the guide to responsible investment...figure 16.2: coincidence, or indicators of an evolution in the...

THE GUIDE TORESPONSIBLEINVESTMENT

Creating value in private equity with effective ESG management

Edited by Tom Rotherham Hermes Equity Ownership Services

Published in March 2011 byPEISecond FloorSycamore HouseSycamore StreetLondon EC1Y 0SGUnited Kingdom

Telephone: +44 (0)20 7566 5444www.peimedia.com

© 2011 PEI

ISBN 978-1-904-696-87-2

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PEI editor: Catherine HillProduction editor: Julie Foster

Printed in the UK by: Hobbs the Printers (www.hobbs.uk.com)

Contents

Figures and tables ix

About the editor xiii

Foreword xvBy Deborah Young, Australian Private Equity and Venture Capital Association,Claire Wilkinson, European Private Equity and Venture Capital Association and Doug Lowenstein, Private Equity Growth Capital Council

Introduction from the editor xvii

SECTION I: IN-DEPTH CHAPTERS 1

1 What is responsible investment? 3By James Gifford, PRI

Defining responsible investment 3ESG factors that can create material risks 3Responsible investment and related terminology 3Why invest responsibly? 4What might be material? 9A brief history of the PRI 10Responsible investment and different asset classes 11Responsible investment and private equity 12Conclusion 13

2 Stewardship: a comparison of public and private equity 15By Ebba Schmidt, Pension Protection FundFundamental misalignment of time horizons 15Good stewardship improves alignment 16Challenges to stewardship 17Shareholder rights do not guarantee effective stewardship 19Making stewardship work 20Reporting on stewardship 21Private equity versus public equity 23

3 The changing relationships between LPs, GPs and portfolio companies 27By Alan MacKay, Hermes GPEPrivate equity is governance 28

iii

Good governance requires good reporting 28Turning noise into action 29Portfolio companies show the way 31GPs and LPs take individual action in 2010 32GPs and LPs take collective action in 2011 33Private equity making a positive impact 35

4 Trade unions, private equity and responsible investment 37By Philip Jennings, UNI Global Union

Responsible investment in private equity 37Do private equity-owned businesses operate responsibly? 38Union engagement 41Role of limited partner 42Private equity – a sustainable source of return? 43Conclusion 44

5 Responsible investment – building capabilities in a private equity firm 47By Douwe Cosijn and Hetal Damani, 3i

Introduction 47Scoping capability requirements 47Aligning capability requirements with the business 49Cascading responsible investment across the business 50Building knowledge and expertise 51Implementation – policies and procedures 53Responsible investment training and workshops 55Ongoing challenge to private equity 55Conclusion 56

6 How can LPs integrate ESG into risk management? 59By Carol Kennedy, Pantheon

Internal change 59External change – how to engage with GPs 61Case studies on the benefits to GPs 63Helping GPs to engage with the issues 63Ranking, monitoring and benchmarking 64GP case study: Italian GP 65Staying engaged 66

7 How can GPs integrate ESG? An LP’s perspective 69By Maaike van der Schoot, AlpInvest Partners

Defining a responsible investment policy 70Implementing the responsible investment policy 73Reporting 77Conclusion 78

iv

Contents

8 ESG considerations in the context of fund documentation 79By Daniel Greenaway and Victoria Younghusband, SJ Berwin LLP

The private placement memorandum 79The limited partnership agreement 81ESG-related obligations 82Side letters 84Investment restrictions 84Conclusion 85

9 Modelling how ESG factors can impact risk-adjusted returns 87By Vincent Neate and Jonathan Martin, KPMG

Introduction 87Increased focus on ESG 88Understanding the scope of ESG 89Link between ESG factors and financial performance 90Long-term benefit for private equity 97Impact time horizon on perceptions of risk 98Exiting responsibly 98What methods are appropriate to measure these benefits? 99Conclusion 100

10 Engaging with portfolio companies on ESG issues –building communities of practice 103By Elizabeth Seeger, KKR

Defining the issues 104Identify internal experts 104Identify external experts or advisers 105Develop opportunities to exchange challenges and solutions 105Seek continuous feedback and develop metrics of success 106Portfolio engagement in action 106Conclusion 108

11 Monitoring ESG issues within portfolio companies 109By Adam Black, Doughty Hanson & CoIntroduction 109Ongoing monitoring of portfolio companies 110The importance of a positive ESG culture 112Plan, do, check and act 115Internal ESG reporting 118Who is currently responsible for monitoring ESG initiatives? 119Concluding remarks 119

