How Can Fund Managers Integrate ESG Best Practices Into the Investment Life Cycle of EM PE?
CDC Group plc, the UK’s development finance institution (“DFI”) has been investing in businesses in emerging markets for nearly 70 years. Since the early 1990s CDC has played a significant role in nurturing the emerging and frontier market private equity industry, most notably in Africa and Asia. It has committed over US$7.2bn to over 160 funds since 2004 alone. During that time, CDC has developed a deep understanding of how to work with private equity fund managers (“GPs” or ”Fund Managers”) to assess, manage and improve environmental, social and governance (“ESG”) standards at their funds (“Funds”) and at their funds’ underlying portfolio companies (Portfolio Companies). CDC’s free-to-use toolkit for Fund Managers (“Toolkit”), which was recently updated and relaunched as a fully web enabled resource, is becoming the industry standard text for implementing ESG management systems (“ESGMS”) at Funds and Portfolio Companies. The Toolkit can be accessed via toolkit.cdcgroup.com.
ESGMS are now well-established as good practice in the private equity industry, but these systems are arguably more established and of higher quality in the emerging markets than in the developed markets. This is due to a number of factors:
- First, in many emerging markets DFIs are large and active investors in the private equity space. The development mandate and public ownership of DFIs mean that a focus on ESG standards has been hardwired into much of the emerging markets private equity industry since the early days.
- Second, enforcement of national laws and standards can be less rigorous in the emerging markets than elsewhere, so a greater burden of responsibility for managing ESG risks falls upon GPs.
- Finally, the practice of emerging markets private equity is focused on creating value through growth and operational improvements, rather than through leverage as is often the case in developed markets. So GPs take an active interest in how good ESG standards can, for example, reduce costs or open up new markets.
It follows that regardless of whether a fund has DFI investors, GPs investing in emerging markets tend to integrate ESG standards into the investment cycle and ensure that their requirements are fully documented in investments agreements with Portfolio Companies. It’s not just the right approach, it’s the logical approach because without this focus and without clear enforcement rights, GPs place themselves at risk of financial and reputational damage, and could miss out on potentially large value creation opportunities.
Knowing your objective: what does a good ESGMS look like?
A well designed and properly implemented ESGMS adds value to Funds, Portfolio Companies and their stakeholders by ensuring that ESG factors are part of the decision making and investment monitoring processes throughout the life of an investment. It provides a framework to manage ESG risks and identify and realise value creation opportunities in Portfolio Companies, and integrate these into plans for organisational and operational business support.
Crucially, an effective ESGMS includes a policy that clearly sets out the ESG standards that the Fund expects its Portfolio Companies to meet, and provides clarity for all parties involved in a given investment. It can also help a GP to capture the financial value of ESG factors, record the lessons of its team’s experiences and demonstrate an ESG track record to prospective investors and portfolio companies.
Regardless of the size of the Fund, the ESGMS must be owned by a senior partner of the GP’s Investment Committee and this individual must have the appetite, interest, resources and support to ensure ESG will receive due focus in the investment process. Implementation of the ESGMS can then be managed at a more operational level within the fund, with support and adequate resources assured from above.
At the other end of the scale, inadequate ESG systems will be characterised by ownership at a junior level or by individuals without the resources or authority to effect change. This would be a concern for CDC when we consider whether to commit to a Fund. We would be equally concerned to find an extensive ESGMS document that has been prepared for a Fund by an external consultant, but is poorly understood by the GP’s investment team and is likely to gather dust on a shelf or be explained poorly to the management of Portfolio Companies
Integrating ESG into the investment process
GPs need to follow robust and pragmatic procedures throughout the investment cycle to identify and analyse ESG factors, determine their relevance to each deal and ensure they are properly addressed. A helpful approach is to consider six phases: screening, due diligence, investment decision, legal agreements, monitoring and exit.
Before signing the investment agreement, the GP should ensure sufficient post-investment influence on and oversight of the Portfolio Company. ESG terms in the investment agreement can help with this as the process provides an opportunity to:
During the investment screening process, a GP should be undertaking basic checks to ensure that the prospective Portfolio Company doesn’t fall under contractual exclusions in the Fund documentation. It should also be checking for any obvious red flags that might halt an investment. The screening stage provides an early opportunity for the GP and the management of the prospective Portfolio Company to discuss the Fund’s ESG requirements and for the GP to judge the willingness of the promoter or management to assess manage and improve standards as necessary. This early communication is the key to managing expectations and ensuring alignment.
