Developing an ESG Framework
ESG considerations in private equity are increasingly becoming a focus across the board as LPs seek to measure the sustainability and social impact of their investments. Ironically, in this time of heightened focus on ESG, many GPs still harbor misconceptions – the first being that it is dilutive to the value creation that they are responsible for as fiduciaries of capital. Furthermore, given the changing definitions of what fulfills ESG requirements, many GPs I speak with are unsure how best to outline it and integrate it into their strategy. ESG – if implemented properly – can give a GP a formidable advantage in the market, especially in terms of differentiating oneself from competitors.
The key question of what counts as ESG is subjective, so GPs should introspect as to what standards make the most sense for them and complement their strategy. What is clear, however, is that LPs are developing institutionalized practices to “grade” the sophistication of a GP’s ESG policy while underwriting a new commitment (especially in the public plan world). ESG implementation is often a topic of prolonged conversation at onsites and most LPs ask for a GP’s formal ESG policy as a part of their diligence. I think of ESG considerations as falling into one of three buckets – restriction list-based ESG, integration investing, and impact investing.
Restriction list-based ESG – the most common form of implementation in today’s market – is essentially fulfilled by precluding your fund from making investments in certain types of industries that are controversial or known to have negative public externalities. For example, GPs may have restrictions that preclude them from investing in tobacco, gambling and arms, among other sectors. This form of ESG implementation is seen as the bare minimum in today’s market – primarily because it is the easiest to integrate into your strategy and is quite common.
Integration investing takes a more hands-on approach to implementing ESG and is likely where the market will be heading in the next few years. In this approach, managers take ESG factors into account in the same way that they would regard factors such as company financials, customer base, competitive landscape, etc.
The third bucket, impact investing, is the most specialized and sophisticated form of ESG integration but certainly is not for everyone. In this approach, managers deliberately seek only to invest in companies that provide some sort of positive impact towards pressing social and environmental issues. Such managers go beyond simply using ESG as one variable in their investment decision and instead make it the central focus of their strategy. Unlike the other forms of implementation, the adoption of impact investing is binary – a firm will either choose to make this a focus of their strategy or not.
Beyond integrating ESG into investment decisions, LPs also expect GPs to be transparent in the ways that they maintain ESG-compliance while monitoring portfolio companies. Best practices that I have seen in the market include setting clear objectives with company management at the time of acquisition as well as a timeline for implementation. Is the company providing safe working conditions for employees? Is the company taking steps to minimize pollution from its factories? Does the company have a social responsibility program and does it give back to the community? These are all potential factors to discuss with company management while setting objectives.
At the end of the day, there is no one-size-fits-all solution to implementing ESG. Managers should take into consideration their long-term goals and set a realistic ESG policy that complements those goals. That being said, given the heightened scrutiny around environmental and social impacts of private equity investments – particularly in the pension and endowment community – you can expect this to remain in focus for the foreseeable future. As always, please feel free to reach out with any questions on this or any other topic and have a great weekend!
Sixpoint Partners, LLC, is a registered broker/dealer, member FINRA (http://www.finra.org) and SIPC (http://www.sipc.org). Sixpoint Partners Asia Limited is licensed by the Securities and Futures Commission (http://www.sfc.hk).
