Demand for private equity is at a high. Fundraising in Europe last year reached almost €74 billion – the highest level since 2008 – according to Invest Europe data, as investors flock to one of the remaining sources of returns in today’s low-yield environment. But does this level of investor appetite compromise LPs’ negotiating power?
Some LPs would say yes. According to a recent institutional investor sentiment study by Preqin, a growing number – now over a third – believe LP/GP interests are not aligned. This indicates an opinion that it is harder for LPs to drive change within the GP community, though four in 10 investors surveyed acknowledged the progress that has been made by GPs in areas such as management fees and transparency.
These kinds of fund terms have traditionally been the major battleground for LPs with GPs. However, today it is also environmental, social and governance factors where their voices have started to be heard. In recent years, ESG has grown from a niche topic for specialists into a mainstream consideration that is – or should be – part of the very fabric of how GPs go about their business and raise and invest funds. Large institutional investors – pension funds, insurance companies and other asset managers – have been at the forefront of this change, calling for GPs to focus more closely on responsible investment.
This is best done through dialogue. Making progress on ESG in a negotiation is not simply about going through a checklist, requesting side-letter commitments and considering the matter addressed. To effect real change and monitor their investments, many LPs nowadays engage directly with GPs on this topic, most notably in the diligence process, but also during the life of the fund. GPs value constructive feedback about the ESG performance LPs observe in this process.
For a GP to develop ESG frameworks that will apply across the firm and to all investments they manage, it takes effort if it is to be meaningful and requires time for it to have an impact. It can also represent a challenge for the mid-market and small-cap managers, where resources may be more limited. However, as the importance of good ESG management grows, GPs are becoming more open to change. There is momentum in the market towards wholesale ESG integration in investments and operations. Many private equity firms are now seeing a calibrated responsible investment approach as truly beneficial to their investments, both in terms of risk management and value creation within portfolios.
While individual LP engagement will always be necessary so interests can be aligned on ESG expectations, industry associations will also continue to be valuable forums for dialogue – such as Invest Europe’s platform councils, responsible investment roundtable and the professional standards committee – where LPs and GPs have the opportunity to share best practice and work on developing much-needed industry guidance.
Of course, the clearest signal an LP can send about the importance of RI matters is their choice of where to invest. While some fund terms and conditions may fluctuate with market cycles, ESG requirements are likely to remain a constant for LPs. It is therefore vital that LPs engage more broadly with peer groups, come together to define best RI practice, and be vocal with GPs about the policies and practices that are required. Then – even in a market where GPs are flush with capital – private equity will continue to listen and evolve.
Marta Jankovic is senior responsible investment and governance specialist at APG Asset Management and chairwoman of Invest Europe