1 LPs pump up the pressure

From the social and economic fallout of covid-19, to the inequalities highlighted by the Black Lives Matter movement and the devastation caused by wildfires in Australia and the US, 2020 laid bare the pressing need for action around environmental, social and governance issues.

Already on an upward trajectory, ESG has taken an even stronger foothold in the private equity industry over the past year as firms took steps to mitigate the immediate effects of the coronavirus pandemic and paid increasing attention to how climate risks may impact portfolios moving forward. In Q3 2020 alone, 262 firms – including 43 asset owners – signed up to the UN Principles for Responsible Investment, which encourages investors to incorporate ESG factors into investment and ownership decisions, increasing the PRI’s signatory base to over 3,300 firms worldwide.

In line with this, ESG is taking on greater weight in limited partners’ due diligence processes – 88 percent take a manager’s consideration of ESG factors into account when conducting due diligence, according to Private Equity International’s LP Perspectives 2021 Study, up from 81 percent the previous year. Meanwhile, sister title Private Funds CFO’s recent Insights Survey, found that almost three-quarters of LPs either always or sometimes ask whether funds have an ESG consultant in place to advise on responsible investing across their portfolios.

Julia Wikmark, sustainability manager at global private markets firm EQT, tells PEI that demand for climate-related information is on the rise. “The level of detail and number of questions has rapidly increased over the past two years, both in terms of EQT’s own operations and portfolio performance,” she says.

And while questions on climate risks ramp up, the latest LP Perspectives Study suggests not all investors believe general partners are paying enough heed to climate change. Forty-one percent of respondents either somewhat or strongly agree GPs are taking climate risks seriously enough in their own investment policies and practices, yet 22 percent either disagree or strongly disagree and a further 37 percent remain ambivalent.

It has been almost a year since three of the asset class’s biggest LPs – the California State Teachers’ Retirement System, the UK’s USS Investment Management and Japan’s Government Pension Investment Fund – issued a joint statement calling for a greater focus on long-term sustainability-related risks, rather than short-term returns at the potential expense of other stakeholders “including the environment, workers and communities”. The statement warned: “Asset managers that only focus on short-term, explicitly financial measures, and ignore longer-term sustainability-related risks and opportunities are not attractive partners for us.”

USS Investment Management’s head of responsible investment, David Russell, tells PEI that an additional 12 global funds have joined as co-signatories to the ‘partnership for sustainable capital markets’ statement since its release in March 2020. Russell says: “It is for each signatory to decide how to respond to address the challenges and opportunities highlighted in the statement. For our part, we hope that the support for the statement will send a strong signal to the market that asset owners now see long-term sustainability risks as a core component of investment and stewardship processes.”

2 Collaborations flourish

The statement by CalSTRS, GPIF and USS is just one example of how industry players are working together to address climate risk.

In October, a new private sector-focused initiative backed by 16 institutional investors launched to support emissions reduction in Australia – Climate League 2030. Supporters, which include superannuation funds such as Aware Super and Cbus, will be asked to pledge at least one new action a year to help drive down greenhouse gas emissions under three themes: the integration of Paris-aligned emissions reduction goals into investment policies or business strategies; collaboration between investors, clients and companies to deliver emission reductions; and investment in new clean energy, clean technology and other projects and measures that reduce Australian emissions.

In a statement announcing Climate League 2030’s launch, Aware Super chief executive Deanne Stewart said: “To really shift the dial and achieve lasting action to halt the potentially devastating impacts of climate change, it is critical businesses, investors and governments alike set and deliver on transparent, meaningful and measurable targets and goals. We can do this individually but collaboratively we have the power to do so much more.”

The following month, Ardian, The Carlyle Group, Macquarie Infrastructure and Real Assets, Global Infrastructure Partners and SoftBank Investment Advisers formed the One Planet Private Equity Funds initiative. Their goal is to “advance the understanding of climate-related risks and opportunities within our investment portfolios so that we can build better and more sustainable businesses”.

