Considering environmental, social, and governance (ESG) factors when making an investment is no longer solely the province of “impact-first” investors—those who prioritize social or environmental impact above return on capital—but has become, to one degree or another, the norm among private equity (PE) funds. As the calls from both investors and consumers for companies to integrate ESG considerations into their operations and rethink the way they have done business grow louder, funds are increasingly looking to respond to these concerns and integrate consideration of ESG factors into their investment and portfolio management strategies. This means that even “return-first” funds—those whose primary focus remains return on capital—are seeing advantages to considering ESG factors and synergies in connection with their own investment strategies.
ESG is no longer simply “the right thing to do.” As market incentive structures have shifted, ESG factors drive bottom lines. Within the PE fund context, consideration of ESG factors historically started with fundraising as limited partners, particularly European-based limited partners, began insisting that fund managers track and report on ESG metrics within the fund’s portfolio.
As more and more LPs made ESG factors a priority, more and more fund managers proactively sought out investment opportunities that carry positive ESG impacts; when combined with the general market push to integrate ESG considerations into operations, focus on positive ESG factors has been proven, among other benefits, to reduce costs, improve worker productivity, and create enhanced opportunities in customer and supply chain channels. The specific approach and path ahead will and should look different for every fund, but, as we explore below, there are key considerations that funds should consider and a plethora of tools at the disposal of funds to forge their own strategies that include social impact.
Identifying Relevant ESG Factors
Before fund managers can consider whether it is appropriate to integrate ESG factors into their investment strategy, it is important to define what ESG factors specifically mean to them and the industries in which they invest. For the purposes of this article, we will consider it an emphasis on ESG factors in addition to financial returns by companies, investors, and donors. Relevant ESG factors look different in every industry and to every company, so when considering what impact means for a specific fund, one has to look to what ESG factors are material to the operations of the target industry or industries of that fund. The positive impact a software company can produce will and should look very different from the positive impact a reproductive health company can produce, and should be measured and considered differently. A helpful starting place in this analysis is the Sustainable Accounting Standards Board (SASB), which has developed frameworks detailing the ESG factors likely to be most material to companies within a particular industry. For example, one of the key considerations for a reproductive health company would be access to and affordability of its products, whereas for a software company, customer privacy and use of data would be among the more important ESG factors.
Key ESG Issues for LPs
Once they understand what impact looks like within the particular industries on which their fund focuses, managers can begin to determine how to meet the demands of limited partners while factoring ESG considerations into their strategies.
- Complementary Goals. Many managers fully appreciate that these goals can be complementary and are often synergistic. Just as consumers use their purchasing power to reward companies who embrace ESG practices of the companies that produce the products they buy (from environmentally friendly packaging to gender parity and from sustainable manufacturing practices to assurances against use of child labor), many limited partners are beginning to demand that fund managers use their money in ways that provide a social, as well as financial, return. Further, these demands are echoed by employees who strike to bolster demands for social and environmental change. The chorus of consumers, investors, employees, and community leaders signals that the focus on ESG as part of an investment strategy is permanent and in fact increasing.
- Positive Social Returns. Further, many family offices and nonprofits are beginning to realize that investing capital may provide a greater social return than simply donating capital and are looking to traditional funds as a mechanism to deploy those funds.
- Positive Financial Returns. Finally, many managers are finding that considering ESG factors is also simply a prudent financial decision; such managers are realizing that, in most of the industries in which they work, portfolio companies that are considering ESG factors in the companies’ operations are better positioned to address all manner of business risks and to consider and generate long-term growth and competitiveness. These managers have found that considering ESG factors can generate a number of positive returns not directly related to ESG factors themselves, including risk mitigation (through awareness and planning of long-term risks and a focus on long-term sustainability), brand/reputation building, opportunity positioning (e.g., exploring new technologies), and employee satisfaction/productivity, which also benefits from inclusionary hiring like diversity of views.