12 Making ESG an integral part of investor reporting 121By Chris Davison, PermiraEvidence of responsible business practice 121

v

Contents

Emergence of ESG as a communication requirement for private equity 121Lehman Brothers, the banking crisis and a new era of investor sensitivity 123Diverse LP community leads to different ESG sensitivities 124Developing ESG reporting and communications practices:

the Permira approach 125Evidencing good ESG practices under pressure:

the test of communications 126

13 Responsible exits – following patient capital through to the end 129By Geetha Tharmaratnam, Aureos Capital

Risks of failing to consider ESG issues when exiting 129Long-term view 130Maximising returns versus exiting responsibly 131What does it mean to exit responsibly? 133How should this process be managed? 134Best practice when exiting 134Summary 135

14 Responsible investing in emerging markets 137By Niclas During, CDC GroupIntroduction 137Where to invest 138Integrating ESG when investing in emerging markets 141From basic compliance to adding value 147Summary 152

15 Responsible investment: engaging with the media 155By Ian Bailey, Capital C Partners LLC Commitment to clear, tangible goals 157Public commitment from senior leadership 157Honesty about the firm’s motivations and the scale of ambition 157Considering the bigger picture 158Acceptance that private equity is not so private any more 159Focusing on the overall communication objective 159Seeking feedback and support from industry groups and NGO experts 160Focusing on long-term media relationship building 160Summary 161

16 The future of private equity: building better businesses 163By Tom Rotherham, Hermes EOSLearning about the future from the past 163Does private equity need its own Equator Principles? 164What lessons should private equity learn from project finance? 165What would private equity look like if it was created today? 166Conclusion 168

Contents

vi

SECTION II: CASE STUDIES 171

17 An investor perspective of responsible investment 173By David Russell, Universities Superannuation Scheme (USS) Ltd

USS’s responsible investment process in private equity 174Due diligence 174Ongoing assessment 175Outcomes 177Reporting and disclosure 177Broader market initiatives 178Conclusion 179

18 Responsible investment outperforms 181By Rugger Burke and John Grafer, Satori Capital

What differentiates Satori? 181Responsible investment begins with a sustainable mindset 181Implementing a sustainable mindset 183Support for responsible investment 184Responsible investment in action 185Challenges of investing responsibly 187The future of responsible investment 188Conclusion 189

19 Building a sustainable company in perilous times 191By Adam Blumenthal and Michael Musuraca, Blue Wolf Capital Partners

Overview 191Finch, Pruyn’s place in the community 192Company’s strong façade concealed troubling fissures 193In the face of uncertainty, opportunities abound 194New direction, new results 196Reducing energy use, protecting the environment 197A safety success story 199Labour relations: where it all begins 201The future of Finch Paper 202

20 Private equity as a change agent for corporate citizenship 205By Andrew Marino and Bryan Corbett, The Carlyle Group

Introduction 205Responsible investment guidelines 205Case studies – the guidelines at work 207Strategic partnerships further responsible investing 209Environmental stewardship 209Case studies: EcoValuScreen 211The importance of reporting 215Looking forward 215

vii

Contents

21 Investing responsibly in Asia – the governance turnaround of a Chinese portfolio company 217By Alexia Wai-Chun Tye, AddVenture Advisers

ESG integration in Asian private equity markets 217Collaboration between LPs and GPs 217The portfolio firm: a high-growth healthcare company 218The industry context: heavy dependence on regulatory authorities 218The bribery incident 218Further governance incidents 219A radical overhaul of corporate governance 219Environmental and social considerations 221Future outlook 222

22 Integrated value – a new private equity model for driving value creation 223By Diana Propper de Callejon, Expansion Capital Partners

Introduction 223Clear direction of markets 226Expansion Capital Partners’ investment strategy 227Conclusion 232

23 Investor perspectives: interviews 235Cbus 235KL Felicitas Foundation 238London Pensions Fund Authority (LPFA) 242

SECTION III: PEI RESPONSIBLE INVESTMENT SURVEY 247

Responsible investment in private equity: an institutional investor survey 249Survey devised and conducted by PEIIntroduction 249Profile of respondents 249Scope of investment activity 251Significance of ESG factors 252ESG management 254Communication 256UN-backed PRI 258Motivation 258Future outlook 259

About PEI 262

Contents

viii

Figures and tables

Figure 1.1: Growth in PRI signatories and assets under management (AUM)

