European Funds Comment: Invest Europe Updates Its ESG Due Diligence Guide

5 April 2019

Companies face a pincer movement when it comes to “responsible investment”: there is increasing pressure from all sides, including from regulators and investors, to ensure that environmental, social and governance (ESG) issues are addressed by any business of significant scale. As enlightened, active owners – with a keen interest both in maximising returns and keeping their key stakeholders happy – private equity fund managers have responded very positively to the shifting landscape. Most have ESG policies, and have become used to answering investor questions on the subject. Many others have signed up to the UN PRI, whose six principles help to inform a firm’s investment decisions and the ways in which it exercises ownership rights.

But one problem for firms is deciding which ESG issues to focus on, and when and how they can be addressed. The range of issues that falls within the category of “responsible investment” has rapidly increased in recent years, and many of these could have a very material effect on exit value and saleability. Data security, for example, has jumped up the list of material risks that many companies face, and is now often regarded as an ESG issue. Similarly, as societal expectations have changed regarding supply chain due diligence, many businesses have re-doubled their efforts to ensure their products are ethically sourced. And while environmental considerations have always been important, the growing expectation that carbon emissions will be subject to significantly increased taxes has elevated this issue in energy-intensive industries.

But firms cannot focus on everything, so identifying the most important ESG risks, and deciding in which order to tackle them, is critical.

For that reason, the second edition of Invest Europe’s ESG Due Diligence Guide (available to Invest Europe members only) is more than just an expanded list of DD questions. The revised version – the culmination of an Invest Europe project led by James Holley at Bridgepoint and Graeme Ardus at Triton Partners – splits ESG due diligence into its pre-investment phase and the ongoing, post-investment work. Recognising that certain ESG issues will need to be addressed before a positive investment decision is taken, such as those which would breach an investment restriction or which create the potential for very significant reputational damage, Section 1 of the Guide looks at how high-level screening and sectoral reviews can inform internal and external due diligence reviews. Investment committee decisions can then take account of key ESG risks and opportunities, with legal documents and post-investment business plans incorporating the necessary protections and commitments to address identified topics.

However, intensive work on ESG can begin in earnest after the investment has been completed. Section 2 of the Guide is therefore concerned with the portfolio company board’s responsibility for ESG and the importance of identifying a person with day-to-day responsibility. The Guide recommends that the portfolio company should establish an ESG management system. The private equity fund manager is encouraged to monitor the management of relevant issues and, where possible, their impact on the business. There are also recommendations to establish reporting lines from the underlying company to the fund manager, and for the manager to consider ESG issues before exit. These ongoing issues are vital: ESG due diligence does not end when the investment is made, and ongoing governance aspects need constant attention.

Section 3 of the Guide then includes an expanded list of due diligence questions, with an indication of the type of due diligence (legal, commercial, financial, …) that might reveal further information. This list is non-exhaustive, but is also not intended to be used in its entirety – instead, it is meant to be tailored for the pre- or post-investment work that is contemplated in Sections 1 and 2.

This revised due diligence guide will no doubt be a useful resource, perhaps especially to those firms who are at an early stage in designing their ESG processes, and the many others who have developed an effective ESG policy but now need more help in taking it to the next level.