Responsible Investment special: What do LPs want from their GPs on ESG?

Diversity and climate change are two of the issues that investors are most likely to focus on when scrutinising a fund’s responsibility record.

Ask a GP what drives their environmental, social and governance agenda and more often than not they attribute a significant portion of their commitment to LP pressure to demonstrate responsible investor credentials. So, when LPs are scrutinising a GP’s ESG approach, what are they asking for?

For private market advisor StepStone, the answer is relatively simple. GPs need to be “good corporate citizens”, says David Jeffrey, partner and head of StepStone Global’s European business, adding that as the definition of ESG expands, “what LPs are demanding of GPs [in terms of ESG] continues to grow”.

A solid understanding of ESG issues and their integration into the investment process, accompanied by robust documentation and reporting, are GP must-haves commonly flagged by LPs.

Sixth Swedish National Pension Fund (AP6) is one such LP. The ESG evaluation tool deployed during fund due diligence scores the investment team and its processes, including which issues a GP focuses on and how they decide what is material, rather than looking at individual sustainability topics, says AP6 sustainability manager Anna Follér.

“We look more at ESG-related beliefs, policy ambitions and practice,” she notes, adding that a lack of understanding about ESG issues is considered a red flag. For funds without a formalised ESG programme, ambition and willingness to develop ESG processes is key. “If there’s not enough commitment from the GP we see that as a risk,” she says.

Michael Cappucci, senior vice-president, Harvard Management Company, which manages Harvard University’s $37 billion endowment, echoes this approach. “We look for intentionality of our managers: do they have a commitment to ESG or are they using it as a glossy marketing tool?” he says.

While assessing risk in due diligence remains important, LPs are seeking more input from GPs regarding reporting, monitoring and dialogue. “Through this dialogue we can make sure that we understand the GP and how they are looking at ESG and we have some sort of assurance that they understand the companies they are investing in on our behalf on a much deeper level,” says an advisor for a Dutch pension provider.

An LP’s interest in specific ESG topic areas will depend on how that institution defines its fiduciary duty and investment priorities, says Jennifer Choi, managing director of industry affairs at the Institutional Limited Partners Association.

However, “governance is a universal priority [among LPs] regardless of whether they have a formalised ESG programme or not. All investors are looking for evidence of good governance, both at the fund level, in terms of how the manager prosecutes its fiduciary duty to the fund and in particular how conflicts are managed”.

For those LPs with a strong ESG agenda, two topics commonly rank high as priorities: diversity and inclusion, particularly around gender, and climate change.

In general, “LPs are always demanding more from GPs, on everything. Better and more performance, more disclosure, more transparency”, says Cappucci. “One area that has gotten a lot of exposure in the last 12 months is gender diversity and discrimination issues. It’s got a lot of attention in response to the #MeToo movement.”

“The broader secular trend in the industry of attaching greater importance to diversity and inclusion means that some institutions have elevated these issues as a prominent feature of how they think about their portfolio and the relationships they have with their managers,” says Choi, noting that ILPA has engaged a cross-section of its global membership to ask what resources the association should develop regarding diversity and inclusion.

For AP6, diversity and inclusion – along with climate change – is an explicit priority and an issue where it seeks to influence GPs. “These [topics] span the portfolio and we believe the industry should work systematically to improve in these areas,” says Follér.

To further its agenda, in November, the LP hosted a second roundtable for Nordic GPs to discuss gender diversity in the industry. It followed a meeting in 2016, where the group considered the state of play, the challenges and what to do about them.

Two years on, and the discussion has evolved from recognising there is an issue, to how to measure the impact of steps taken to increase the number of women working in private equity. “Everyone is really interested in this topic and attended, not just with their presence but by sharing their experiences,” Follér says.

Recognising the impact of environmental issues on portfolio company operations, LPs are also demanding more from GPs in relation to climate change. Expectations placed on GPs to provide carbon footprint data will grow as LPs are required by the Task Force on Climate-related Financial Disclosures to look at these issues, says David Russell, head of responsible investment at USS Investment Management.

USS expects to request more data from GPs so it can carbon footprint its private equity funds. “USS has undertaken the carbon footprinting for all our investment portfolios, but faced difficulties in private equity in either getting the data or estimating it,” he says.

In future, it seems that all GPs not already actively addressing these two topics will face increasingly pointed LP questioning as to why not.

US and them

While ESG is undoubtedly rising up both LP and GP agendas globally, it appears not everyone is convinced yet of its contribution to value creation, and LPs in the US in particular.

For US state public pension funds sensitive to funding deficits, applying ESG criteria can seem like an expensive choice when their focus is on generating returns, says David Fann, chief executive officer at advisor TorreyCove Capital Partners.

Even at the largest LPs, the impact on returns of pursuing an ESG agenda can be contentious. “Whether ESG has led to lower investment returns has been a hot debate at CalPERS [California Public Employees’ Retirement System],” Fann points out.

At Harvard Management Company “we do believe that responsible investing creates value for investors – with a caveat,” says Michael Cappucci. “The caveat is the relationship is not linear. More responsible investing doesn’t necessarily lead to an increase in economic or investment performance. We think it’s the managers who focus most on the most material issues and have the most experience who deliver the most value.”

In proving that ESG creates value, data is an issue, says StepStone’s David Jeffrey. “We’re still on a journey within the world of private markets to be able to provide the empirical data that is required to show responsible investment can add value,” he says, noting that it falls to the LP community as a whole to standardise GP due diligence so that managers can make the case.

In the face of wide-ranging interpretations of what ESG includes, “the challenge is to find common ground” and a “relatively unified voice to help guide GPs,” Fann says. This is not easy. As an example of differing regional approaches to ESG, Fann notes that European and Asian LPs have embraced Principles for Responsible Investment and UN Sustainable Development Goals, while on the other hand, the US government has withdrawn from the Paris climate change agreement altogether.