Figure 1.2: Signatories that have ESG management processes in place

Figure 3.1: The gap between recognition and activity in private equity

Figure 3.2: A proposed hierarchy for private equity responsible investment principles

Figure 5.1: Responsible investment procedure

Figure 6.1: Simplified example of portfolio monitoring, showing ESG progress at GP level

Figure 6.2: Example from a portfolio risk management database

Figure 10.1: Developing an ESG programme for portfolio companies

Figure 10.2: Green Portfolio approach

Figure 11.1: The Deming methodology

Figure 14.1: Key considerations for investments in emerging markets

Figure 14.2: Quality of ESG management systems and portfolio company returns(mean IRR, %)

Figure 16.1: UK Companies Act 2006: §172 duty to promote the success of the company

Figure 16.2: Coincidence, or indicators of an evolution in the asset class?

Figure 18.1: The sustainability model

Figure 18.2: Cumulative returns from ‘firms of endearment’ versus S&P 500

Figure 19.1: Finch Paper reduction in total energy use

Figure 19.2: Finch Paper reduction in purchased energy

Figure 19.3: Finch Paper reduction in greenhouse gas emissions

Figures

ix

Figure 19.4: Finch Paper safety success

Figure 19.5: Union grievances at Finch Paper

Figure 19.6: Finch Paper employee absences

Figure 20.1: Integration with current due diligence process

Figure 20.2: Analysis of environmental impacts on portfolio companies

Figure 22.1: Three waves of sustainability

Figure 22.2: An integrated value approach to achieving authentic sustainable businesses

Figure 22.3: How integrated value approach drives improved shareholder returns

Figure 1: Profile of respondents

Figure 2: Respondent firm headquarters

Figure 3: Private equity investment experience

Figure 4: Geographic focus of primary investment

Figure 5: Planned investment in private equity for 2011

Figure 6: Importance of ESG issues when deciding to invest in private equity funds

Figure 7: ESG policies affecting overall investment decisions

Figure 8: Environmental, social or governance?

Figure 9: Role of LP

Figure 10: Responsibility for ESG management

Figure 11: Fund documentation

Figure 12: Due diligence questionnaire

Figure 13: Frequency of reporting

Figure 14: Method of reporting

Figure 15: PRI signatories

Survey figures

Figures and tables

x

Figure 16: Investor motivations

Figure 17: Future outlook

Table 1.1: Examples of ESG issues

Table 1.2: Some commonly used terms

Table 1.3: Potential material impacts of ESG factors

Table 1.4: Examples of incidents and trends driving a growing awareness of therelationship between ESG issues and company value

Table 2.1: Performance areas for managers’ responsible investment assessment

Table 5.1: Responsible investor spectrum

Table 7.1: Formulating the responsible investment policy

Table 9.1: ESG sample checklist

Table 11.1: Balanced scorecard reflecting ESG performance

Table 11.2: Example ESG KPIs

Table 14.1: Example typology of emerging markets and investment risks

Table 14.2: Generic ESG activities at each stage of the investment lifecycle

Table 14.3: Examples of good corporate governance

Table 14.4: Examples of main ESG risks in select industries

Table 14.5: Impact of ESG initiatives on operational costs and revenues

Table 21.1: Timeline of events in Company W

Tables

xi

Figures and tables

How can GPs integrate ESG? An LP’s perspectiveBy Maaike van der Schoot, AlpInvest Partners

Across the corporate landscape, there is a growing recognition that good corporatebehaviour promotes stronger management, enhances stakeholder relationships andcreates better-performing companies in the long term. As significant investors in awide variety of companies, general partners (GPs) are well positioned to ensure thatcompanies deal adequately with environmental, social and governance (ESG) matters.This may not only have a positive impact on the businesses themselves but also on thevalue that is created for the shareholders.

Besides the financial interest they have in maximising value creation in their portfolios,GPs can also be motivated to adopt and pursue responsible business practices in theirorganisation and the companies in which they invest by their responsibilities as ashareholder, by their responsibilities vis-à-vis their limited partners (LPs) and otherstakeholders and/or by regulatory requirements.

A growing number of institutional investors, many of whom are LPs in private equityfunds, believe that ESG factors can impact the performance of their portfolios to vary-ing degrees across companies, sectors, regions, asset classes and through time. Goodmanagement of ESG issues could protect or significantly enhance profitability and thevalue or attractiveness of their investments from various perspectives. Applying ESGprinciples may avoid embarrassing situations that can harm a company’s reputationand brand value, as well as potentially adversely affecting the reputation of generaland limited partners. Furthermore, they believe that good management of ESG issuescan lead to the avoidance of future costs or significant savings. Lastly, they think animproved focus on ESG can also create business opportunities. For these LPs, compa-nies and GPs that focus on ESG are more attractive investments.

