For example, a new investor might request to examine a fund manager’s ESG policy at the start of the diligence process. It may then potentially request that the fund manager adopts a set of ESG industry standards or signs up to a certain code of conduct, such as the Principles for Responsible Investment. It might also negotiate excuse rights in its side letter for investments it deems environmentally or ethically distasteful or unacceptable, or might ask for regular updates on the fund’s, and each individual portfolio company’s, compliance with various ESG metrics.
ILPA’s framework gives a standardised structure by which a limited partner can evaluate and benchmark fund manager practices regarding ESG matters. The different levels of sophistication set out below are consistent with the level of diligence undertaken and extent of requests made by investors, and map out what investors can achieve in practice and what can be expected from fund managers.
The framework is separated into six categories, each of which can be graded on a sliding scale from ‘not present’, to ‘developing’, to ‘intermediate’, to ‘advanced’. Questions for limited partners to ask, and goals for general partners to meet, are clearly presented.
The six categories are summarised as follows:
- Policies and commitments to standards – What is the extent of the fund manager’s ESG policy, and/or are there any further plans to develop and enhance the fund manager’s approach to ESG issues?
Are contractual commitments related to ESG referenced in side letters, PPMs or LPAs? In other words, is there substance to the fund manager’s commitment to ESG that can be contractually guaranteed? Does that extend as far as a commitment to annual ESG reporting?
- Governance – Who, if anyone, is responsible for ESG oversight? Practically, there is a big difference between statements of general responsibility and a leadership team that is held accountable, with dedicated ESG staff to support it.
Is ESG training provided for staff? This should ideally extend to the investment teams, as well as the board or senior management team of the underlying portfolio companies.
- Communications and reporting – Are ESG considerations discussed as a matter of course at AGMs and LPAC meetings? This can often be driven by certain limited partners, such as development finance institutions (DFIs), who insist on more regular informal updates at LPAC meetings.
Is the ESG reporting that is in place meaningful? Are there procedures for reporting incidents and remediation and prevention? Does annual ESG reporting, if any, include both quantitative and qualitative updates on ESG issues, referencing case studies and clear examples of sustainability outcomes?
- Investment process – To what extent are ESG matters scrutinised during due diligence? Any risks identified during the due diligence process should form part of and be considered during the IC decision-making process.
Is there provision of active monitoring and management of ESG issues, set out in a structured process, including annual reviews for all portfolio companies? Does the fund manager support buyers to continue sustainable investment initiatives at the time of sale?
- Responsiveness to DEI – What analysis and tracking of diversity is provided at fund and portfolio level? Are there policies and qualitative assessment of metrics? What recruitment, engagement and other relevant targets are in place?
Certain investors now require fund managers to meet specified diversity, equity and inclusion (DEI) targets within a set time period following closing. Material economic consequences can follow for failure to comply, such as a step down in the fund manager’s fee entitlement.
- Responsiveness to climate risks and opportunities – What processes and strategies has the fund manager put in place for conducting climate assessment at the macro level, and deal-by-deal? Is climate risk included as a factor in pre-acquisition due diligence?
What is the extent of reporting on climate-related metrics, including by reference to climate-related KPIs at portfolio company level? Does the fund manager show a desire for the portfolio to become net zero by or before 2050?
ILPA says it has developed the framework with “mid/large cap buyout managers and strategies” in mind (although, as acknowledged, it could also be useful for other asset classes). The intention, according to ILPA, is a “starting point for analysis and dialogues with GPs” rather than a one-size-fits-all approach. It is certainly a very practical tool for both general partners and limited partners in aligning expectations and direction on this highly topical and fast-evolving subject.
Client Alert 2021-224
