Institutional investment
August 2017
6 min read

LP intel

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Attention LPs – Effective ESG implementation

Some months ago, MJ Hudson shared a missive on ESG and making it great again.  Unlike some, MJ Hudson likes to follow through on its ideas.  Accordingly, MJ Hudson has since conducted a considerable amount of research and prepared a Guide on all things ESG – a copy of which can be downloaded here.  The Guide, which includes a practical toolkit for successful ESG implementation, is aimed at being a very useful resource to help investors understand how the market is treating ESG, and to evaluate the ESG policies of fund managers.

The Guide was prepared with the dual objectives of being informative and of practical use.  One important takeaway from the Guide is the Seven Private Equity ESG Policy Implementation Habits of Highly Effective LPs – a self-help guide for LPs.  ESG policies, however comprehensive they might be, are almost useless unless effectively implemented. The below seven habits will help LPs ensure that their ESG policies do not live out their life in a filing cabinet, and instead form the spine of how they approach business.

LPs hold the purse strings in private equity. It’s time to start using this not only to ensure better economics, but also to ensure GPs are responsible with LPs’ money, or the money with which they are entrusted.  Here is how:

1. Develop key performance indicators (KPIs)

KPIs will be specific to each LP, with some LPs attributing more importance to some issues over others. Whatever an LP’s key issues are, to ensure improvement, it should set clear targets.  This may involve training its staff to identify key ESG risks or considerations with each investment, or by setting long-term objectives to impose on fund managers.  If an LP has sufficient resources, it should consider establishing a specialist internal ESG operations group or engaging specialist consultants to assist with monitoring its portfolio’s ESG performance.

2. Put in place an ESG reporting policy

Creating a robust ESG reporting policy ensures that ESG remains at the forefront of both fund managers’ and investors’ minds.  LPs should ensure such contractual obligations appear in their side letters at the very least, if not negotiated in the main fund documents, including the LPA.  Transparency is the aim of the game – from portfolio company to investor, comprehensive ESG reporting is a boon to everyone in the private equity family tree.  While ESG reporting may appear complex to GPs, given its reliance on, for instance, the asset class, strategies, perspective and exposure, it is necessary to explain where and how ESG affects the screening of portfolios. Furthermore, LPs should request that fund managers highlight how they have integrated ESG practices when acquiring and managing each portfolio company. This level of transparency leads to a stronger and more aligned relationship between investor and fund manager.

3. Monitor portfolio companies and ensure enforcement on serious transgressions

Fund managers can demonstrate effective ESG leadership to investors by setting KPI targets at portfolio company level and regularly reporting progress of ESG implementation to investors. LPs should be the driving force behind this.  At the outset of an investment, LPs should raise enquiries of the GP to understand the extent to which it maintains oversight, training, and where appropriate, enforcement of the fund manager’s ESG policies in respect of its portfolio companies.  LPs should consider seeking disclosure of staff training programmes and the actual consequences of a breach at portfolio company level.  LPs should further question whether the right sort of procedures are in place to deal with such a breach, whether there is adequate monitoring to ensure a breach is identified quickly, and how and when investors are notified.

4. Benchmarking

Benchmarking is perhaps to best way for LPs to measure the ESG credentials of one fund manager against another.  Be it against standards issued by the UNPRI or BVCA, or against other fund managers of a similar size and adopting a similar strategy, benchmarking provides investors with clear and concise differentials to assist with investment decision-making.

5. Conduct specialist ESG due diligence

A bespoke systematic framework will naturally flow from the above, for example, including measuring ESG in investor DDQs. Template DDQs from the UNPRI, BVCA or ILPA, amongst others, are freely available and are an excellent starting point.  Due diligence is critically important in the context of ESG implementation.  The benefits are twofold: (i) due diligence helps weed out fund managers who do not meet an investor’s ESG criteria, and (ii) the process helps prove to an investor’s stakeholders that ESG is an integral part of vetting fund managers, thereby minimising a range of risks, including, inter alia, reputational risk.

6. Demand detailed ESG reporting and supplement through monitoring fund managers

With capital committed to private equity funds for ten years or more, investors should actively monitor fund managers to ensure ESG policy compliance during the fund lifecycle.  However, this can quickly become cumbersome.  The solution is comprehensive reporting.  Investors should seek to include a hard reporting obligation in the LPA or side letters, which is in turn actively scrutinised. Further, investors should consider engaging ESG consultants or building an in-house ESG team to support this process.

7. Develop ratings

A sensible route forward for LPs is to develop and use a shared ESG rating system to evaluate the key risks and opportunities of investing with a fund manager.  Fund managers would then be reviewed, assessed and rated using a common ratings system that allows investors to reach an objective opinion on the fund manager.  A standardised rating system also incentivises fund managers to strive for higher ESG operating standards.

The MJ Hudson Private Equity ESG Policy Level Framework is an example of a ratings system that is simple to implement and easy to integrate into more complex and sophisticated frameworks.  The five-tier rating system is as follows:


Level 0 – AbsentNo visible ESG policy and/or investor does not require an ESG policy to be in place.
Level 1 – SignatoryThe fund manager is a signatory to UNPRI.
Level 2 – ExpressThe fund manager has an ESG policy which includes a policy to be discussed with or enforced on portfolio companies and the manager agrees to use commercially reasonable efforts to operate the partnership in accordance with UNPRI or similar.
Level 3 – ActiveThe fund manager has an ESG policy that includes a policy to be imposed on portfolio companies, actively monitors such portfolio companies and reports back to its investors. The fund manager warrants that ESG impacts investment selection.
Level 4 – InformedThe fund manager has an ESG point person who is responsible for the enforcement and/or review of ESG policies on portfolio companies and reports details of the same to investors.
Level 5 – IntegratedESG is ingrained into the business. The fund manager warrants and discloses active examples of how ESG has influenced investment process and decisions, and/or has raised an impact fund. All key decisions are influenced by ESG.
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