The six founding members will engage with members of the previously established One Planet Sovereign Wealth Funds and One Planet Asset Managers and collaborate on the One Planet Sovereign Wealth Fund Framework. This framework sets out three principles – alignment, ownership and integration – “to accelerate the integration of climate change analysis into the management of large, long-term and diversified asset pools”.

Two heads, as they say, are better than one, and given the scale of the climate challenge it makes sense for stakeholders from within the private equity industry and beyond to work together. It is hoped that by sharing key learnings, expertise and best practices across responsible investing themes and through initiatives such as those outlined above, more progress can be achieved at a faster pace.

3 A greater focus on diversity

Another area where the industry is increasingly coming together is diversity and inclusion. In December, the Institutional Limited Partners Association announced the Diversity in Action initiative for GPs and LPs, which requires signatories to meet four core diversity, equality and inclusion criteria and at least two optional DEI criteria.

Signatories must: have in place a DEI statement or strategy communicated publicly, or a DEI policy communicated to employees and investment partners, that addresses recruitment and retention; track internal hiring and promotion statistics by gender and race/ethnicity; have in place organisational goals that result in demonstrable practices to make recruitment and retention more inclusive; request (if an LP) or provide (if a GP) DEI demographic data for any new commitments or new fundraises. Examples of optional criteria include assigning senior-level DEI accountability and providing unconscious bias training for staff.

Diversity in Action comes on the heels of ILPA’s Diversity and Inclusion Roadmap, which launched in February last year to provide LPs and GPs with access to online resources and best practices.

Some private equity firms are also taking steps to support initiatives dedicated to advancing groups that are particularly under-represented in the investment industry, such as black women. Last month, for example, Blackstone, KKR, Clayton, Dubilier & Rice and Livingbridge became the latest members of London-based organisation Black Women in Asset Management.

“LPs may be forgiving of a firm that has been around for decades and needs time to adjust, but they are not going to support a brand new manager with a line-up of 10 middle-aged, white males”

Guy Townsend
Walker Hamill

It seems investors have begun to take greater note of the role they can play in making progress on diversity and inclusion. In late 2020, ILPA managing director of industry affairs Jennifer Choi told PEI that LPs had started taking a more direct approach to D&I.

“The focus for our members seems to be around transparency and ensuring they have access to information they deem important to their organisation, such as specific metrics on gender and ethnicity at the manager, and how recruitment and retention efforts support broader D&I goals,” said Choi. “Members have shared that there is an expectation GPs will improve their D&I efforts over time, with the understanding that, at the time of investment, diversity metrics may fall short or D&I practices may be more nascent.”

And as LPs probe GPs further, emerging managers are seeking to build in diversity from the outset, Gabrielle Joseph, head of due diligence and client development at Rede Partners, tells PEI.

As Guy Townsend, joint chief executive at Walker Hamill, notes: “LPs may be forgiving of a firm that has been around for decades and needs time to adjust, but they are not going to support a brand new manager with a line-up of 10 middle-aged, white males.”

4 Disclosure demands increase

A pressing issue for managers is the EU Sustainable Finance Disclosure Regulation, taking effect in March. SFDR requires managers doing business in the EU to disclose how sustainability risks are integrated into investment decisions and ensure remuneration policies are consistent with the integration of sustainability risks. While the UK will not be implementing SFDR, it plans to develop its own disclosure regime.

Paul Davies, partner and co-chair of the ESG taskforce at Latham & Watkins, says: “International private equity houses may find themselves subject to EU regulatory requirements and/or other regulatory developments concerning ESG disclosure, including those that emerge in the UK. As such, the ability to obtain the necessary information and data from portfolio companies will be an important consideration.

“We can expect significant developments and innovation in technology, as the ESG data lake grows and resources are needed to enable a quick, simple and cost-effective means to analyse ESG performance and benchmark performance against peer companies.”

Data standardisation has been particularly challenging, yet GPs appear relatively optimistic progress is being made. Three-quarters of fund managers in Intertrust’s Global Private Equity Outlook 2020 report expect ESG data across portfolio companies to be fully standardised within five years.