How to identify options for incorporating responsible investment considerations into fund terms when committing to a private equity fund.
The objective of the drafting and negotiating process as it relates to responsible investment considerations is to articulate the LP’s expectations on responsible investment and formalise the GP’s commitment to responsible investment, as established during fundraising.
The LPA and associated legal documents outline the fundamental terms governing the operations of the fund including the rights and responsibilities of the parties. In addition to partnership economics, the LPA covers a number of important aspects affecting the alignment of interests between the LP and the GP, such as control and governance, conflicts of interest and transparency. As investors have become increasingly sophisticated in their understanding of how responsible investing impacts the quality of their portfolio and returns, and how it might relate to their fiduciary duty or equivalent investor obligations in some jurisdictions, many have sought a more formal, structured and binding approach to ensure their own understanding of responsible investment is being upheld. This guidance aims to help LPs and GPs reach a contractual agreement on this point.
Both LPs and GPs will benefit from harmonising their current (and emerging) market practices to articulate and refine ESG-related fund terms. By moving towards greater consistency with their responsible investment requirements, LPs should expect deeper engagement from GPs.
By formalising their commitments to responsible investment in the first draft of the LPA, GPs can expect a more streamlined drafting and negotiation process with LPs.
Case study on investor collaboration: The DFI investment code
“Development Finance Institutions (DFIs) have been front runners on the inclusion of ESG requirements in their LPAs. DFIs have historically tended to work on a more isolated basis, mainly because they started investing equity at different times. In the interests of practicality, a dialogue between the DFIs concluded in agreement to collaborate on a harmonised approach on their contractual requirements.
“This effort has resulted in the Investment Code which is now used for LPAs by all European DFIs. The Investment Code is typically inserted into the LPA by default, making the ESG requirements mandatory for all funds that the DFI invests in.
“The Code’s requirements are an exclusion list and a system to incorporate ESG risk management in the fund. The Environmental and Social Management System (ESMS) requirements include the appointment of qualified staff to deal with ESG risks and opportunities, training on the topic and proper ESG reporting. The key to a successful ESMS is that it should be a transparent and light description of how the fund is incorporating ESG risks in its investment process, rather than an onerous and complex set of rules. In order to verify whether the ESMS is a functioning system that does in fact address, mitigate and manage ESG topics in the (intended) investments, the fund is required to engage with the DFI LPs during its initial investments. This gives LPs the opportunity to share knowledge and experience with the fund manager, as well as providing constructive comments during the implementation of the ESMS. It must be said that the role of DFIs is slightly different from the traditional LP role, as they often deal with first-time fund managers and/or GPs in emerging markets.”
Walter van Helvoirt, Environmental and Social Officer – Private Equity, FMO
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Incorporating responsible investment requirements into private equity fund terms