Frederique Duval, TMF Group

PE fundraising has bandwidth to accommodate ESG-related regulation


By James Williams & Paul Bryant – Capital is flowing into ESG investments with many private equity GPs now on the case. But to stay ahead, they will need credible evidence of impact, not just slick marketing.   

Environmental, social and governance (ESG) investing is fast becoming a juggernaut. In European ESG-oriented funds, AUM grew 40 per cent to EUR684 billion between 2015 and 2018, with 290 ESG-oriented funds launched in 2018. In the US, AUM doubled over the same period, reaching almost USD90 billion.

“To be (green) or not to be. That is the question!” states Frederique Duval (pictured), Head of Relationship Management and Local Sales, TMF Group (Luxembourg). “What was considered a new trend 10 years ago for ESG/Social Responsible Investment has evolved into a wakeup call and real awareness at every level of the chain. Climate change and other factors combined to make people more aware of ESG investing. Suddenly investors became more concerned about how and where they wanted to invest, and what lay behind the assets in the funds they were allocating to; this signaled the start of impacting investing gaining prominence in the global funds industry.”

Sachin Vankalas, general manager of the Luxembourg Finance Labelling Agency (LuxFLAG), which certifies funds’ ESG credentials, says ESG is playing an increasingly prominent role in the PE space: 

“The capital deployed via PE has the potential to have much more impact compared to investments in listed equities. Because PE holdings typically involve significant equity stakes in portfolio companies and board representation, GPs know their portfolio companies better and can influence underlying ESG strategies. Holding periods are also longer in many cases which is very compatible with sustainable investing.”

Luxembourg is a well-known regulated market and since the AIFM Directive was formally transposed into law in July 2013 global PE/RE managers wishing to use Luxembourg as a distribution hub have gotten increasingly comfortable with regulatory compliance. As well as offering a range of regulated fund products, Luxembourg has an active listed green bond market and LuxFLAG, referenced above, is a foundation that awards the LuxFLAG label to funds that meet responsible investment criteria in MicrofinanceEnvironmentESG (Environment, Social, Governance)Climate Finance and Green bonds

“These initiatives, which apply to regulated fund vehicles, are also helping to influence the behaviour and investment practices of PE/RE managers running unregulated vehicles. That is a trend I’m now seeing,” observes Duval. 

LP demands 

LPs recognise there are now more opportunities to have a positive impact on the world through PE. 

Adam Black, head of ESG & sustainability at Coller Capital, a PE secondaries investor, says LPs want to be seen to be close to ESG investing. 

“Their engagement is also becoming more sophisticated,” he says. “A few years ago they were asking GPs if they had an ESG policy in place. Today, they want to understand the investment management process in some detail, the level of engagement with portfolio companies, and want to see evidence of an ESG policy being put to work, such as through case studies. They want to be shown that their ESG investment is not just a box-ticking exercise.”

However, there are distinct regional differences. 

The Coller Capital Global Private Equity Barometer, which reports on a survey of 112 LPs from around the world revealed that two thirds of European and Asia-Pacific LPs were either taking climate change into account in their PE decision-making or said they would be doing so within two to three years. In North America, it was one third.

The report stated: “A significant minority of North American investors continue to regard ESG-related investment criteria as irrelevant or inappropriate for their private equity funds.” But Dr Andy Sloan, deputy chief executive, strategy at Guernsey Finance, says this is changing quickly: “About a year ago I would have said there was very little interest from North American LPs in initiatives like our Guernsey Green Fund – a regulatory ESG ‘kitemark’ - but they are showing a lot more interest now, particularly since the launch of the US Alliance for Sustainable Finance (USASF), which is supported by some of the world’s largest financial institutions.”

There are also regional differences within Europe. The Nordics and the Netherlands in particular seem to have been at the forefront of ESG investing, although it is difficult to pin this down to any specific reason – it seems to be a combination of cultural, structural and regulatory factors. 