AlpInvest Partners, on behalf of its investors, has committed over €28 billion to privateequity funds of more than 220 GPs in the last decade. Following the formulation of itsown corporate social responsibility policy in 2008, ESG has become an integral part ofAlpInvest’s due diligence process for new investment opportunities. Having soughtactive dialogues with both GPs and portfolio companies to encourage them toimprove their own ESG approach, AlpInvest is well positioned to offer a broad analysisof some of the best practice GP activity on ESG integration.

The growth of the private equity industry in the last decade has sparked an increasinginterest from politicians and the general public. They focus both on financial parame-ters of private equity ownership like leverage levels, as well as non-financial aspects,

7

69

Defining aresponsibleinvestment

policy

Section I: In-depth chapters

for example, labour relations and governance structures. Furthermore, public policyand regulation around ESG issues is growing worldwide, for companies as well as theinvestors that control them. Paying insufficient attention to compliance can lead to highcosts and suboptimal value creation in private equity portfolios.

Although many investment professionals may be reluctant initially at the thought ofincluding additional requirements to their organisation’s processes and procedures,they should realise that many GPs already incorporate risk management and a reason-able level of ESG due diligence in investment decision making. Often this is concen-trated on compliance and ESG-related liabilities, and is performed in an ad hocmanner. For those investors it is not a big step to start taking a more structured andstrategic approach to integrating ESG, which can ensure that these issues are man-aged consistently, risks and opportunities are more easily identified and informationcan be communicated effectively to stakeholders. Such an approach consists of sever-al stages, including the formulation of a responsible investment policy, the integrationof the policy into the organisation and processes, and ESG reporting.

A well-defined responsible investment policy gives guidance and support to ESG deci-sion making in investment processes and portfolio management. It will also act as abasis for reporting and responding to ESG inquiries from LPs and other stakeholders.

The starting point is the GP’s own vision and ambitions. However, in defining the poli-cy, the requirements of its key stakeholders should also be taken into consideration aswell as its overall business strategy. Due to the vast differences between organisations,there is not one uniform responsible investment policy that can be formulated for thewhole private equity sector. Each GP will have to decide which approach to take andwill most likely find that it may have to adapt its strategy and ambitions as responsibleinvestment becomes more fully integrated and the external environment changes.

Table 7.1: Formulating the responsible investment policy

• Why do we believe ESG is important?

• Will we focus on all aspects of ESG or just a subset?

• What ESG attention do the industries in which we invest require?

• What do our key stakeholders require?

• How do the geographies in which we and our portfolio companies operate affect ourresponsible investment policy?

• What is our typical investment type?

• Will the responsible investment policy only cover (potential) investments or also themanagement firm?

• Do our ambitions match the resources we have available?

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Why do we believe ESG

is important?

Will we focus on all aspects of ESG or just

a subset?

What do our key stakeholders

require?

How do thegeographies in

which we and ourportfolio companies

operate affect our responsible

investment policy?

What ESG attention do the

industries in which we

invest require?

However, there are a number of questions that a GP can ask itself and the answers tothese may serve as the basis of formulating its policy (see Table 7.1).

Is this investment-driven, based on ethical beliefs, due to regulatory obligations, requiredby LPs, and/or something else? Once this has been established, the scope of the ESGefforts can be determined: will it only be a focus on regulatory compliance, or also onreputation management, risk management and/or creating business opportunities?

As ESG covers a very broad number of aspects, GPs may choose to (initially) focus ona subset. This could, for example, be driven by resource constraints, knowledge avail-able in the firm, most urgent issues in the sector in which the GP typically invests or fun-damental beliefs. However, from a risk management perspective, it would make senseto cover all three elements. If a GP is focusing on the environmental aspect only, forexample, it is potentially ignoring risks in other categories. Furthermore, LPs and otherstakeholders may expect that eventually all three ESG pillars are addressed by GPs andtheir portfolio companies, where relevant.

Some LPs may have certain geographies, sectors or activities they cannot invest in, likecontroversial weapons or countries with doubtful human rights reputations. Certaininvestors will require extensive ESG reporting, whereas others will not require any. AGP could have portfolio companies to which the policy must be tailored, for example,a GP that invests in clothing shops could decide it wants to be certain that there are nolinks to child labour in its investment portfolio, but it is very difficult to guarantee thisas retailers typically do not have full control over their supply chain. In this case, itwould be better to formulate certain ambitions and to assist the portfolio company incontinuously improving its visibility and control of its supply chain.

