ESG provisions in fund terms typically fall under four categories (with some overlap):
- Commitments to ESG policy or standards, and compliance with ESG-specific regulation
- Investment restrictions, exclusions or excuse rights
- Investment decision-making processes
- Providing ESG reporting and incident reporting to investors
For an example of how ESG provisions might be constructed, see the 2017 ESG Research Report by MJ Hudson and Allenbridge, which presents an Investor Toolkit with sample side letter provisions and a fivepoint grading system for side letters of varying strength.
Commitments to ESG policy or standards, and compliance with ESG-specific regulation
Some LPs may require the GP to comply with an external standard (such as the UN Global Compact or the UN Guiding Principles on Business and Human Rights), whilst recognising the possibility that the standard may be subject to change during the life of the fund. One way of addressing this is to refer to standards as they are in place at the time of the original commitment or as they may be amended from time to time.
The LP may seek assurance that the GP has a long-term commitment to its own responsible investment policy, and to its continual improvement. The GP would want the flexibility to amend its policy as its approach to responsible investment evolves over time. Any plans to make material amendments to the responsible investment policy could be communicated to or agreed upon with the LP. LPs in some instances may want to be consulted on any material evolution of the policy to ensure that it reflects the original investment proposition of the fund. The LP could stipulate that any material amendment to the GP’s responsible investment policy should feature on the meeting agenda of the LP Advisory Committee (LPAC) to avoid situations where a policy may be reduced in scope.
The LP should thoroughly examine the strength of the GP’s responsible investment policy – a vague policy, or one not anchored in an external responsible investment standard, may prompt a more rigorous provision from the LP. If the GP does not have a responsible investment policy in place already, the LP could request that it implements one.
Through dialogue with the GP, the LP should have an understanding of the degree to which the responsible investment policy is already implemented (for example, in relation to earlier generation funds), and could require relevant updates on the status of, compliance with and enhancements to, the responsible investment policy. What should be well communicated to the GP is that the LP expects appropriate levels of resources to be dedicated to the implementation of and adherence to the responsible investment policy and that the GP should be able to demonstrate internal capacity to deliver this. The LP could examine the GP’s responsible investment policy against its own set of responsible investment criteria and seek to address any clear gaps via a side letter if deemed necessary.
Assessing a responsible investment policy
LPs should benefit from a clear idea of what they require from a GP’s responsible investment policy to assess if and how it aligns with their own policy and investment beliefs. A GP’s responsible investment policy may cover: investment beliefs/motives; adherence to external responsible investment standards or principles and compliance with applicable legislation; commitment to continuous improvement; approach and objectives; policy coverage/scope; responsibility and resourcing for policy implementation, policy compliance; process for policy review and improvement; and for reporting; thematic focus (if any).
By assessing a responsible investment policy, the LP can seek assurance that the GP has processes in place to identify, analyse and manage material ESG issues, and that there are appropriate ESG incident reporting and mitigation procedures in place.
LPs may wish to see evidence of a GP’s internal commitment to upholding ESG standards across its own operations.
Investment restrictions, exclusions or excuse rights
The GP may have its own ESG-related investment restrictions, depending on its investment strategy, and these should be disclosed upfront during fundraising and outlined in the LPA. The LP, in line with its own investment strategy, may also require investment restrictions that preclude a fund from investing in individual companies, companies engaged in certain activities (e.g. cluster munitions) or securities associated with certain countries. Investment restrictions should be precise and capable of being implemented easily by GPs and understood by all LPs.
When drafting or considering ESG provisions on investment restrictions, the GP will analyse whether these will materially impact the fund’s investment strategy. The LP may consider tailoring its investment restrictions according to the investment strategy of the fund. The investment strategy of a fund is decided by the GP and the GP generally will not (and cannot) accept investment restrictions which materially modify the investment strategy of the fund (which is why the LP must do appropriate due diligence on the fund before deciding to commit). If it is not clear whether the LP’s investment restrictions might impact the investment strategy of the fund, the investment restriction could be framed as an excuse right (or opt-out right) rather than a fund investment restriction and determined on an investment-by-investment basis.
The LP’s investment strategy may evolve over time in accordance with institutional views on how its investment universe should be constructed, which may affect its institutional ESG policy on investment restrictions. Moreover some LPs may have a dynamic investment restrictions list of listed companies that they wish to prevent GPs investing in. The LP could request through a side letter that the GP monitors the LP’s investment restrictions policy and dynamic restrictions list, as communicated by the LP. However, in these instances the investment restriction should be framed as an excuse right (or opt-out right) rather than an investment restriction as the LP could not retrospectively alter the fund’s investment restrictions list and investment decisions on behalf of all LPs. Moreover, if the GP has already drawn down capital from the LP for an investment that is categorised under a new investment restriction, the LP must acknowledge that investment restrictions cannot be applied retrospectively.
An excuse right (or opt-out right) can allow an LP to be excused from a particular investment if the investment falls within the restricted categories previously agreed with the GP (distinct from an investment restriction which would prohibit the fund as a whole from making the investment). In such circumstances, the LP should be notified in the capital call notice that the investment may fall under the LP’s excuse right, that a drawdown would not be made from that LP and the LP would not be entitled to receive any distributions in respect of that investment.
