by Lauren Hulme and Keira McKee
Environmental, social and governance (ESG) considerations in the private fund space will continue to warrant the attention of fund sponsors as they grapple with a) increasing ESG requests from investors, b) patchwork ESG standards and measures and c) the ESG benefit debate (including the U.S. anti-ESG movement). We suspect that ESG-related diligence, disclosure and undertakings of the sponsor are likely here to stay (and will continue increasing); however, as the debate continues in respect of any potential trade-off in investment returns as a result of a focus on ESG-related metrics, fund sponsors (and institutional investors) will be challenged to determine how best to manage.
A solid framework and plan, together with a streamlined process-based approach, can help fund sponsors (and institutional investors) navigate the continuously evolving ESG landscape.
Increasing investor ESG requests
Over the past several years, there has been increasing pressure on fund sponsors to consider and diligence ESG criteria when making portfolio company investment decisions. This increasing pressure has been predominantly driven by institutional investors, particularly pension plans, with internal objectives, mandates and requirements to advance ESG policies and commitments.
More than two-thirds of institutional investor respondents to a recent survey conducted by the Institutional Limited Partner Association (ILPA) and Bain & Company indicated that ESG considerations play a part in organizational private equity investment policies, with approximately 85% of such investors indicating that their policies include at least some ESG initiatives, with 52% having fully implemented ESG-specific policies and 33% having partially implemented such policies 1. These ESG policies inform and guide investment decisions and dollar allocations, making ESG an important consideration for fund sponsors who are seeking to attract these investment dollars. As a result, many fund sponsors have recently begun, or have continued to, figure ESG considerations more predominantly into their investment strategies.
Fund sponsors are challenged with addressing ESG-related requests while ensuring these requests are operationally and strategically achievable over the short-term and the long-term.
Furthermore, as institutional investor ESG policies have developed, investors are seeking more robust, disclosure-based commitments from the funds in which they invest. Fund sponsors are challenged with addressing these requests while ensuring these requests are operationally and strategically achievable over the short-term and the long-term.
Specifically, institutional investors are more commonly seeking the following types of commitments from fund sponsors.
- Diligence. Requests for fund sponsors to complete ESG questionnaires and checklists that have become increasingly detailed with specific metrics and undertakings for ESG improvement and monitoring.
- Investment restrictions. Limitations are being requested to be built into fund governing documents that restrict the fund’s ability to invest entirely, or up to a specified threshold in certain restricted markets and commodities. These limitations most commonly take the form of side letter restrictions and are typically addressed through excuse rights for individual investors. Although less common, these limitations also can arise in limited partnership agreements and apply fund-wide.
- Some examples include restrictions on companies investing or involved in: oil sands, natural gas or coal-fired power plant industries; for-profit prisons or immigration detention centres; cluster munitions or firearms; gambling activities; pornographic or sexually exploitative content; the sale or production of tobacco, alcohol or cannabis; activities exhibiting insufficiently strong mitigation of the degradation of protected critical natural habitats; and pork production. Other types of investment restrictions can be tied to ensuring the fund only invests in portfolio companies that have strong diversity policies and fair employment practices.
- Reporting and disclosure. Increased ESG reporting and disclosure at the fund sponsor, individual fund and portfolio company levels can be in response to investor requests as to: the total number of women and visible minority employees, senior management and board members at portfolio companies; evidence that portfolio companies that have committed to net-zero targets are achieving those goals; the adoption of ESG criteria by management teams employed at the portfolio company level; discussions on diversity and inclusion initiatives and considerations; and the fund sponsor maintaining a formal ESG policy.
These requests are heavily data-driven and require detailed, comprehensive and evidence-based responses from fund sponsors. With fund sponsors committing to various restrictions and thresholds, it can be daunting for them to navigate and track their ESG undertakings, particularly over the long-term lifespan of a fund (e.g., traditional closed-end model is 10 years). Some of these undertakings may be agreed to by some fund sponsors in fund-wide offering documentation (often as a result of investor pressure and/or to attract more capital), while other fund sponsors may keep the ESG-related language broad in offering documentation and investor side letters to maximize flexibility (sometimes while they work on developing their own ESG policies, often in consultation with external ESG experts).
We would also note that, like many institutional investors, many fund sponsors believe ESG diligence and related disclosures have value in serving as an additional lens for assessing investment risk management.
Patchwork ESG standards and measures
In addition to increasing investor requests related to ESG metrics, fund sponsors are also faced with navigating the surge in domestic and foreign regulatory developments that attempt, in part, to address the lack of a uniform ESG standard.
While many fund sponsors are monitoring ESG performance in some capacity, the lack of clearly defined standards and definitions of ESG among stakeholders continues to make it difficult to quantify, measure and compare ESG performance of a given investment and across investments. This has led to confusion from a) fund sponsors seeking to diligence ESG aspects of investments and b) investors looking to use ESG disclosure received from fund sponsors to assess investment opportunities. There has been a number of voluntary and benchmark frameworks to ESG reporting that have been developed, but the number of such frameworks has in many ways emphasized rather than resolved the nebulous nature of the current ESG standards environment.
This lack of standardization and uniformity has not gone unnoticed, and efforts are underway by regulators and international standard setters to provide clearer guidance on ESG disclosure and monitoring. Some of the international, U.S. and Canadian initiatives to watch include the following.
- International Sustainability Standards Board (ISSB) proposal aims to create a global baseline for climate-related disclosure standards, the first of which may be reported in 2025. The UK government has confirmed an intention to adopt the reporting standards, while Canadian and U.S. securities regulators have yet to make similar announcements.
