the investors looking for the fund to invest in portfolio companies that have strong ESG policies related to diversity and inclusion, fair employment practices.

So they want to see not only the certain industries the fund's investing in, but also that these portfolio companies abide by those same types of ESG mandates and restrictions. Moving on, this is our third ESG request that we commonly see that investors are bringing to the table relates to reporting and disclosure. This is very important for funds to consider because we're seeing a lot more of investors coming to the table looking for strong disclosure and reporting at not only the fund sponsor level, but also at the individual fund and all the way through to the portfolio company level.

Examples that investors are looking for include the number of women and minority employees, senior-level management and sitting on the boards, as well as progress towards net zero goals that the portfolio companies have abided by to and were present in the fund governing documents or the investor documents that the investor received and invested on those bases.

You know, generally this relates to ESG disclosure and policies at all levels of the fund, from sponsor to individual and through to the portfolio company.

Lauren Hulme (04:12): Perfect. Thank you so much, Keira. The requests really are very significant and can be very time-consuming for fund sponsors. And it's difficult for fund sponsors. It's difficult to respond. It's difficult to understand what to do next and how to manage over the long lifespan of a fund potentially across platforms of different fund investment strategies. So we have a handful of tips that sponsors can think about when they're looking to address ESG-related requests from investors.

So first, I think we would say there's nothing wrong with starting small. By gradually implementing ESG processes, you can take steps to look to build your own systems in place internally and be able to respond and react to investor requests. Second, we would look to standardize processes. The more that you can take a concerted approach to put uniform policies and procedures in place, the more you can then respond to investor requests and say, This is what we do, this is how we do it.

And then investors can take comfort in those responses, policies, practices and procedures as opposed to being in a place of reactivity and having to address one-off requests from investors because there's no standardized process in place internally. The third tip we would suggest would be just to be proactive with ESG data collection, monitoring and reporting.

And the more you can kind of get out of the gates with it and stay on top of it, the easier it will be to manage over time. Fourth, just take care when drafting and agreeing to an investor ESG request. Typically, private market funds have very long lifespans. Open-ended funds have an evergreen life, closed-end funds—traditional term is 10 years, and you're agreeing to a commitment upfront for the lifespan of the fund and often sometimes the commitments can expand outside of that one fund investment strategy. And so a fund sponsor could be responding in the case of all of its portfolio companies across multiple platforms. And so we would just recommend that a lot of thought and care is put into what is being agreed to with investors.

And lastly, it's an international and domestic patchwork of regulations in respect of ESG, and they are constantly evolving. And so we would suggest to fund sponsors that they stay on top of what's going on domestically and abroad and look to be proactive in implementing as regulations move. So, of course, ESG-related requests for investors isn't the only reason many fund sponsors are paying attention, but it often is the initial kickstart really as to why a fund sponsor is going to suddenly start really caring about ESG and figuring out how to implement and manage internally and respond accordingly.

But, you know, some fund sponsors do incorporate ESG into their investment decisions in an effort to be socially responsible, and others do it as an added lens from an investment risk management perspective. But whatever the reason, fund sponsors can get their ESG house in order by adopting some of these steps. And we really do anticipate all of this will become even more necessary in the years ahead.ESG scrutiny really is reaching increasingly higher levels, and we're here to help.

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.

Increasing investor ESG requests

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.

Fund sponsors are challenged with addressing ESG-related requests while ensuring these requests are operationally and strategically achievable over the short-term and the long-term.

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.

  • Diligence. Requests for fund sponsors to complete ESG questionnaires and checklists that have become increasingly detailed with specific metrics and undertakings for ESG improvement and monitoring.
  • Investment restrictions. Limitations are being requested to be built into fund governing documents that restrict the fund’s ability to invest entirely, or up to a specified threshold in certain restricted markets and commodities. These limitations most commonly take the form of side letter restrictions and are typically addressed through excuse rights for individual investors. Although less common, these limitations also can arise in limited partnership agreements and apply fund-wide.
    • Some examples include restrictions on companies investing or involved in: oil sands, natural gas or coal-fired power plant industries; for-profit prisons or immigration detention centres; cluster munitions or firearms; gambling activities; pornographic or sexually exploitative content; the sale or production of tobacco, alcohol or cannabis; activities exhibiting insufficiently strong mitigation of the degradation of protected critical natural habitats; and pork production. Other types of investment restrictions can be tied to ensuring the fund only invests in portfolio companies that have strong diversity policies and fair employment practices.
  • Reporting and disclosure. Increased ESG reporting and disclosure at the fund sponsor, individual fund and portfolio company levels can be in response to investor requests as to: the total number of women and visible minority employees, senior management and board members at portfolio companies; evidence that portfolio companies that have committed to net-zero targets are achieving those goals; the adoption of ESG criteria by management teams employed at the portfolio company level; discussions on diversity and inclusion initiatives and considerations; and the fund sponsor maintaining a formal ESG policy.

