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Best Practices in ESG Due Diligence for Private Equity Firms

By November 5, 2019May 5th, 2022No Comments

The widespread adoption of ESG is forcing private equity firms to rewrite the rules of deal due diligence.

By Trysha Daskam and Fizza Khan

Reprinted with permission from the October 25, 2019 edition of  LAW.COM | New York Law Journal ©2019 ALM Media Properties, LLC. All rights reserved.

The biggest sea change for private equity firms over the last decade has been the rapid rise of ESG. Of the $30.7 trillion in global sustainable, responsible or impact (SRI) assets under management, nearly $1 trillion is held by private equity and venture capital funds, according to the latest figures from the Global Sustainable Investment Alliance (GSIA).

The widespread adoption of ESG is forcing private equity firms to rewrite the rules of deal due diligence. Instead of looking only at financial statements and growth plans prior to making an acquisition, dealmakers are increasingly taking ESG issues into consideration. For example, is a company’s business model sustainable in a resource-constrained world? What environmental risks does a company face based on its geographic location? Is there strong gender diversity across the firm? Is executive compensation aligned with positive social or environmental outcomes?

These are not easy questions to answer. Even with improvements in the quality and availability of data, there is still no one-size-fits-all approach when it comes to ESG due diligence. Dealmaking professionals, and the internal or external counsel supporting them, must therefore consider an ever-growing list of ESG issues that may potentially affect a deal.

However, part of the challenge is the uncertain regulatory landscape for ESG. There is a patchwork of rules and regulations that can vary widely from country to country, with new proposals and studies released on a regular basis.

In general, there are two sides to the regulatory conversation: (1) top-down regulation from governments or regulatory bodies, and (2) bottom-up self-regulation from industry leaders and standard bearers.

Top-Down Regulation

Financial regulators have started to pay increased attention to ESG, partly in an attempt to prevent future market abuse and partly in an effort to push investors and their managers towards certain standards. The European Commission has historically been the most active on ESG regulation, taking another step forward in early 2018 by releasing their action plan on sustainable finance to help: (1) reorient capital towards sustainable investment to achieve sustainable and inclusive growth; (2) manage financial risk stemming from climate change, environmental degradation and social issues; and (3) foster transparency and long-termism in financial and economic activity.

It is still unknown if or when these objectives will turn into real policy, or whether there will be enough of a penalty to encourage financial firms to comply with EU rules. However, EU officials are clearly signaling that they intend to hold market players accountable to a high standard of behavior. This has led to speculation of a so-called “Brussels Effect” on ESG policy, since any asset manager with exposure to the European market would be expected to align their firm-wide approach to ESG and sustainable finance with the EU’s guidelines.

Meanwhile, in the United States, the ESG policy conversation is still in its infancy. In late 2018 there was a coalition of major financial firms representing more than $5 trillion in assets under management that signed a petition calling on the SEC for action on ESG disclosures and standardization. There was also a bill on climate risk disclosures, H.R.3623, that was passed by the House Financial Services Committee along a party line vote. However, these proposals are unlikely to make it through the current iteration of Congress, which means major policy or regulatory changes will have to wait until after the 2020 Presidential election, at the earliest.

There is also movement in China, Japan, Australia, South Africa and a few other major economies. But given how much of the capital markets is dominated by Europe and the U.S., any ESG rules or regulations will ultimately have to be adopted by those two markets to truly be considered global.

Bottom-Up Self-Regulation

Despite the regulatory conversation beginning to pick up steam across various markets, we are likely still several years away from anything resembling an international set of binding rules or regulations on ESG. But despite this, the private equity industry—and the broader asset management industry—seems to be coalescing around a set of voluntary standards and guidelines.

The American Investment Council (AIC), the main trade body for U.S.-based private equity firms, first published guidelines for responsible investment in 2009. The first guideline speaks directly to due diligence by calling on AIC member firms to “consider environmental, public health, safety, and social issues associated with target companies when evaluating whether to invest in a particular company or entity, as well as during the period of ownership.”

