Perspectives 2018: ESG rises up the LP agenda

Investors are placing increasing emphasis on environmental, social and governance factors in due diligence, our LP survey suggests.

There’s a definite sense that responsible investment criteria are figuring more prominently on the limited partners’ landscape in our PEI LP Perspectives Survey 2018.

Nearly half of the 115 LPs surveyed said ESG was “becoming a more regular consideration” in fund due diligence, with 22 percent saying that it was “always a consideration” and 11 percent saying they considered it “vital”.

This would appear to mark a significant strengthening in ESG sentiment since last year’s survey when “commitment to ESG” came second to bottom in the list of fund terms that LPs consider mandatory in limited partnership agreements – key-man clauses and the level of management fee were, perhaps unsurprisingly, the top concerns.

There were certainly strong indications at PEI’s Responsible Investment Forum in Berlin in September that limited partners are pushing general partners to deliver on ESG metrics. One reason is that investors are coming under increasing pressure to rate their portfolios against ESG criteria – and that is having a knock-on effect on GPs. “We are being asked to do it and expected to do it for all our assets so this is coming your way,” said David Russell, co-head of responsible investment at USS investment management, one of the largest UK pension funds.

Or as Anders Stromblad, head of alternative investments at AP Fonden 2, the second Swedish national pension fund, put it: “Reporting and data collection from GPs to LPs will increase over time. Prepare yourself for that. That will happen.”

Russell was also keen to stress that LPs firmly place the responsibility for ESG at a GP’s door. USS is invested in more than 2,000 portfolio companies via its private equity investments, he said. “There’s no way for us to monitor 2,000 companies. Our expectation is that the GP is managing the material risks. It’s not our job. It’s what we pay funds for.”

Global warming

The conference heard that new guidelines from the Financial Stability Board calling for private equity firms to disclose the risks portfolio companies face from climate change are a potential game-changer.

Speakers said proposals in June from the FSB’s Task Force on Climate-related Financial Disclosures (TCFD) will encourage LPs to increase pressure on GPs to come clean about the potential risk to their businesses from climate change.

Tatiana Bosteels, director of responsibility and head of responsible property investment at Hermes Investment Management, said the fund of funds manager, which has £4 billion ($5.4 billion; €4.6 billion) invested in private equity, has turned down potential private equity investments because it wasn’t satisfied the GP had given sufficient consideration to the risks to the business model from global warming.

“The private equity world is not doing enough to consider climate risks and we need to wake up to that, especially when you see the pressure from the FSB recommendations,” she told the forum.

Or as Anna Follér, sustainability manager at Swedish national pension fund AP6, put it: “It is part of our fiduciary duty. Climate change is affecting our investments and this is something we need to manage and that means we need GPs to manage it.”

Why climate risk is top of the agenda

New guidelines from the Financial Stability Board calling for private equity firms to disclose the risks portfolio companies face from climate change are a potential game-changer: “For the first time we are being asked to consider the impact on the company not the impact of the company,” said James Stacey, partner at environmental consultancy ERM, which carries out climate risk assessments for general partners. The FSB’s Task Force on Climate-related Financial Disclosures has said the financial risk that climate change poses to companies should be disclosed as part of annual financial filings.

Our Perspectives survey does, though, throw up some interesting regional variations in the emphasis that LPs put on ESG: 24 percent of North American LPs said it was “not a consideration” versus only 7.5 percent of European LPs; 22 percent of Asian and European LPs said ESG was a “vital consideration” compared with only 2 percent of North American LPs.

There are signs, though, that the big US institutional investors are starting – finally – to formalise their approach to responsible investing. In March 2017, the California Public Employees’ Retirement System, so often a bellwether for LP activity, released details of its five-year strategic plan for ESG which will scrutinise its managers’ practices more closely, using the UN PRI’s Disclosure Framework as guidance.

“Developing a strategic plan of this magnitude was no easy task,” said Henry Jones, CalPERS Investment Committee chair. “It will guide our ESG efforts in a comprehensive and integrated way across all asset classes.”

The other big North American pensions are also placing greater stress on responsible investment criteria. For Tanya Carmichael, head of global funds at Ontario Teachers’ Pension Plan in Toronto, ESG is a mandatory part of the pension’s due diligence agenda. “We’re not having the why conversation anymore,” Carmichael told our Responsible Investment Forum in New York in March. “Now it’s more the how conversation.”

“ESG used to be seen as a value detractor,” said Janine Guillot, director of capital markets policy and outreach at the Sustainability Accounting Standards Board, at the conference. “Now many are talking about ESG as a return driver. I think this is a very long-term game but I think it’s moving very quickly.” Her organisation sets industry standards for corporate sustainability disclosure.

The attitude towards ESG also varies widely according to the type of investor, with family offices lagging behind other investors: 61 percent of family offices would not be deterred from making an investment if there was no ESG policy in place, according to a recent family office survey conducted by PEI in association with Montana Capital Partners.

That mirrors a survey carried out by law firm MJ Hudson in 2017 which found family offices were the least likely to have ESG provisions in side letters – 77 percent didn’t have any. Only 33 percent of insurers and pensions lacked provisions: “Single family offices are rarely accountable to any third parties nor are their investment decisions a matter of public record. So, there is limited pressure to endorse ESG,” says Eamon Devlin, managing partner at MJ Hudson.

The big public pension plans are a key driving force behind ESG in Europe, Devlin says, especially those based in The Nederland’s. There is, though, widespread agreement that LP attitudes are changing and ESG is rising up the agenda. As James Stacey of environmental consultancy ERM said: “LPs are asking questions and we are seeing that in the conversations we are having with GPs.”