The “why”

For many private equity general partners (GPs), Europe provides an attractive source of investment in the private capital sector. Alongside financial returns, many European investors (LPs) are also seeking investments with ESG impact and are therefore actively embracing ‘sustainable investments’. Demand for sustainable investments is coming from European LPs, driven by commitments made by EU governments and businesses that relate to sustainable goals, such as reducing carbon emissions in line with the Paris Agreement in order to achieve net zero by 2050.  In addition to environmental commitments, LPs are also looking to social and ethical standards and practices (the “S” in the ESG).

A tsunami of cutting edge ESG-related disclosure regulations have been introduced by the EU and these have revolutionised sustainable investing.  The most important EU regulations applying to private equity funds are the Sustainable Finance Disclosure Regulation (EU) 2019/2088 (the SFDR) and the Taxonomy Regulation (EU) 2020/852 (TR).  They require fund managers based in the EU or marketing into the EU to disclose the degree to which they are investing in “sustainable investments” and/or “environmentally sustainable investments”.  Both of these terms are subject to pre-defined criteria which, if satisfied, enables a fund to be marketed as ‘sustainable’ within the EU.  If GPs want to sell ESG-related funds to European LPs, then they need to comply with the SFDR and TR.

The “when”

The SFDR and TR apply now.  Fund managers based in the EU or marketing ESG integrated funds/sustainable investment funds in the EU (under Article 8 or Article 9 of the SFDR) will have begun to disclose information on their websites and in respect of specific funds from 1 January 2023, consistent with the SFDR regulatory technical standards. 

The “when” is now, shown by the research completed by PwC and reported in their report “GPs’ Global ESG Strategies: Disclosure Standards, Data Requirements and Strategic Options 2023”.  They suggest that private equity firms are now taking an ‘ESG or nothing approach’ and they report that “75.3% of PE LPs and 83.8% of PE GPs globally [are] planning to cease investing in and launching non-ESG investments – of which over half intend to do by end-2025”.  This acknowledges the sentiment of the market towards ESG but whether or not this is reflected in practice remains to be seen.

The “how”

How can GPs seize this opportunity, respond to LPs’ needs and mitigate the additional risks and regulatory compliance associated with ESG-related funds?  The answer is, if they have not already, GPs need to analyse their investment purpose (and how ESG fits in with it) and incorporate this vision into ESG policies and (pre- and post-investment) processes throughout the business.

Integration of ESG factors introduces new complexities and risks that require careful assessment. As private equity investments have a typical investment cycle of 3-5 years it is vital a firm’s ESG strategy is embedded from the start of the investment relationship.

This will look different for everyone; some firms may be at the start of their journey and are considering integrating ESG considerations into their investment deliberations, whilst others might be considering how to make their investments compatible with Article 8 or 9 of the SFDR.  In either case, the obligations stemming from the SFDR and other global frameworks require ESG to be integrated into all steps of the investment process.

Practical Considerations

How are GPs integrating ESG into their overall strategy? Best practice includes:

• development of ESG policies and ensuring that ESG factors are considered and given sufficient weight at all investment committee meetings to satisfy relevant SFDR/compliance obligations;
• specific ESG due diligence (DD) – this includes pre-investment DD to understand investments’ ESG risks and opportunities and to ensure that they are consistent with the firm’s strategies, policies and procedures (including exclusion criteria).  This will also allow for risk and loss mitigation at an early stage;
• engagement with portfolio companies pre-investment, including signing side letter/agreements setting ESG standards, key performance indicators (KPIs) and targets to enable GPs to comply with ongoing SFDR obligations (including implementing provisions to facilitate the sharing and monitoring of data);
• ongoing monitoring of progress against ESG standards, KPIs and targets throughout the investment cycle, including provisions to rectify any issues that may have been identified during DD or the ongoing asset management phase;
• conduct annual reviews to ensure the continued compatibility of the investee company as an SFDR compliant investment; and
• reflect ESG reporting requirements (the SFDR and other) in templates for annual reports and clients.