In some respects, a functioning system of appropriate regulation, oversight and enforcement is a risk mitigation tool on which a GP is implicitly dependent.However, these systems can differ significantly in different regions. While it may be safeto assume that, for example, the French and German labour codes are robust and willbe monitored effectively, labour conditions in certain developing markets are muchmore difficult to assess. In these situations, a GP should ideally create a guideline,defining what it deems to be acceptable labour conditions. When the GP then consid-ers an investment in the future, this guideline will clarify what information is needed tomake a proper assessment in due diligence and in monitoring the situation thereafter.

Each industry faces different ESG risks in varying degrees. At a software company,the number and extent of potential issues can be relatively small, including, for example, office energy efficiency, employee engagement and intellectual rights.A chemical operator on the other hand, could potentially face a large number ofissues that can have a bigger impact, including various environmental challenges

How can GPs integrate ESG? An LP’s perspective

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What is our typical investment

type?

Will the responsible investment policy

only cover (potential) investments or also

the management firm?

Do our ambitionsmatch the resources

we have available?

(water, pollution and noise), as well as social issues (health and safety) and regulato-ry requirements.

Being the majority shareholder, a GP can exercise more influence on a company’sESG performance than when they hold minority positions. Also, larger companies typ-ically face different ESG challenges from smaller companies. Venture capital start-ups,with a limited number of employees and small offices or operational sites, will typical-ly have few or no ESG issues. However, in managing their assets, venture capital firmsshould be aware that ESG issues could increase as their portfolio companies grow insize. At the other end of the scale, large companies, with a high number of employ-ees and one or more large operating sites, need to be more considerate of how ESGimpacts their business at various levels of the organisation. Also, people often havehigher expectations of larger companies and, through their public exposure, they arelikely to attract more attention from NGOs and the media than smaller businesses.Increasingly, NGOs appear to bring ESG issues at private equity portfolio companiesto the attention of LPs in the fund, asking them to take action. From this respect,AlpInvest were contacted a number of times in 2010 regarding labour and supplychain situations.

The key ESG aspect for GPs in their own organisations is probably the human resourcespolicy. This also matters to its investors, as many LPs will ask questions regardingemployee retention and corporate culture when undertaking due diligence of a fund.As professional services firms, with limited staff numbers and office locations, the envi-ronmental and social impact of GPs is usually relatively small. However, by aiming to begood corporate citizens and taking their ESG responsibilities seriously, they can be anexample for their portfolio companies. Opportunities for improvement, either small orlarge, will exist in many GP organisations, from strategic choices in communication withstakeholders to more practical matters such as office supplies recycling. Internal focuson corporate responsibility will help raise employees’ awareness for the matter, whichmay positively impact the focus on ESG in the investment processes as well.

If resources do not match ambitions, GPs will need to prioritise. From an investmentperspective, it would probably make most sense to first focus on aspects that can havea substantial negative impact on the investment performance, like risk managementand reputation damage, before addressing positive value drivers including identifyingoperational efficiencies and new business opportunities. A large buyout firm may havededicated operations professionals assigned to the task or larger funds that it candeploy for external advice than a smaller venture capital or private equity firm but, onthe other hand, these GPs typically pursue smaller, less complex investments for whichit may be easier to make a good ESG assessment.

In addition to the above, a GP can seek expert advice, for example, from consultants,and/or can look at existing ESG standards for inspiration and guidance. Examples

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Implementing the responsible

investment policyOrganisational

requirements

Investment process

could include general responsible investment principles, for example UN-backedPrinciples for Responsible Investment (PRI), Private Equity Growth Capital Councilresponsible investment guidelines, ILPA governance principles, as well as more specif-ic ESG business principles and guidelines, like the UN Global Compact, the GlobalReporting Initiative (GRI) and the many industry sector codes that are available.However, these standards are to be used as a starting point for defining and imple-menting a responsible investment policy that suits the GP organisation and adoptingthem should not be an aim in itself.

Successful integration of ESG into the organisation, investment process and portfoliomanagement requires internal buy-in and awareness across the whole organisation ofhow the firm’s responsible investment policy will affect their roles and responsibilities.

