European Funds Comment: ESG Monitoring and Reporting in Private Equity

6 July 2018
Issue 43

Last month saw publication of a key resource for all private equity and venture capital investors and fund managers, and one that will surely lead to important changes in the way that the industry monitors and reports on the environmental, social and governance (ESG) issues arising from its investing activity. ESG Monitoring, Reporting and Dialogue in Private Equity, published by the UN Principles for Responsible Investment (UN PRI) after collaboration with a wide range of industry stakeholders, not only explains how best-in-class LPs and GPs currently monitor and report on ESG issues, but also presents a clear and coherent reporting structure that aims to balance the dual aims of consistency and flexibility. It recognises that one size does not fit all, but pushes a framework that can be adapted for individual needs.

That acknowledgement of individuality is important. The UN PRI reckons that, of the 2,000 firms that have signed up to its six Principles, around 700 have some private equity investments. However, they will be a diverse group, including seasoned private equity specialists with large portfolios and dedicated ESG personnel, first-time funds with minimal infrastructure and relatively modest environmental and social impact, and LPs with widely divergent allocations to the sector.

But a coherent structure is also valuable, and the detailed Guidance provided by the UN PRI – the most authoritative source in this field – will assist firms in understanding how to re-shape their internal processes to comply with emerging best practice. Case studies from fund managers and investors are included throughout the document and help to explain in more concrete terms what is expected.

The framework is broken down into three sections: (i) Policy, People and Process, (ii) Portfolio Issues and (iii) Incident Reporting. The first section focuses on processes at the fund manager level, looking at the responsible investment policy and the resources available to implement it. There is a recommendation to describe how the policy has been implemented, including how the Investment Committee oversees ESG due diligence and how ESG issues are factored into the investment process. The second section is portfolio-specific and seeks information on ESG opportunities and risks in the investee companies. These can include, for example, the environmental impact of the portfolio, and opportunities taken to mitigate it – but the range of issues that are covered by this section is huge, and a non-exhaustive list of 41 ESG factors is reproduced in the Guidance. In addition, information is sought on portfolio company board-level engagement with ESG issues and contractual provisions in the investment documentation dealing with portfolio obligations to manage material issues. Finally, section three of the Guidance suggests immediate notification of material incidents arising during the life of an investment, as well as a periodic summary of such incidents, with some examples of how materiality might be determined.

The Guidance seeks to accommodate investors with differing appetites for reporting – and managers at different levels of maturity with their ESG programme – by including both Core Disclosures, which are designed to elicit the key information needed by investors, and Additional Disclosures, which are designed to support more detailed understanding. And, to further emphasise its flexibility, the disclosure framework is not to be used on a “comply or explain” basis, but rather there is a recognition that not all fund managers – especially those who have recently adopted a responsible investment strategy, or raised their first fund – will be in a position to make even the Core Disclosures. For them, that may be an aspiration to be achieved over the lifetime of a fund – and it is certainly true that some managers would currently struggle to match the relatively demanding disclosure standards that are laid out in the Guidance.

The UN PRI Guidance is a very helpful resource, adding to the wealth of private equity-specific materials (including a list of publicly available Responsible Investment Policies) already available on its website. It will have an important impact on investor expectations, and GPs would do well to reflect on its recommendations.