Due diligence and deploying capital

One of your key roles as a GP will be to help your portfolio companies improve their ESG performance. Therefore, depending on the stage of the firm and the fund, it is important to find portfolio companies with the right ESG profile and growth prospects – this is important from both an implementation and a data gathering perspective.

Investments will not be limited to companies that are already aligned with the GP’s view of ESG best practices; rather, most GPs will purchase a portfolio company, being aware of any ESG risks and opportunities, and then make sure that those ESG risks or opportunities are mitigated/explored as part of the value creation plans.

A thorough ESG due diligence exercise is fundamental to finding and taking on board the right portfolio companies that have the potential to be taken to the next stage of their ESG journeys. Understanding the ESG opportunities and risks of a company allows you as a fund manager to actively improve its performance. Matters to cover include but are not limited to:

• ESG approach if defined;

• Overall company structure and governance arrangements;

• Register for ESG and non-ESG past incidents;

• Environmental policies, capacity, progress to date and any past incidents; and

• Social policies, enforcement, and any past incidents.

A full list of items can be found in Invest Europe’s “ESG Due Diligence Questionnaire for Private Equity Investors and their Portfolio Companies”.

Reputational assessment is also important based on information available in the market about the portfolio company, its founders, and its supply chain. Any reputational issues in the past, could impact the reputation of not just that company at a later stage but also that of the firm and indirectly that of other companies in its portfolio. Thus, the exercise cannot be taken lightly. Such an assessment generally begins with a desk review assessment, but you may also need help from resources on the ground to confirm or dispel any matters that come to light.

Firms that are in the higher echelon of ESG performance, may also want to consider including ESG-related clauses in the agreements with their portfolio companies. These could include remuneration being tied to certain ESG goals.

Together with the other matters considered in the 100-day plan, ESG increasingly also features high in the things to look at – subject to materiality of course. The materiality of ESG factors will vary by industry, and may be company specific, so as a fund manager you will need to decide what to focus on (this will likely only be issues flagged during due diligence).

Including ESG in the 100-day plan is important because implementing some of the recommended changes to improve ESG performance at the portfolio company, can take a long time to happen. These can include supplier choices, energy alterations, diversity, etc. Most red flags are highlighted during the ESG due diligence exercise and give a list of areas that GPs need to focus on.

All firms, depending on their nature and size, could receive a lot of ESG data from the underlying portfolio companies.

Firms that are more advanced on the ESG journey will also be providing a great amount of feedback to the portfolio companies. Having the right level of ESG support and expertise is imperative to firstly being able to collect and analyse all this data but then also to provide and implement feedback at the portfolio company level. As a fund manager, you should determine and meet such requirements at an early stage if your firm aims to create a considerable impact on exit.

Due to the dynamic nature of ESG data reporting, fund managers should have a robust system to be able to gather, calculate, analyse, and report meaningful information.

Collecting information from your portfolio companies can become a cumbersome task due to its sheer volume and because often the required information can be held across various sources and departments. Also, the data that comes back from your portfolio companies, could be in various formats and may not conform to your firm’s methodology and thus would need to be sense checked, standardised, and then analysed and interpreted. The more historical data your firm has, the better targets it can allocate and achieve, adding much greater value to the ESG process.

Finally, there are scenarios where some inference needs to be made from data on hand, that could be through use of proxies for calculations like carbon emissions or measuring impact on the environment/societies based on the geographies and sectors that firms operate in. The right technology can help with all the above which could add great value, but the decision needs to be made as early as possible to make the full use of technology.

It is a fundamental question for many firms to decide which ESG KPIs they need to monitor and thus collect data on. Rather than being an isolated question, which it is assumed to be and thus the desire to find one-size-fits-all KPIs, many factors including the below impact the choice of KPIs:

• stage of your firm’s lifecycle;

• role that ESG plays in your firm’s investment strategy and whether ESG is only used as a minimum regulatory requirement or whether you utilise ESG data to make more informed investment decisions;

• impact philosophy and if a positive impact on the society is a core focus of your firm;

• regulatory requirements;

• investor and stakeholder requests for information;

• the industry and sector your firm operates in;

• percentage of ownership of portfolio companies and your firm’s ability to have influence at a management/board level; and

• cost and benefit analysis.

That is why it may not always be possible for all firms to have the same KPIs, although some basic standardisation is possible and desirable.

Firms that are generally advanced on their ESG journeys can look to alter their financing structure as well through targeting the right investors and financiers.

More and more investors and financiers are now willing to invest and provide loans at more favourable rates to an asset that performs well in understanding its ESG risks and opportunities. However, this requires constant monitoring and gathering of data and may also need external certification on a periodic basis. Firms that have the right data and resources are best placed to avail this opportunity.