As with any company ambition, it starts at the top. Commitment of senior managementto the responsible investment policy is critical for a successful rollout throughout theorganisation. Therefore, it is preferred that one of the senior partners takes overallresponsibility for the execution and continuing development of the policy. This rolecan also partially be delegated to a wider committee of partners and managers thatregularly discusses progress made and actions that need to be taken.

Those carrying overall responsibility for the responsible investment policy, do not nec-essarily need to be the ones implementing it on a day-to-day basis. This responsibilitycan be delegated to one of the investment professionals or a staff member, for exam-ple, a dedicated responsible investment officer, ESG expert or a legal counsel. Thischoice will depend on the agreed strategy and the resources available and within theindustry GPs are already seen to be approaching this in different ways.

Once it has been determined how ESG will be integrated into the firm’s investmentpractices, employees can be trained on how to apply this in their day-to-day activities.More on integration of responsible investment in the investment and portfolio man-agement processes can be found in the sections below. Successful training shouldresult in enhanced awareness of ESG issues and their relevance to the investmentportfolio, which will facilitate implementation of the firm’s responsible investment pol-icy. Besides detailed explanation of the new ESG-related process requirements, it canbe useful to include practical examples and case studies. For most GPs the key objec-tive will be to ensure that investment professionals are sufficiently equipped to iden-tify the magnitude of specific ESG risks and opportunities and call in experts whenthey need further information. The employees also need to be informed on the inclu-sion of responsible investment in their job descriptions and/or performance evalua-tion criteria.

Responsible investment considerations can play a role in each stage of the invest-ment process, from transaction sourcing, through due diligence and to the finalinvestment decision.


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The most obvious way in which transaction sourcing can be impacted is if the responsibleinvestment policy includes negative screening elements, that is, restrictions that preventthe GP from investing in certain industries or geographies. Another way sourcing can beimpacted is if the GP applies positive screening and is specifically looking for companieswith a good responsible investment profile like cleantech companies or has a certain viewon sectors where they believe they can create substantial value by focusing specifically onESG. For many LPs, responsible investment goes beyond this investment selectionprocess, and their main focus is on ensuring that all material ESG risk and opportunity fac-tors are integrated into the investment decision and in portfolio management.

With respect to the due diligence process, the key objective is that the target’s ESG per-formance and its potential consequences for the business case are well understood.The scope of the due diligence process will vary depending on the nature, location andactivities of a business as well as the GP’s responsible investment policy. However, inorder to ensure that all current and reasonably foreseeable ESG risks and opportunitiesare identified, a holistic approach is recommended that goes beyond focusing on reg-ulatory compliance and obvious potential liabilities like hazardous waste contaminationor trade union relations. Such a holistic approach could include a focus on aspects likeinherent ESG risks and opportunities associated with the sector(s) and/or geographiclocation(s) of the target’s operations; the existence of an ESG policy at the target thatsatisfactorily incorporates relevant topics; an assessment of the management’s attitudeand the company’s reputation with regards to ESG issues; and the impact of ESG issueson the business model. For example, a fish processing company should consider thelonger term effects of overfishing and stricter fishing regulations on its supply chain andmay therefore need to look for more sustainable sources of fish to ensure its future.

Depending on a GP’s due diligence processes, ESG can be incorporated in variousways in the procedures of the investment analysis. Whichever way is chosen, it is impor-tant that the approach is structured so that all potential areas, as defined by theresponsible investment policy, are covered and satisfactorily answered. The output ofthe approach should be that at the time the investment decision is made, the team isable to present an overview of ESG risks and opportunities and their magnitudes.

In order to ensure maximum take-up by investment professionals, the ESG proceduresmust be designed in such a way that they fit logically into a GP’s existing transactionapproach and do not require disproportionate attention within the whole deal process.

Tools that could facilitate ESG due diligence include standardised or sector-specificquestionnaires, ESG assessment tools and checklists covering typical ESG focus areasper sector. A number of GPs, including KKR, Carlyle and 3i, already have ESG frame-works in place to support their investment professionals in assessing ESG matters. ESGinformation can be collected from various sources, including the deal data room, themanagement of the company under consideration and public research. Depending onthe internal resources and expertise available, it may be necessary to seek externalexpert advice to make sure that certain ESG issues relating to a specific company orsector issues are adequately covered.

