2. How do you identify and manage material ESG-related risks and use ESG factors to create value?

Having established an understanding of the GP’s responsible investment policies, an LP could then ask the GP to demonstrate how their investment decision-making processes will protect and/or create value by identifying and managing ESG-related risks and/or opportunities. An LP could also establish whether the GP has the capacity, commitment and capability to execute these processes.

Resources for integrating ESG factors into investment processes

BVCA Guide to responsible investment– A reference tool for fund managers with detailed and practical advice on how ESG factors can be managed throughout the life cycle of investments.

CDC ESG toolkit for fund managers– Aframework that offers guidance and tools for identifying, evaluating and managing ESG factors at all stages of the investment cycle, from initial screening through to exit.

FMO ESG risk management tool for private equity– Based on the IFC Performance Standards, this toolkit provides three outputs at the investment level and at the portfolio level in aggregate: the most relevant ESG risks, a score for the effectiveness of ESG risk management and the main ESG opportunities.

Invest Europe Handbook of professional standards– Practical and clear guidance on principles of governance, transparency and accountability between private equity managers and their investors, and between managers and the companies they back. Includes guidance on responsible investment matters for different stages of the investment cycle.

2.1 How do you define the materiality of ESG factors? Please give 2-3 examples of ESG factors that you have identified as material to portfolio companies in your most recent fund.

ESG and materiality

When asking about materiality, LPs are asking GPs how they determine which ESG factors are likely to have the most impact on their investments. Materiality encompasses quantifiable impacts on financial performance and investment returns, reputational risks and broader potential consequences on business operations (such as license to operate). When responding to the LP RI DDQ, the GP is expected to focus on material ESG factors. The GP’s determination of materiality should be based on both their own assessment of materiality and an assessment oftheir LPs’ views. Where necessary, LPs should discuss and agree with the GP to ensure an aligned approach.

In practice: AP6

AP6 is one of six national pension funds in Sweden, investing exclusively in private equity both directly and through funds. AP6’s mandate is to create high, long-term return with balanced risk, and responsible investment is an integral part of this. The fund investment team currently manages SEK23.6 billion and invests mainly in European buyout, with a Nordic focus.

Based on existing frameworks such as the ESG Disclosure Framework for Private Equity and the PRI Reporting Framework, AP6 has developed a proprietary method for GP evaluation. The evaluation factors are biased toward policies and processes as these are comparable between GPs, but AP6 believes that it is only when specific issues or cases are discussed that they really understand the granularity of the GP’s approach to ESG integration. If a GP can provide examples from recent funds of material ESG issues that extended beyond legal liabilities into broader ESG risks and even into business opportunities, that is telling of the GP’s capacity to identify material ESG issues.

Asking for examples of material ESG issues can result in responses such as, “We invest in mature Nordic companies so there are very few ESG risks involved.” The answer indicates that, although policies and processes may be in place, there is a fundamental lack of understanding around the potential ESG risks and opportunities in any investment. Take a cloud-based digital business case, for example. The mature GP would perhaps answer that, in addition to employee relations, data integrity and server capacity/energy consumption would be relevant areas to manage, whilst the less mature GP might answer that a cloud-based digital business case does not have an environmental or social impact. Tangible examples such as these help AP6 to understand the maturity of a GP’s approach toward responsible investment.

2.2 Describe your process for identifying and understanding (i) potentially material ESG risks and (ii) ESG-related opportunities during due diligence.

Developed questioning

  • What is the scope of your ESG due diligence?
  • Do you have a process to grade the ESG risks and/or opportunities of each investment during due diligence?
  • Explain whether this is a systematic approach that is consistently applied to all new investment opportunities.
  • Specify the point(s) at which ESG due diligence is typically carried out.
  • Which sources do you use to get information on potential ESG-related risks and opportunities (e.g., internal expertise, company data, company interviews, benchmarking, sector codes and guidelines, external expertise, third party audits)?
  • If you engage external expertise, describe what type(s) of service is provided and at what stage of the due diligence process.
  • Specify whether you would conduct ESG due diligence on the supply chain(s) of a target company during due diligence and under what circumstances.

Scope of ESG due diligence

It useful for LPs to understand how a GP reasonably decides the level of ESG due diligence that is needed for each target investment. By asking about gscope h, LPs are asking GPs to specify the purpose, process and depth of their ESG due diligence with the aim of determining whether it goes beyond minimum compliance. The GP can illustrate the typical scope of their ESG due diligence and demonstrate good practice by establishing, through examples, the:

  • purpose – what the motivation is for conducting ESG due diligence, e.g screening for high-level risks, identifying outstanding liabilities or compliance obligations that may have a financial or reputational impact and/or affect investment returns, identifying risks to mitigate post-closing, thereby identifying opportunities for value creation or cost efficiencies during ownership;
  • process – what the process is for determining the depth of ESG due diligence that is needed; is a materiality assessment conducted and what is the typical materiality threshold;
  • depth – what resources are allocated for ESG due diligence (either internally or externally resourced) and what this level of resource typically delivers during due diligence.

