Can private equity meet public responsibilities?
The legal implications of ESG in private equity
4 min read
Traditionally, asset owners' investment strategies focused on short-term financial return. Investors funding projects with social or environmental objectives would have needed to seek out philanthropic investment opportunities, without expectation of financial returns.
The past decade has seen the growth of an "impact economy", which is a move away from the traditional investment strategies where investment opportunities are followed which do not require a trade-off between financial objectives and positive outcomes for people and the planet. This is illustrated in the British Private Equity & Venture Capital Association's "Spectrum of Capital" (published in 2014 for the G8 Social Investment Taskforce) which identifies three investment strategies sandwiched between "traditional" and "philanthropic" approaches, comprising: "responsible", "sustainable" and "impact-driven".
Some high-profile players and well-recognised investor brands have raised a series of funds specifically to invest in sustainable and ESG-aligned endeavours. This has proved to be immensely popular in attracting investment and the funds have often been oversubscribed. However, with that growth comes controversy and anti-ESG sentiment, particularly in the US.
But using ESG considerations to identify non-financial risks and opportunities is not new to private equity. For many fund managers, ESG-related due diligence has been integrated into fundraising over the past decade. Increasingly, investors understand that integrating ESG considerations across investment processes is not only about mitigating reputational exposure, but that ESG is also critical to performance and should be viewed through the lens of value creation for the portfolio. ESG can also be a deal-breaker in the context of proposed acquisition activity and IPOs.
ESG-related obligations are increasingly being imposed at the limited partnership, general partnership and portfolio levels, not only as a standard clause in a side letter, acknowledging the UN Principles of Responsible Investment, but incorporated into the LP agreements.
For acquisitions, many LPs and asset managers are demanding ESG considerations for DD processes. A March 2023 Deloitte survey revealed that US PE sponsors are nearly three times as likely as corporates to approach ESG DD consistently and formally, and nearly twice as likely to include ESG clauses in M&A contracts. The survey also showed that 27 per cent of PE sponsors integrate ESG conditions in M&A contracts, compared with only 14 per cent of corporates. ESG factors which could influence sponsor-side DD include voluntary commitments (eg, net zero targets), fund- or firm-wide exclusion provisions (eg, tobacco or gambling), exit strategy (eg, if the target would be attractive to potential "impact" buyers), investment dynamics (eg, whether the sponsor can control or influence the level of ESG DD). Sponsors are also increasing their scrutiny of how portfolio companies manage cyber security (now considered a core facet of ESG). Whereas cyber-DD previously focused on high-level policies and governance, firms now include more technical pre-acquisition processes such as network scanning and penetration testing.
ESG regulatory overlay is of particular significance in DD processes as part of an acquisition. KEY ESG's survey of 100 GPs and portfolio companies in Europe, the UK and the US revealed that while 75 per cent of GPs are required to provide ESG disclosures to LPs, 90 per cent of portfolio companies are unsure how to provide such disclosures, with a vast majority of US GPs remaining unclear about which Europe-based fund regulations apply to them.
In the EU, funds registered to market to EU investors must comply with disclosure requirements under the Sustainable Finance Disclosure Regulation. The SFDR has been in force since March 2021, but in September 2023, the European Commission published a consultation to explore how certain concerns around the regime's implementation could be addressed in the future. Nevertheless, in its current form, SFDR must be considered at multiple stages of a transaction:
- Initial scoping phase: identifying the categorisation of the fund making the investment (Articles 6, 8 or 9).
- DD request phase: with respect to Article 8 and 9 funds, issuing/ responding to Due Diligence Questionnaires which cover "E"/"S" objectives, good governance practices, sustainability risk commitments, and where relevant, Principal Adverse Indicators and minimum safeguards.
- Investment Committee memo phase: confirming SFDR diligence has been undertaken and identifying any red flags.
- DD report phase: incorporating an SFDR-focused rider in the ESG section of the report.
- Post-closing phase: in the "100 days" action plan, including any steps required to address SFDR-related gaps.
As a recent VentureESG report finds, LPs require integration of ESG considerations as part of investment decision-making and integral fund management. Hannah Leach, co-founder of the nonprofit VentureESG and GP at Houghton Street Venture, notes: "Many European LPs are pushing ESG into the ecosystem and are very thoughtful about not making it a tick-box exercise." Portfolio companies may also be subject to obligations imposed under other ESG reporting or DD regulatory regimes, including at EU-level, at national level in European countries, in the US, Canada and Australia. Any contemplated acquisition requires a fact-specific analysis to determine which regulations (including proposals) may apply.
White & Case LLP has partnered with the Financial Times on the publication of its Moral Money Forum reports, which explore key issues from the ESG debate. This article has been reproduced with permission from the Financial Times.
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