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Ideally, the GP has the full ESG picture prior to finalising the transaction. However, dueto timing issues, constrained resources or limited access to information this may not beachievable. In that case, initial due diligence should focus on identifying those ESGrisks that can have a material negative effect on the investment performance, eitherfrom a cost or a reputation point of view. Risks differ per company but could, for exam-ple, include clean-up costs for historical land contamination, poor labour relationsleading to strikes, rising commodity prices as a result of climate change, changes inenvironmental regulation or child labour in the supply chain. Even unlikely eventsshould not be ignored if they may potentially have a high impact, such as the explosionof an oil platform. The investment team may gain additional comfort if it can determinethat the existing ESG culture at the target company is good. ESG aspects that were notinvestigated during the initial due diligence process can then be addressed post-investment, offering potential to tackle smaller risks and opportunities for value cre-ation, like operating efficiencies and new business opportunities early on.

It would be advisable to put one team member in charge of the ESG due diligence work-stream, including the liaison with specialist advisers. This person can either be one of theinvestment professionals or an in-house responsible investment specialist. Althoughinvolving a specialist can bring relevant knowledge and allows the rest of the team tofocus on other aspects of the business case, there is a risk that ESG is not perceived as aninherent part of the investment strategy and essential ESG knowledge is not shared withthe rest of the firm. Also, certain organisations, particularly smaller GPs and venture cap-ital firms, may lack the resources to appoint such a dedicated responsible investmentprofessional. It should be emphasised that whoever is appointed in charge of ESG, thisdoes not release other team members from their responsibilities to signal ESG issues andopportunities they encounter.

The investment proposal, or any other document that is prepared for the purpose ofmaking an investment decision, should include an overview of all relevant and materi-al ESG aspects of a transaction. Although individual aspects could be included in otherparts of the investment analysis (for example, as part of the analysis of operational risks,the legal review, or underpinning of value creation opportunities), a dedicated sectiongives focus in the due diligence process and provides a complete picture of the ESGstatus of a target at the moment the investment decision is made. This may be espe-cially beneficial when a GP is relatively new to responsible investment and the organi-sation needs to further familiarise itself with ESG issues. Such an approach can alsohelp in embedding RI into the system. A structured approach, preferably with a meas-urable output, can also serve as a baseline for future reporting.

ESG performance is just one of a whole series of factors that GPs will consider when mak-ing investment decisions. Investors should not consider a company’s ESG performancein isolation but rather how it may affect cash flow, revenues, profits and, hence, return oncapital. If the outcome of due diligence is a low ESG scoring of an investment target, thisis not necessarily a deal breaker. On the contrary, if the investment team identifies areasof ESG improvement potential, and is in a position to address these, together with man-agement, following acquisition, this could represent a significant driver for value creation


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Portfolio management

process

in a transaction. Some examples of this include reducing costs, improving governance orbrand value, identifying new business opportunities and decreasing staff turnover.

Once a transaction has completed, the GP will start to work with the management of itsnew portfolio company to ensure maximum growth and value creation. ESG will be oneof the factors that need to be considered in this process. The responsible investmentpolicy in combination with the information that was gathered as part of the due dili-gence process, and recommendations that followed from this process, can be used asa baseline from which future strategies should evolve. The actions required will dependon the nature of the issues and opportunities that were identified.

As a starting point, the GP needs to consider whether the company has an ESG codethat sufficiently addresses all aspects relevant to the company and the sector(s) andgeography(ies) in which it operates. It is also important that this does not conflict withthe GP’s principles and values and, if necessary, the existing code should be adjustedor a new code established.

In the process of identification and tackling ESG issues, company management playsan important role. They will need to ensure compliance with any ESG code and willoversee implementation of the value enhancement measures. Depending on howeffective the ESG approach of a company has been so far, the GP can take a more orless active role in overseeing and guiding management. If necessary, the GP can sup-port management by providing ESG resources to the company, either from an internalor external ESG expert or from other companies within the GP’s portfolio. Sharing ofknowledge and good practice, either industry specific or more general ESG insights,can be beneficial for both portfolio companies and GPs. Especially in ESG, an area thatis often relatively new to GPs, experienced management teams can add value to boththe GP itself and to other investments in the portfolio.

In order to ensure that the GP can effectively monitor ESG progress in the portfoliocompany, it is important that management is aware of the GP’s objectives and that theGP ensures that key ESG metrics are included in management reporting. It may also beadvisable to put a manager of the portfolio company in charge of overseeing all ESGresponsibilities. Throughout the holding period of their portfolio companies, GPsshould keep themselves updated with changes that would affect the ESG performanceof these businesses, thereby potentially impacting their value. These can includechanges in consumer and investor preferences, regulation and technology. For exam-ple, as a result of the UK’s Bribery Act 2010, companies were required to update anyexisting codes of conduct to ensure they were sufficient in light of the new regulations.