Walter van Helvoirt, environmental and sustainability expert in the private equity department at FMO, the Dutch development bank (which invests as an LP into emerging market private equity funds and directly in EM corporates) says that in the Netherlands, ESG has been recognised as an important factor in business risk mitigation for many years now. 

He points to a close interaction between the wider impact and development finance community and commercial investors, who have mostly been welcoming of society’s views. He also says the liberal, more progressive governments of the Netherlands and the Nordics have probably also played a role – influencing how businesses are governed and putting ESG high on the agenda.

Regulation will also have played its part. According to Morningstar: “In the Netherlands, pension plans are required to disclose in their annual report whether or not ESG factors are incorporated and, if so, how. In Sweden, industry guidelines on marketing and information were updated to encompass ESG factors at the request of the regulator.”

In the UK, it’s a variable picture, although pension funds on the whole appear to be a little behind the curve. 

Nick Spencer, founder of responsible investment advisory boutique, Gordian Advice, says: “I would divide it into two groups. You have ‘compliant’ pension funds that integrate ESG into their investing policies as they are told to do it. And then there are those that are approaching this from a totally different mindset. They recognise that ESG integration is now a requirement if you want to seek the best returns and mitigate the risks associated with investments.” 

The 2017 report from Harvard Business School, Why and How Investors Use ESG Information, based on a survey of 413 senior investment professionals from ‘mainstream’ investment organisations (not socially responsible investing funds), found: “The primary reason survey respondents consider ESG information in investment decisions is because they consider it financially material to investment performance ... Respondents believe that this information is primarily relevant for assessing a company’s reputational, legal and regulatory risk. The second reason relates to better ESG performance serving as a proxy for management quality.”

Another trend, which is leading to even more LP interest, is the growth of private capital funding of PE. Sloan says: “This is a trend we have been seeing for over five years now. And those private capital providers are very interested in green and sustainable assets. They are also more likely to be quicker than larger institutional investors to move their asset allocations into the ESG space.”

Moreover, part of the reason for increased ESG investing in the PE space is down to the fact that millennial investors, who after all represent the next generation of investors, are far more switched on when it comes to socially responsible investing. Because of this, says Duval, fund sponsors are doubling their efforts “to make sure they do not risk losing a booming segment of business created by the ‘millennial effect’.”

“Today’s millennial generation and soon the Z generation care about the future of the planet and PE/RE managers – as well as long-only fund managers – are building ESG-compliant funds to attract younger investors, and impact the environment in a more positive way,” she says.  

ESG investing correlating to better returns

This shift of LP focus hasn’t caught PE by surprise. 

The Coller Capital ESG report 2018 reported on a survey of 71 GPs representing 278 PE funds and found that 85 per cent already have an ESG policy in place; 88 per cent integrate ESG principles into their investment process; and 51 per cent reported to their investors on ESG (up from 40 per cent in 2016). 

It is also a phenomenon clearly led by European GPs. 

Seventy two per cent have signed up to the United Nations supported Principles of Responsible Investing, compared with 40 per cent of Asian GPs and only 19 per cent of North American GPs, according to the ESG report.

While PE interest in ESG is becoming more widespread, the intensity of activity is also increasing. 

Black says: “Where the ESG role started out in some firms as a function in investor relations or communications, today, firms are making more ‘operational’ ESG hires to engage with their portfolio companies. They are realising the most important place for ESG skills is the deal team.”

Private Equity fund administrators are moving swiftly to embrace the virtues of ESG investing in tandem with GPs and LPs, none more so than TMF Group, which has seen its PE clients increasingly adopt ESG principals into their investment decision-making processes. 

As Duval explains: “UN PRI has seen an increase of signatories and that testifies to this collective awareness and shows how important ESG has become. At TMF Group, we are on board the ESG train and currently submitting our file to UN PRI supported by strong local initiatives, efforts and management.”

Tom Whelan, global head of private equity and partner at law firm Hogan Lovells, says the sharp increase in ESG investing activity by PE funds over the last two to three years isn’t necessarily driven by pressure from LPs or altruism. 