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.

Patchwork ESG standards and measures

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.

  • International Sustainability Standards Board (ISSB) proposal aims to create a global baseline for climate-related disclosure standards, the first of which may be reported in 2025. The UK government has confirmed an intention to adopt the reporting standards, while Canadian and U.S. securities regulators have yet to make similar announcements.
  • Sustainable Finance Disclosure Regulation (SFDR) aims to harmonize ESG disclosures at the EU-level to counter greenwashing and facilitate comparability between different financial products. SFDR introduces pre-contractual and ongoing disclosure requirements on financial market participants, including investment fund managers (IFMs) and financial advisers. Notably, IFMs are required to disclose in the fund documents the sustainability risks relating to the fund, the manner in which those risks are integrated into the investment decision-making process, the impact of the sustainability risk on the performance of the fund as well as evidence as to whether the IFM considered the adverse impacts of investment decisions on sustainability factors (and if not, to provide a clear explanation).
  • EU Taxonomy Regulation was adopted alongside SFDR to establish a classification system to clarify what is “green” or “sustainable” by setting harmonized criteria for environmentally sustainable economic activities (learn more about evolving EU ESG regulation in “EU sustainability rules: ESG disclosure and supply chain due diligence regulations affecting non-EU companies”).
United States
  • The U.S. Securities and Exchange Commission’s (SEC) climate change disclosure proposal, while currently outstanding, aims to provide guidance on climate change disclosure and may be issued as early as April 2023. At the time of writing, the SEC is considering over 14,000 comments received during the comment period.
  • The Canadian Securities Administrators’ (CSA) climate change disclosure proposal is outstanding, with the likelihood that that the final proposal will be released after the ISSB’s guidance.
  • Sustainable Finance Action Council (SFAC) has released a sustainable finance taxonomy for Canada that outlines a framework to allow businesses and capital providers to credibly identify Canadian Green and Transition Finance Taxonomy.

The benefit debate (including the U.S. anti-ESG movement)

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.

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.

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.

The path forward

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.

  • Sponsor processes and policies.
    • Consider a gradual shift toward implementing ESG processes to meet investor ESG requests. This shift can start small, for example, by looking to comply with aspects of ILPA’s Diversity in Action pledge and other similar initiatives.
    • It is preferable to have policies and procedures in place that are uniform and work for the fund sponsor, rather than having to react and adapt to varying investor requests during negotiations. An external ESG expert can be hired to help draft the fund sponsor’s ESG policy—and that policy can be shared with investors and otherwise referenced in investor negotiations.
  • ESG undertakings. Take careful consideration when drafting ESG commitments in offering documents, marketing materials and other fund governing documents (including investor side letters), including recognizing when you are making a potential ESG commitment for “every portfolio company”.
  • Monitoring. Consider adopting front-end ESG data collection, monitoring and reporting practices as a framework for addressing ESG considerations and issues. This also includes monitoring investment restricted lists and having procedures and technologies in place to respond to these types of investor requests.
  • Regulations. Remain aware and attuned to domestic and international ESG regulations and ensure that requirements are in place to maintain compliance.
  • Framework and processes. Given the associated costs, together with the level of coordination and effort required by fund sponsors to assess, operationalize, monitor and comply with investor ESG requests, overall, we recommend that a solid framework and plan, together with a streamlined process-based approach, be put in place by fund sponsors (and institutional investors) to help navigate the continuously evolving ESG landscape.

  1. “Limited Partners and Private Equity Firms Embrace ESG”, Institutional Limited Partners Association and Bain & Company. Available here. 2022.

To discuss these issues, please contact the author(s).

This publication is a general discussion of certain legal and related developments and should not be relied upon as legal advice. If you require legal advice, we would be pleased to discuss the issues in this publication with you, in the context of your particular circumstances.

For permission to republish this or any other publication, contact Janelle Weed.

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