The evolution of ESG investing in Asia
Sustainability has been gaining momentum in the private equity industry
Since the establishment of the United Nations’ World Commission on Environment and Development, sustainability has been gaining momentum in the private equity (PE) industry. This trend has led to an increase in PE firms and funds coming to the market that are dedicated to addressing aspects of sustainable development in their investment processes.
In this context, responsible investing has become a stated priority for the investment decision-making process of both PE sponsors (i.e. general partners or GPs) and their investors (i.e. limited partners or LPs). This article examines factors driving these changes and considerations for GPs and LPs alike.
Factors driving ESG in private equity
ESG principles have become integral to the investment strategy of many PE firms. ESG covers an array of issues and considerations but generally refers to environmental, social and governance principles applied to gauge the sustainability and ethical impact of an investment. According to a 2019 UBS survey, 78 percent of asset owners are already integrating ESG into their investment processes, pushing PE sponsors to respond with their own ESG initiatives.
While Asia generally lags behind other regions, the drive and pressure from Asian investors to incorporate ESG factors into investment analysis is increasing and PE sponsors are responding. This increase is due, in part, to financial data indicating that ESG integration may increase returns and the influence of foreign investors and international policy. In Asia, foreign development finance institutions (DFIs) often play a key role in supporting first-time fund managers in emerging markets. These DFIs promote sustainable financing by requiring ESG integration and reporting as pre-requisites for investment.
Furthermore, between 2018 and 2019, there has been a 15 percent increase in Asian fund managers who have signed the United Nations’ Principles of Responsible Investment (PRI). PRI signatories pledge to:
- incorporate ESG into investment analysis and decision-making processes;
- be active owners and incorporate ESG into ownership policies and practices;
- seek appropriate disclosure on ESG by the entities in which they invest;
- promote acceptance and implementation of the PRI within the investment industry;
- work together to enhance the group’s effectiveness in implementing the PRI; and
- report on activities and progress towards implementing the PRI.
Considerations for PE sponsors and investors
In light of the growing appetite for ESG integration, the question for asset managers is not if they should consider ESG at all, but whether they should proactively incorporate ESG principles into their ecosystems or address investors’ ESG-related concerns as and when they arise. We have observed that more PE sponsors in Asia and Europe are proactively addressing investors’ growing concerns regarding ESG by:
- Identifying suitable investments – investigate possible adverse impacts on communities or the environment, or adverse environmental or social performance associated with an entity, and resolve identified adverse impacts in accordance with the sponsors’ ESG requirements, or agree to an ESG action plan to do so;
- Monitoring and reporting - incorporate ESG monitoring and reporting in the constitutive fund documents; and
- Tailoring investment allocation according to the makeup of their LP base – employ fund structures or terms ensuring that LPs concerned with particular ESG issues are directed to investments aligning with their views.
Sponsors can pre-empt investors’ concerns effectively and definitively in fund terms, either by including ESG provisions in draft fund documents or constructively responding to LP requests to include such provisions before parties reach the negotiating table. When preparing a fund’s term sheet or constitutive document, sponsors should consider the PRI’s suggestions for ESG incorporation:
- Commitments to policies, standards and regulation: Investors may require the sponsor to comply with an external standard, like the United Nations Global Compact, or seek assurance that the sponsor has a long-term commitment to its own responsible investment policy and its continual improvement.
- Investment restrictions and limitations; exercise of remedies: Constitutive documents could disclose the sponsor’s own ESG-related investment restrictions. Investors may require “negative screening” restrictions that preclude a fund from investing in certain companies, sectors or assets. Remedies, including rights to be excused from any of the fund's investments, could be applied if such investment falls within such negative screening categories.
- Investment process and decision making: A sponsor should adopt an investment policy explaining how ESG issues factor into investment decisions, or incorporate disclosure to that effect in placement memoranda or constitutive documents.
- Reporting: Reporting requirements (supported by repeating representations on each drawdown) will help ensure the fund complies with ESG policies.
No matter how investment managers address investors’ ESG concerns, practices are evolving rapidly and investment managers can’t remain static. In addition to the above, sponsors can act now by (i) adopting a responsible investment policy and (ii) incorporating ESG toolkits into existing investment processes.
The main hurdles to increased ESG integration within PE firms in Asia include:
- Limited understanding of ESG: Among investors there remains a general lack of understanding of ESG issues and their materiality. There also remains insufficient evidence of tangible investment benefits derived from integrating ESG into corporate culture (generating risk that adherence becomes a “tick-the-box” exercise).
- Lack of comparable data: While the availability of ESG data has improved, quality and comparability remain an issue even where ESG toolkits from DFIs are used to collect and report data. As there is no agreed reporting methodology for ESG matters in most jurisdictions, the data collection process is difficult. This situation hampers modelling or back-testing of ESG factors.
- Regulators’ role: Generally, ESG regulation in Asia tends to lag behind Europe and the US. ESG reporting requirements often apply to listed entities only – and even then, on a comply-or-explain basis. The United Nations encourages regulators to support its Sustainable Development Goals.
Mark Uhrynuk is a partner and Alex Burdulia is an associate in the Hong Kong office of Mayer Brown. Norah Mugambi is based in the Singapore office of Mayer Brown.
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