He says the biggest driver is that GPs are realising that ESG investing is highly correlated with better returns on investment: 

“ESG investing tends to be in high-growth sectors anyway – for example, an investment into recyclable or degradable packaging is odds-on to beat an investment into non-recyclable plastics. Also, as more investors get into this space, you see valuation multiples being driven higher in comparison to non-ESG investments.” 

There is growing evidence to back this up. Bain & Company studied a sample of 450 PE-led exits (between 2014 and 2018) in the Asia-Pacific region and found that the median multiple on invested capital was 3.4x for deals with social and environmental impact, compared with 2.5x for other deals. 

“More and more of our PE clients in Luxembourg are looking at ESG. It is being discussed more widely. We have a number of ESG-oriented PE funds and we are seeing appetite grow in the market for these types of investments,” confirms Duval.

Regulation – an unlikely ally? 

GPs should also expect regulation to accelerate LP demand for ESG investments, and to impact on their own operations. 

France was an early regulatory mover. In 2016, it introduced Article 173, a mandatory reporting framework for institutional investors to demonstrate how climate change considerations are incorporated in their investment and risk-management processes. 

In the UK, the government released its Green Finance Strategy in July 2019. 

It expects all listed companies and large asset owners to disclose in line with the recommendations of the Financial Stability Board’s Task Force on Climate-related Financial Disclosures (TCFD) by 2022. It is also looking into the appropriateness of mandatory reporting.

But it is the EU’s Action Plan on Financing Sustainable Growth, launched by the European Commission on 8th March 2018 that will probably have the biggest impact. 

The Action Plan aims to connect finance with the specific needs of the European and global economy for the benefit of the planet and has three objectives:

  1. Reorient capital flows towards sustainable investments to achieve sustainable and inclusive growth;
  2. Manage financial risks stemming from climate change, natural disasters, environmental degradation and social issues; and
  3. Foster transparency and a long-term outlook for financial and economic activity.

Part of this strategy will be to ensure that asset managers, institutional investors, insurance distributors and investment advisors include economic, social and governance (ESG) factors in their investment decisions and advisory processes. 

While it is still early days as the plan has not yet come into law, it is proposed that: advisers will be required to ascertain their clients’ ESG investment objectives and preferences; managers of investment products will need to publish written policies regarding the integration of sustainability risks in their investment decision-making process; and disclosures will need to be made in accordance with a common taxonomy, to ensure consistency of ESG reporting, making investment products easier to compare.

Van Helvoirt says this common taxonomy will be useful, saying the lack of a common ESG reporting structure today is an unnecessary burden on GPs. 

He says: “For us as an LP, it is a necessity to be able to evaluate and compare the impact of different ESG investments, but there is no value in the reporting itself, so it has to be lean and efficient.”

Regulation is even being used to stimulate the flow of capital. Sloan of Guernsey Finance says the Guernsey Green Fund has been developed as a regulatory framework to provide confidence and transparency in the underlying investments, which are verified and certified for their ESG credentials. 

“It is a very deliberate strategy to go ‘upstream’ to the sources of fund capital and be a generator of green assets in Guernsey,” comments Sloan. “The Green Fund is an ideal ‘wrapper’ for PE funds because that’s where you often find highly focused investment strategies – and ESG can be one of these. There is a growing acceptance that it lends itself towards being able to attract capital.”

Attitudes to these regulatory moves tend to be sanguine or even positive, and as Duval states:

“I think people tend to see regulation as a barrier or an additional constraint that will involve more compliance costs; it takes additional work and manpower to comply with the regulation(s) but I think ultimately it is always to protect the end investor. If you take the UN PRI, this is not a regulation but a way to encourage best practices and for GPs to show that they are making an effort. I would say that is a very good start.” 

Whelan says that PE houses have become more comfortable with a more demanding regulatory environment and over the last few years have taken on more compliance and administrative staff, even general counsel, to keep up. 

He concludes: “There’s more bandwidth in the industry to handle a new ESG-related regulatory burden. I think they’ll take it in their stride.”

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