It is also the time to plan an appropriate due diligence and budget for the use of consultants if necessary.
- DUE DILIGENCE
The ESG strand of the due diligence process should check that the business is compliant with the Fund’s policies and relevant legislation. The Toolkit has a comprehensive suite of guidance and downloads to help with this process, with specific materials for different sectors and different ESG risks.
Due diligence should uncover any liabilities that the business may face – these of course may affect the valuation – as well as risks and opportunities to add value. The principal output of the exercise should be an ESG action plan that can be incorporated into the investment agreements, placing an obligation on the prospective Portfolio Company to do specific things at specific times.
The decision of whether to make the investment should include consideration of how ESG risks and opportunities affect the investment thesis and whether the Investment Committee believes that the fund and the company have the necessary capacity, expertise and commitment to implement any ESG improvements that have been agreed to ensure the fund meets its obligations to its LPs.
By the time the investment agreement is being negotiated, a Portfolio Company should already have a good understanding of what the Fund requires from an ESG perspective; and it should have planned for the necessary financial and human resources to comply with the terms of the investment agreement. It should not come as a surprise to the Portfolio Company that the Fund requires an investment or shareholders’ agreement that includes detailed ESG clauses and clearly outlines how ESG matters will be handled during the life of the investment.
- verify due diligence findings via representations and warranties;
- achieve a clear agreement and record of what the Fund requires and the Portfolio Company commits to doing in relation to ESG;
- put in place agreements and structures that will give the Fund leverage to use in the future should the Portfolio Company fail to implement what has been agreed;
- establish mechanisms for monitoring, such as information and inspection rights;
- prevent inappropriate transactions;
- address issues that arise; and
- take action in cases of flagrant non-compliance, including visits and investigations, compensation and in extreme cases cease funding and/or exit rights.
After investment, the Portfolio Company should follow the strategy agreed with the Fund, including any ESG action plan set out in the investment or shareholders agreement. Included in this (as discussed above) should be the ESG information that is provided to the Fund on a regular basis; notification triggers, such as serious incidents; information and facilities it wishes to have access to; and whether the Fund wishes to use a consultant as part of the monitoring, including details of how costs will be covered.
Typical rights CDC would expect to be in play during the investment monitoring period would be access, information and inspection rights; copies of papers and minutes; and reporting of serious or fatal incidents and where appropriate Fund representation on the Board, including any sub-committee tasked with monitoring ESG if such a committee exists.
The value of implementing ESG improvements in investees should be used as a selling point during exit. ESG processes and improvements should be included in the private placement memorandum and be a feature of roadshow presentations. Potential buyers, especially international trade buyers or strategic investors, will draw comfort from a well-managed and well-documented ESGMS. This also ensures that prospective buyers cannot use ESG factors to negotiate a lower price by arguing for expensive warranties on potential ESG liabilities.
Good ESG management is as important as good management of people, financials or other levers of a business. While there are considerable opportunities for value creation, the advent of social media and citizen journalism means that the potential for ESG risks to become reputational threats or jeopardise a business’ licence to operate is greater than ever.
CDC will not back a Fund if we’re not convinced that the GP is committed to our ESG requirements, understands them properly, has the process and capacity to implement and will communicate what has been achieved effectively. We’re not alone: a recent report by PWC looking at the importance of ESG in the global private equity industry indicated that 71 per cent of investors would decline to participate in a GP’s fundraising on ESG grounds.
We trust that the Toolkit (toolkit.cdcgroup.com) will be used to engender constructive discussion between GPs and prospective Portfolio Companies regarding the benefits of implementing value-creating ESG standards as well as to facilitate effective management of ESG factors throughout the life of investments.
About the authors
Mark Kenderdine-Davies is General Counsel for CDC Group plc
Dr. Samantha Lacey is the Environmental and Social Manager for CDC Group plc
Edgar Buckley is Head of Marketing and Public Engagement for CDC Group plc