The scope of ESG due diligence may be determined by an inherent risk rating according to industry/sector/ geography. It may be useful for the GP to share a typical scope of work for different levels of perceived ESG risk. The scope of the GP’s ESG due diligence may be restricted by circumstance, depending on the nature of the transaction and the varying complexity and size of different investments. It may be that the GP only has a short time window in which to conduct ESG due diligence before submitting its offer for the business and/or finalising the transaction. It would therefore be useful for the GP to clarify whether there is:

  • a minimum standard of ESG due diligence required for closing deals;
  • a systematic process in place for conducting a more detailed ESG assessment post-closing that can be used to inform the improvement programme.

A minimum standard of ESG due diligence could be a combination of desk based research on publicly available information and working knowledge of ESG impacts on the target industry and sector. Whether internally or externally sourced, the GP should ensure that there is the requisite expertise in place to deliver this minimum standard and subsequently determine the scope of the ESG assessment that is needed.

CDC good practice: Environmental and social due diligence– This good practice note covers nine themes that should be considered when determining an appropriate ESDD process; for example, how to define the scope of ESDD and when/how to involve third party technical consultants.

In practice: Bridges Ventures

Bridges Ventures, a UK-based specialist fund manager dedicated to sustainable and impact investment, applies its Impact Radar* to grade investment opportunities during due diligence. ESG is one of four key dimensions of impact analysed, with a simple 1-3 scoring approach for ESG risk (3, or a high risk, indicates high potential for significant unmanageable negative externalities) and ESG return (3, or a high return, indicates significant potential for positive externalities for material stakeholders).

Behind this simple grading approach, used to inform and guide discussion at Investment Committee, are several steps of analysis. First, depending on the sector in which the business operates, the investment team (supported by Bridges Impact+ team) identifies appropriate ESG issues to be reviewed. In order to make this as practical as possible, Bridges makes it a conversation about operational excellence—using this analysis as a basis for an ESG opportunities workshop with management, which explores existing and potential ESG issues in relation to material stakeholders (e.g., customers, employees, regulators, the local community). The high likelihood / severity (risk) and high potential (return) issues identified through this process are captured in an ESG materiality analysis, which details priority issues and action points which arise. Post investment, these form part of the 100- day plan and inform engagement throughout ownership.

These steps serve to identify ESG KPIs (both risk and return) that are tracked against pre-agreed benchmarks or targets in an Impact Scorecard reviewed during Board meetings and a portfolio-wide annual review. The Impact Radar is also revisited on an annual basis, forming part of LP reporting.

2.3 Once identified, how might potentially material ESG risks and ESG-related opportunities impact the investment decision?

Developed questioning

  • Provide recent examples of situations, if any, where a potentially material ESG factor was identified during the due diligence process. How did you identify the issue(s) and how did it impact the investment decision-making process?

2.4 How are ESG risks and/or ESG-related opportunities reported to, considered and documented by the ultimate decision-making body, such as the Investment Committee?

Developed questioning

  • Provide recent examples, if any, of situations where potentially material ESG considerations have impacted the Investment Committee fs decision and/or pricing negotiations.

2.5 During deal structuring, what is the process for integrating ESG-related considerations into the deal documentation and/or the post-investment action plan?

Developed questioning

  • Provide recent examples, if any, of situations where potentially material ESG considerations have been integrated into the deal documentation and/or the post-investment action plan.

In practice: New Forests

New Forests is a sustainable real assets investment manager in forestry, land management and conservation in Australia, New Zealand, Southeast Asia and the United States. Their certification policy sets requirements for the use of specified third-party standards and guidelines, such as the Forest Stewardship Council and the IFC Performance Standards. Therefore their deal structuring must ensure that these certification requirements and standards can be met throughout the lifetime of the investment, through a combination of transaction documentation and shareholder controls.

As an example, during a recent transaction to acquire a minority interest in a growing Indonesian plantation company, New Forests developed an Environmental & Social Agreement (ESA) that forms part of the Shareholders Agreement and covers implementation of ESG measures. This includes defining an Executive role with Board-level representation and charged with oversight of compliance with the ESA and implementation of an Environmental & Social Action Plan (ESAP). The ESA also requires appropriate resourcing for ESG management and compliance, as well as describing remedies in the case of breaches. The ESAP is a living document initially developed from due diligence exercises focusing on gap analysis against the IFC Performance Standards, community appraisals and a land use assessment. This executive role is also responsible for all operational planning and preparation of annual work plans and budgets related to the ESAP. These work plans and budgets require approval by a board member representing each material shareholder, and so provide a regular mechanism to ensure mutual agreement on management of ESG considerations within the core operations of the business.

By developing and negotiating operational controls and third-party certification and standards requirements during deal structuring, New Forests is able to collaborate with portfolio companies and investment partners on ESG management from the start of investment and ensure operational controls are in place for the lifetime of the investment.

2.6 Please describe how oversight responsibilities, and implementation responsibilities for ESG integration are structured within your organisation. Please list the persons involved and describe their role, position within the organisation and how they are qualified for this role. Please also describe any external resources you may use.

Developed questioning

  • How are staff, in particular investment staff, incentivised to implement responsible investment practices through your performance management and/or reward processes?

2.7 Do you provide training, assistance and/or external resources to your staff to help them understand and identify the relevance and importance of ESG factors in investment activities? If so, please describe what level of training is provided.

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LP responsible investment DDQ: and how to use it