What is ESG?
In case you really have missed this ever growing movement, ESG stands for 'environmental, social and corporate governance'. It covers a huge range of issues, from workplace diversity, to reducing carbon emissions to anti-bribery.
What does ESG have to do with private funds?
A lot, as it happens. Over recent years the incorporation of ESG principles into portfolio management in private funds has become commonplace. ESG principles force fund managers to look beyond the balance sheet of an asset and consider an additional set of risks when acquiring, and subsequently managing, that asset.
Why do investors care?
Investors care for two reasons. First, investing with a social purpose should, in theory at least, improve the world we live in. As gate keepers of a lot of cash, some investors feel a responsibility to ensure their capital yields more than just a healthy monetary return on investment. Second, investors are finding themselves subject to increased scrutiny from their own investors (such as pension contributors), who want their hard-earned cash used to build a better future for themselves and everyone around them.
Why do fund managers care?
Increasingly fund managers are being scrutinised, by investors and regulators, on their ESG credentials. Fund managers without ESG policies or with very basic ESG policies are coming under increasing pressure from investors to up their game. ESG is an issue that is not going away.
ESG is regarded by some fund managers as a boon to investing. Adhering to robust ESG policies will often yield improved financial returns. A responsible investment strategy can also mitigate against potential investment risks. Take the Volkswagen's emissions scandal as an example. The implementation of more robust governance with adequate checks and balances might have prevented the scandal from occurring.
Why do regulators care?
Regulators are concerned with two issues, mis-selling and reporting.
On mis-selling, some regulators are concerned about 'greenwashing', where managers purport to integrate ESG policies into their investment strategy. Without an appropriate framework for measuring ESG performance across the industry, it is difficult for regulators and investors alike to understand whether a fund manager's ESG credentials are more than just window-dressing.
On reporting, regulators are concerned with standardisation of reporting across the industry. In the absence of a cohesive approach across the industry, it is difficult for investors to measure the ESG performance of one asset or fund manager against another.
What are regulators doing about it?
In short, legislating. At a European level, three new regulations, Low Carbon Benchmark Regulations, Disclosure Regulation and Taxonomy Regulation, impose a number of requirements on fund managers in relation to their sustainable or green funds. On a domestic level, the UK Government has set the target for 2050 to become a net zero emissions economy. The FCA has yet to introduce formal guidance on ESG, however, in light of the FCA's scrutiny of 'greenwashing' it might be reasonable to expect some updates to the FCA handbook on ESG matters.
What is everyone else doing about it?
At fund manager level, ESG implementation is being driven on two fronts: by the mega-funds and the smaller impact funds.
At the mega-fund level, KKR and Blackstone recently signed up to the World Bank’s International Finance Corporation ESG principles, pursuant to which fund managers will have their ESG reports independently verified. Further, BlackRock's CEO, Larry Fink, recently wrote that Blackrock's "investment conviction is that sustainability- and climate-integrated portfolios can provide better risk-adjusted returns to investors." With this level of conviction from some of the largest fund managers, it is clear that ESG is no longer a niche interest.
At the other end of the spectrum, impact funds are being established for the principle purpose of creating a positive impact on the company they invest in, and the ecosystem in which that asset exists. Impact funds look at the "double bottom line", where financial performance and ESG impact are equally weighted. With the rise in popularity of sustainable finance, we expect there to be a considerable uptick in the number of new impact funds in the market over the next few years.
How can I improve?
The first step towards improving ESG credentials is engagement. As a fund manager, an all-singing-all-dancing ESG policy is useless if your investors do not like it, or it is difficult to implement. A fund manager should engage with its current cohort of investors and understand the issues that they really care about, and how the manager can improve. The next step is to understand the extent to which an ESG policy can be implemented at portfolio level, the extent to which the manager has the bandwidth to monitor ESG implementation and finally, whether the manager has the capacity to be able to report on ESG matters to its investors.
The effect of inaction or misguided action can be serious. Some large institutional investors now mandate the managers they back to demonstrate improved ESG performance before backing a new fund. Equally, having an ESG policy is one thing, implementing it is another. KPIs set by investors may be a moving target, so managers will need to work hard to ensure they are met. Poor implementation of an ESG policy may encourage unwanted attention from regulators or reputational damage for fund managers.
The private funds landscape as you know it will not look the same in 10 years' time. The associates and trainees of today will be tomorrow's company directors. Millennials care more about sustainability than any other generation before them. In order for private funds to stay relevant, and to remain a desired source of capital, today's fund managers need to adapt or risk being left behind.
How can we help?
We are well equipped at providing expert advice to investors and fund managers on effective ESG policy implementation, from negotiating side letter provisions to drafting ESG policy documents. Please contact your usual contact at Ashurst should you like to discuss.