Excuse rights are a useful mechanism, but can be complicated to execute. Excuse rights should be as explicit as possible to avoid the GP having to second guess the LP on each investment. In a situation where the GP believes an investment falls under the LP’s excuse right, the LP is often given a time frame in which to respond to the GP to confirm whether or not they want to be excused from the investment. It should be agreed upfront whether the default position is that if the LP makes no communication they will be excused from the investment or required to participate. The LP will recognise that it may be unfeasible for the GP to grant too many investors different excuse rights.
Finally, the LP may consider whether excuse rights would protect it from the potential reputational repercussions of investing in a fund that invests in securities that it would deems controversial, regardless of whether its capital is drawn down for that investment.
Investment decision-making processes
If the GP’s responsible investment policy does not explain how ESG issues will be factored into decision-making processes, the LP may use the fund terms to require that the GP has processes in place to identify risks and opportunities that could affect the performance of investments, without necessarily prohibiting investment in companies where risks are identified.
The GP may prefer to commit to considering ESG issues when making and managing an investment, but leave it open to interpretation as to what these issues might be as they will be specific to the investment. The GP might clarify that ESG issues will be considered in the overall investment decision but that the GP will determine the manageability of risk. The LP may have a good knowledge of the GP’s understanding and prioritisation of ESG risk through dialogue before committing to the fund. GPs and LPs should take care when crafting ESG-related provisions for LPAs and side letters to ensure agreement on the legal interpretation of such provisions.
- Conducting an ESG assessment of the portfolio company during due diligence
- Requesting each portfolio company to consider signing the UN Global Compact’s 10 Principles or similar
- Conducting a fund-wide ESG risk/opportunity screen
- Incorporating follow-up items on ESG risks and opportunities into the 100-day plan/value creation plan
- Ensuring that material ESG issues are reported to and appropriately acted upon by the board of each portfolio company
Providing ESG reporting and incident reporting to investors
The GP could be asked, or required, to specify how the LP can expect to receive ESG-related information during the life of the fund – for example in the annual reports of the fund and portfolio companies, the drawdown notices or through a specific reporting format as determined by the LP. The GP should assess its own capacity for delivering on reporting commitments and at what frequency. The GP may negotiate the frequency or the timing of the reporting, once the format has been agreed with the LP.
The GP may also make use of governance structures already in place – such as by including ESG as a regular agenda item at LPAC meetings and/or the Annual General Meeting, which provide a platform for flexible and engaged dialogue between the LPs and the GP. The ILPA Principles 2.0 defines the LPAC as “a sounding board for guidance to the GP and a voice for LPs when appropriate”, and its formal duties are determined in the LPA. It would be of benefit to all LPs investing in the fund that the LPAC be used as a forum to understand ESG risks and performance in the portfolio, as with any other business or reputational issues that are material to portfolio performance.
Through regular reporting, the LP might require:
- updates on any material changes to the GP’s responsible investment policy;
- demonstration of ESG integration in the due diligence process and adherence to the LP’s investment restrictions or exclusions list;
- demonstration of improvements in the GP’s processes for managing ESG issues within the fund and portfolio companies;
- demonstration of portfolio company management of ESG risks and opportunities, and any initiatives taken by portfolio companies;
- analysis of progress made by portfolio companies, against prior goals or KPIs;
- analysis of any material ESG risks or opportunities across the portfolio, with the GP’s own analysis of these issues and identification of areas for improvement and action plans;
- summary of any ESG incidents that may have occurred during the reporting period, regardless of whether these had already been reported on an ad hoc basis (see below) and measures taken to address these.
Some LPs will have specific disclosure requirements that they will request through a side letter, perhaps through a specific format. The LP may consider contextualising ESG reporting requirements in relation to the size and investment strategy of the fund.
Both LPs and GPs would benefit from a consistent approach to ESG reporting.
The ILPA Principles 2.0 stipulate that GP annual reports should include portfolio company and fund information on material risks and how they are managed, including “extra-financial risks, including environmental, social and corporate governance risks, at the fund and portfolio company level”.
The Invest Europe Handbook of Professional Standards, last updated in 2015 to address current industry issues including responsible investment and transparency, sets out a range of recommendations regarding ESG factors throughout the life of a private equity fund (from the very early stages of fundraising through the investment process to divestment). Regarding fund terms, the Handbook states that fund documents should address “other reports, such as those covering ESG issues or those required to satisfy tax and other regulatory obligations”. The Invest Europe Investor Reporting Guidelines, which are part of the Handbook, also set out ESG reporting requirements covering inter alia ESG policy and ESG restrictions. For example, they recommend that ESG reporting should ideally be integrated into the annual/quarterly reporting cycle, rather than operating on a separate timeline.
ESG incident reporting
The LP will appreciate open and honest communication from the GP on incidents that could have serious reputational implications for the LP, and/or serious financial implications for the investment in a timely manner. Furthermore, the LP will seek an understanding of how the incident is being dealt with as a demonstration of the GP’s capabilities. For the GP, having a formal process for investigating ESG incidents at portfolio companies will give them greater insight into the company and an opportunity to address root causes.
Any provision relating to ESG incident reporting should be clear as to how a material ESG incident is defined. Once this is clear, the GP may commit to notifying investors within a specific time period as determined by the LP or as soon as reasonably practical – and there should be some consideration of legal restrictions on disclosure and on timing sensitivities. The LP may prefer an annual summary of ESG incidents – and measures taken to address these – over ad-hoc reporting.
For an example of a serious incident reporting template, see the CDC ESG Toolkit For Fund Managers (under CDC Templates).
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Incorporating responsible investment requirements into private equity fund terms