The AIC guidelines echo many of the same principles from the UN-backed Principles for Responsible Investment (PRI). According to a 2018 UN report, there are 431 private equity firms who are PRI signatories with $1.05 trillion in combined AUM, representing about a third of global private equity assets under management. The PRI has always been heavily involved in the policy conversation and, although the non-profit does not have the authority to pass or enforce legislation, it does play a role in pushing relevant information out to signatories to make sure they are ready for any potential future regulation. For example, the PRI in February 2019 announced that, in order to remain a signatory, members will be required to report on climate issues according to the Task Force on Climate-related Financial Disclosures (TCFD).

Additionally, in September 2019 the PRI partnered with the law firm Debevoise & Plimpton to commission a legal memo on “The Duty of UK Company Directors to Consider Relevant ESG Factors.” Fiona Reynolds, CEO of the PRI, said: “A company’s board of directors is a crucial lever for transformation and adaptation. As our private equity signatories look to integrate ESG considerations into all aspects of the investment process, they utilise their engagement with company boards to drive effective oversight of ESG risks and strategic planning for ESG opportunities.”

The PRI has also commissioned a similar memo focused on U.S. company directors that will delve deeper into the role of private equity firms and help more clearly define investors’ fiduciary duty in considering relevant ESG factors. These bottom-up efforts by the PRI, AIC and others go a long way towards creating industry alignment on best practices for ESG due diligence and company engagement.

Best Practices for ESG Due Diligence

Taken together, this collection of regulations, standards, guidelines and principles offers a clearer path forward on ESG due diligence. While there is no one-size-fits-all approach, we see the private equity industry coalescing around a basic set of five best practices.

  • Develop an ESG policy: Any PE firm that wants to take ESG seriously should have a formal policy that can be shared with investors, consultants and industry bodies. A policy also helps to create a consistent and repeatable process for ESG due diligence, which is why incorporating “ESG issues into ownership policies and practices” is one of the requirements for becoming a PRI signatory.
  • Focus on the material ESG issues: ESG should not be a box-ticking exercise. Focus on which ESG factors are material to the particular business or acquisition target. The SASB materiality map offers a helpful guide and starting point for considering which ESG issues are most material to different industries.
  • Emphasize climate risk disclosures: If there is one ESG factor that investors—and many regulators—will begin asking every company to report on regardless of the industry, it is their climate risk. The TCFD offers a good model for climate risk disclosures, including how to account for Scope 1, 2 and 3 emissions.
  • Track what you can measure: As part of the due diligence phase, it is important to identify ESG-related Key Performance Indicators (KPIs) that are measurable as a potential future input for investment monitoring and engagement. By identifying a company’s baseline ESG efforts prior to acquisition, a GP can better track opportunities and challenges over time.
  • Manage against time constraints: Due diligence can be a lengthy process, especially with the added complexity of ESG considerations. While some PE firms may be tempted to take shortcuts on their ESG due diligence in order to get a deal done quickly, especially in a competitive deal environment, we recommend allowing enough time to conduct high-quality due diligence.

The effectiveness of these best practices will vary depending on at what stage of the due diligence process PE firms look at ESG factors. We have seen two distinct approaches among the PE firms with which we’ve spoken. Among the firms that we would consider mature in their ESG integration, ESG is incorporated into each stage of the due diligence process (often with a focus on governance) and is used as a “go-no-go” for further diligence on any potential deals. However, others focus on strictly financial considerations first and then incorporate ESG considerations as a final part of due diligence prior to finalizing the deal, and sometimes even post-acquisition. In our view, the earlier ESG considerations are incorporated into the due diligence process, the better the ultimate investment outcome.

It may be several more years before the PE industry has consistent standards around ESG reporting and investing. But firms shouldn’t use the lack of regulation as an excuse to continue conducting due diligence without considering ESG as part of the process. Many large institutional allocators, especially those in Europe, expect GPs to have a sophisticated approach already in place. As a way to understand the function and sophistication of a GP’s approach to ESG, many investors are proactively asking potential managers for specifics on the deals that were consummated or passed on because of the management and existence of ESG risks.

Private equity managers face an increasingly high bar on ESG to earn (and keep) an allocation. The firms that take proactive steps now to optimize their due diligence processes in accordance with best practices will have an important edge on the competition.

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