That said, funds should still choose how to focus their consideration of ESG factors: some may choose to consider ESG factors as part of their overall investment strategy, only investing in companies performing well on such factors, while others may choose to focus on underperforming companies and work with portfolio companies to improve their ESG efforts.
Measuring, Reporting, and Benchmarking
Once a fund has decided to consider ESG factors as part of its investment strategy, there are a number of tools at its disposal to consider and ensure impact in its investments. The keys to considering ESG factors in investments are measuring, reporting, and benchmarking impact in investments.
- Due Diligence Process. The elements of ESG are extremely wide-ranging, and each manager should carefully consider (i) what to measure (including focusing on what is material to the operations of the portfolio company given the sector in which the company operates), (ii) what standards to use (including third-party standards like the Global Reporting Initiative (GRI), SASB, or, for climate, the Task Force for Climate-Related Financial Disclosures (TCFD)), and (iii) what to benchmark data against from similar companies. Questions about this information and other relevant ESG factors (such as more qualitative strategies or policies at the portfolio company) should be carefully crafted and included as part of the diligence process before a fund has even invested in the target.
- Reporting to LPs. Once an investment has been made, this information, having been measured at the portfolio company level and reported to the fund, should then be reported to limited partners as part of the standard quarterly report.
ESG-Focused Portfolio and Fund-Level Strategies
Managers can also use a variety of strategies to enhance impact at the time of investment and as part of the portfolio management strategy, possibly incorporated in the initial 100-day plan, regardless of the form of investment, as well as to consider ESG factors at the fund level.
- Portfolio Company Level. These strategies can include the use of financial disincentives for ESG deviation (i.e., an interest rate increase, a prepayment, a redemption, or a preferred stock conversion ratio adjustment if there is a material deviation from defined measurement standards), governance rights (i.e., not just required mission reporting, but preferential waterfall provisions and key investor and board-level approval for actions that may affect impact), or explicitly impact-focused investment vehicles (such as green bonds, SDG or impact performance-linked bonds, or social impact bonds). They can also include the crafting of equity compensation and bonus plans for employees with KPIs based on impact as well as financial performance.
- Fund Level. These strategies can include the use of an impact-focused corporate form as the general partner entity (like a Delaware public benefit LLC), allowing the purpose and powers section of the formation documents to embed a more tailored-purpose, longer-term funds, or compensation incentives tied to impact return (i.e., having a portion of the carry earned through impact performance).
The right mix and degree of these strategies will depend on the fund’s investment strategy and the makeup and expectations of its limited partners and the portfolio companies themselves.
- ESG Considerations Have Gone Mainstream as LPs Push for Them and Their Business Benefits Become Clearer. Expectations from LPs are increasingly encouraging fund managers to [consider how to] integrate consideration of ESG factors into their investment and portfolio management strategies. Many “return first” funds have found that an increased focus on positive ESG factors has resulted in cost-savings, better relations – and often funding – from LPs, and more investment opportunities.
- ESG Considerations May Vary by Fund and/or Portfolio Company. What specific ESG factors are relevant to a particular fund or portfolio company will depend on factors like size and industry. Relevant ESG factors look different in every industry and to every company, so when considering what impact means for a specific fund, one has to look to what ESG factors are material to the operations of the target industry or industries of that fund.
- A Strong Focus on Measuring, Reporting, and Benchmarking Is Required to Implement ESG Strategies. When considering ESG factors, a fund should always include: measurement, at both the investment and the fund level, with due consideration to appropriate factors; benchmarking against other funds or against third-party standards; and reporting, both from portfolio companies to the fund, and from the fund to their LPs.
- ESG-Focused Strategies Can Be Used at the Portfolio Company and Fund Level to Incentivize Stakeholders and Drive Outcomes. Managers can also use a variety of strategies to enhance impact at the time of investment and as part of the portfolio management strategy, regardless of the form of investment, as well as to consider ESG factors at the fund level. The right mix and degree of these strategies will depend on the fund’s investment strategy and the makeup and expectations of its limited partners.
Elizabeth Beutel has contributed to the drafting of this client alert.