Besides implementing ESG for new investments, a GP may want to consider reviewingexisting investments in order to be able to assess the key ESG risks and opportunitiesin its overall portfolio. Similar to new investments, the actions that could follow fromthis identification effort will depend on the possible effects on the value and saleabili-ty of each of the portfolio companies. For existing investments the envisaged holding

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Reporting

period also plays a role as there will be more opportunity to implement changes if thecompany is still a few years away from the envisaged divestment. However, even forcompanies closer to exit it could prove valuable to review ESG practices in order tobest prepare them for a sale or listing.

In preparing for an exit, it is advisable that a GP determines at an early stage whetherthere are ESG issues that need to be addressed before the divestment process can bestarted. Addressing these issues prior to this process commencing may help to max-imise value and to be prepared for any information requirements during the saleprocess. At exit, it may be beneficial to present an integrated ESG story to prospectivebuyers, highlighting the current status of the company and the progress that has beenmade during the holding period. The original ESG due diligence can serve as a goodstarting point to make such an ESG assessment. In cases where no comprehensive ESGdue diligence was undertaken as, for example, the investment was made before theGP had drawn up its responsible investment policy, a more extensive assessment maybe required. In case an IPO is the pursued exit route, sellers should be aware that list-ing regulations of stock exchanges increasingly include ESG disclosure requirements.Strategic buyers that are listed entities can also be affected by this.

Increased transparency is at the heart of the requirement for improved ESG focus ofasset managers. As part of the overall responsible investment programme, sufficientattention should therefore be given to the information that is shared with stakeholders,including LPs and the general public.

GPs should ensure that they receive relevant information from portfolio companies inorder to be able to monitor and improve ESG performance. Based on this information,stakeholders of both the GP and the portfolio companies can be informed.

LPs can be interested in ESG information from various perspectives. This can includeinformation on ESG incidents as well as evidence that their money is invested responsi-bly. The GP needs to agree with the LP in which instances and how they will be informed.ESG incidents can have an immediate effect on the reputation and/or valuation of theportfolio company. Ideally, LPs are informed as early as possible (that is, before it hits thenewspapers) of these situations and actions can be taken to minimise impacts for thebusiness and its investors. This also helps ensure they are prepared to answer any criticalquestions from journalists or their (pension) beneficiaries and they are able to assess thevaluation impact. Information that shows LPs that their money is invested responsibly, inline with the agreed ESG investment policy requirements, can take the form of anoverview of key achievements and metrics in regular quarterly reporting and portfolioreviews. A GP can make this information only available to those LPs that have expressedan interest in ESG. However, if the GP views ESG as a core element of its overall approachto risk management and/or its value creation strategy for portfolio companies, it needsto consider if and how it will communicate the ESG status and progress made to its wholeinvestor base – including to those LPs who are indifferent or who do not (yet) believe inthe intrinsic value of incorporating ESG as an investment consideration.


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Conclusion

Besides LPs, there probably is a wider group of stakeholders that is interested in theESG performance of the GP and the companies in which it invests, including employ-ees, consumers, government, regulators and non-governmental organisations. As partof any ongoing dialogue with these stakeholders, GPs should consider the benefits ofpublicly reporting on ESG issues and other aspects of their business, either online orin print.

Private equity investors are well positioned to benefit from the increased focus on ESGmatters. As long-term, majority shareholders, they can make changes and benefit fromthe impact of those changes at exit. Developing a responsible investment policy andensuring that this becomes firmly embedded in the firm’s processes and procedures,is a first step to gain maximal benefits from a responsible investment approach. Itmakes it easier to involve employees and portfolio companies in the identification andmanagement of ESG issues and it facilitates the dialogue with and reporting to the var-ious stakeholders. Over time, responsible investment requirements of the GP, its port-folio companies and stakeholders will change. Through regular reviews, the GP shouldensure that its responsible investment policy remains relevant and up to date. ��


Maaike van der Schoot is corporate social responsibility officer at AlpInvest Partners. She has beenresponsible for AlpInvest Partner’s CSR policy since 2008 and has been involved in various internation-al ESG initiatives including the PRI private equity steering committee and the EVCA ESG task force. Shejoined the firm in 2002 and was an investment manager in the Co-Investment team prior to her currentrole. Maaike previously worked in Morgan Stanley’s investment banking division and holds an MSc inFinancial Economics from Erasmus University Rotterdam.

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