Figuring out the ESG middle-ground

Most private equity professionals would agree that they would like to make investment decisions that are ethical – or at least not unethical. But drafting an ESG policy that helps guide investment decisions – covering the wide spectrum of environmental and social issues, as well as governance – can quickly become overwhelming, and sometimes contradictory.

"ESG is so broad and covers so many different views and interpretations that eventually they will contradict each other: they do not sit cleanly together," says Cai Rees, investment director of SEI Investment. "You can quickly become paralysed by over-analysing the different issues involved."

Private equity sees almost unanimous agreement in avoiding obvious red flags such as weapons manufacturing or aggressively polluting industries – but grey areas still abound. For instance, solving the conundrum of a company being a bastion of social responsibility, but falling short on environmental policy can be particularly challenging for managers. "Some people are rightly concerned that some pharmaceutical companies are encouraging the overuse of antibacterial drugs in meat and dairy production so that there becomes a meaningful risk of resistant forms of bacteria forming," says Rees. "But in some regions, starvation is a more immediate concern, and low-cost food is needed to reduce poverty and increase living standards."

While there is currently no ESG benchmark or industry-wide criteria for compliance, the United Nations Principles of Responsible Investment (UNPRI) aims to help guide policy drafting. But it remains the responsibility of individual managers to tailor their approach and decide how to deal with potential issues, as well as any contradictions that may arise.

ESG is so broad and covers so many different views and interpretations that eventually they will contradict each other" - Cai Rees, SEI Investment

Putting it in writing
Ultimately, what matters to LPs is that managers are engaged in some way and start putting pen to paper in terms of an ESG policy. "Most investors are already doing ESG and have been doing it for some time. They just have not gotten around to reporting on it or putting it into a documented policy," says Ana Lei Ortiz, a managing director at Hamilton Lane. "For us, it is about [GPs] engaging in best practice, as you will never get a consensus. Since we are giving them a blind pool of money, we need to know they are engaged and have a clear plan. The specific way they execute on that plan often varies from manager to manager, so we are most concerned about making sure they have demonstrated a thoughtful approach."

When it comes to ESG policies, most GPs agree that trying to cover every angle is impossible. Mid-market private equity house Rutland Partners splits its initial ESG checklist into non-negotiable and negotiable elements, says partner Mike Harris: "If [a potential portfolio company] does not conform to the non-negotiable criteria, we will not progress further. After that, it is about evaluating ESG risk and opportunity, and making sure we understand what we are taking on and that any material implications are reflected in the terms of the deal."

Lobbying for change
Other managers will be less selective at the investment point and instead encourage good practice from within – which is something that resonates with SEI, among others. "We do not negatively screen out any investments other than controversial weapons, such as cluster munitions," says SEI's Rees. "Instead, we invest in any profitable company and lobby for positive change from a position of influence and mutual interest. For an oil company, we are not saying 'stop producing oil', but we are saying that, while extracting the oil, you could capture the methane bi-product with the use of new technologies that makes it cost-neutral or potentially profitable over a longer horizon."

In another example Rees cites, SEI encouraged Yum! Brands to commit to helping prevent deforestation by moving to 100% paper-based packaging made from responsibly managed forests and recycled sources by the end of 2020. The firm calls it an engagement policy and reports on it just as it reports on financials.

It is about evaluating ESG risk and opportunity, and making sure we understand what we are taking on and that any material implications are reflected in the terms of the deal" – Mike Harris, Rutland Partners

Similarly, Rutland engages an external ESG consultant to evaluate ESG issues and opportunities in every new company it acquires. This work concludes with an overall ESG rating, as well as a list of around 15-20 detailed recommendations that act as a benchmark for future monitoring. Says Rutland's Harris: "The trick is to break down ESG issues and initiatives into individual tasks to which you can assign responsibility – or else it risks becoming a subject that is eternally talked about in generality, but without actually implementing the change required to move the company forward."

While there is currently little uniformity when it comes to ESG policies, doing nothing is fast becoming a non-option. "We put an ESG rating on a company, but many of our LPs assess our rating as a GP as well," says Harris. "It is important to recognise that a lot of investors in funds such as ourselves are ultimately accountable to pension funds and public bodies at the top of the investment chain, which are all calling for more ESG engagement."

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