- Sustainable Finance Disclosure Regulation (SFDR) aims to harmonize ESG disclosures at the EU-level to counter greenwashing and facilitate comparability between different financial products. SFDR introduces pre-contractual and ongoing disclosure requirements on financial market participants, including investment fund managers (IFMs) and financial advisers. Notably, IFMs are required to disclose in the fund documents the sustainability risks relating to the fund, the manner in which those risks are integrated into the investment decision-making process, the impact of the sustainability risk on the performance of the fund as well as evidence as to whether the IFM considered the adverse impacts of investment decisions on sustainability factors (and if not, to provide a clear explanation).
- EU Taxonomy Regulation was adopted alongside SFDR to establish a classification system to clarify what is “green” or “sustainable” by setting harmonized criteria for environmentally sustainable economic activities (learn more about evolving EU ESG regulation in “EU sustainability rules: ESG disclosure and supply chain due diligence regulations affecting non-EU companies“).
- The U.S. Securities and Exchange Commission’s (SEC) climate change disclosure proposal, while currently outstanding, aims to provide guidance on climate change disclosure and may be issued as early as April 2023. At the time of writing, the SEC is considering over 14,000 comments received during the comment period.
- The Canadian Securities Administrators’ (CSA) climate change disclosure proposal is outstanding, with the likelihood that that the final proposal will be released after the ISSB’s guidance.
- Sustainable Finance Action Council (SFAC) has released a sustainable finance taxonomy for Canada that outlines a framework to allow businesses and capital providers to credibly identify Canadian Green and Transition Finance Taxonomy.
The benefit debate (including the U.S. anti-ESG movement)
Certain perceived operational and strategic burdens and costs associated with ESG-related policies and procedures have contributed to a debate (including a predominately U.S.-based politicization) relating to ESG investing. Some argue the added expense of ESG diligence undermines or is incompatible with the fiduciary duties of a fund’s general partner to act in the best interest of the partnership and its partners; however, on the contrary, others believe that fiduciaries must consider material ESG issues when investing.
In respect of the U.S.-based politicization of ESG, this has been largely driven by concerns raised by the political right that ESG considerations undermine fund sponsor fiduciary duties, arguing they are shortchanging returns and financial objectives in favour of climate and social goals. 2021 and 2022 saw several right-leaning states approving legislation, regulations and policies prohibiting businesses from investing with investment managers who have committed to mandates that restrict investments in certain markets, such as fossil fuel companies.
For instance, in December of 2022, Florida divested $2 billion from BlackRock, Inc. for, in their view, focusing too heavily on ESG at the purported expense of investment returns. Shortly after this, Florida on January 17, 2023, formalized policies and guidelines that prohibit the state’s investment fund sponsors from considering ESG factors when investing state pension funds. These regulations appear to be at odds with the U.S. Department of Labor’s new rule, the “Prudence and Loyalty in Selecting Plan Investments and Exercising Shareholder Rights”, which allows Employee Retirement Income Security Act of 1974 (ERISA) plan fiduciaries to consider climate change and ESG factors when making investments of retirement funds to the extent those factors are relevant to a risk-and-return analysis of the proposed investment. Although the rule came into effect on January 30, 2023, there are currently judicial and legislative efforts to invalidate the rule.
It is becoming increasingly difficult and complicated for fund sponsors to remain neutral as they look to appease a diverse base of current and prospective investors.
While this level of politicization has not made its way north of border, and many in Canada believe in the value creation of ESG risk assessment, in Canada (and worldwide) the debate in respect of any potential trade-off in investment returns as a result of a focus on ESG-related metrics persists—and it is becoming increasingly difficult and complicated for fund sponsors to remain neutral as they look to appease a diverse base of current and prospective investors in the short and long term.
The current efforts underway to increase the uniformity of ESG requirements may help minimize the abundance of requests from investors as investors gain a clearer picture of what is and is not required.
The path forward
As ESG considerations continue to evolve, fund sponsors will likely be under increased scrutiny about their ESG practices, efforts, processes and reporting. Here are some tactics that may help guide fund sponsors when faced with burgeoning requests, regulations and uncertain political dynamics.
- Sponsor processes and policies.
- Consider a gradual shift toward implementing ESG processes to meet investor ESG requests. This shift can start small, for example, by looking to comply with aspects of ILPA’s Diversity in Action pledge and other similar initiatives.
- It is preferable to have policies and procedures in place that are uniform and work for the fund sponsor, rather than having to react and adapt to varying investor requests during negotiations. An external ESG expert can be hired to help draft the fund sponsor’s ESG policy—and that policy can be shared with investors and otherwise referenced in investor negotiations.
- ESG undertakings. Take careful consideration when drafting ESG commitments in offering documents, marketing materials and other fund governing documents (including investor side letters), including recognizing when you are making a potential ESG commitment for “every portfolio company”.
- Monitoring. Consider adopting front-end ESG data collection, monitoring and reporting practices as a framework for addressing ESG considerations and issues. This also includes monitoring investment restricted lists and having procedures and technologies in place to respond to these types of investor requests.
- Regulations. Remain aware and attuned to domestic and international ESG regulations and ensure that requirements are in place to maintain compliance.
- Framework and processes. Given the associated costs, together with the level of coordination and effort required by fund sponsors to assess, operationalize, monitor and comply with investor ESG requests, overall, we recommend that a solid framework and plan, together with a streamlined process-based approach, be put in place by fund sponsors (and institutional investors) to help navigate the continuously evolving ESG landscape.
1. “Limited Partners and Private Equity Firms Embrace ESG”, Institutional Limited Partners Association and Bain & Company. Available here. 2022.