Having a company-wide understanding of ESG can help PE firms reduce compliance risks

Ensuring that all parts of your firm – from finance, accounting and compliance to the investment teams – understand your ESG program can help mitigate the many risks ESG practices can pose, and even help drive better investment decisions.

Investment teams can flag potential issues with portfolio companies, and help companies in which the firm has already invested identify problems and focus on doing the right things.

During a Morrison & Foerster webinar, Navigating Key Legal & Compliance Issues – ESG-Focused Fund and Portfolio Company-Level Strategies, on April 20, panelists discussed how a full understanding of an ESG program can help firms identify the risks associated with the “big six” ESG compliance issues: anti-corruption and anti-bribery; cybersecurity and privacy; human rights and supply chain; diversity, equity and inclusion; climate; and sanctions.

The ‘big six’ 

Stacey Sprenkel, global ethics and compliance practice lead at Morrison & Foerster said the “big six” issues cut across the vast majority of companies. The question for private equity managers is how the issues can manifest and how the firm or its portfolio companies can mitigate them.

“I think you really need to take inventory of what companies are currently doing and the actual and potential risks across these different issues. You then need to prioritize or risk-rank the issues to develop policies and procedures, controls and training to mitigate the risks and better position the company to avoid potential compliance issues,” Sprenkel advised.

Investment teams at PE firms should monitor current portfolio company ESG commitments and see how those align with the firm’s own commitments.

Firms should also ensure they and their portfolio companies are speaking the same language when it comes to ESG considering the definition of ‘ESG’ itself is evolving. The umbrella covers a lot more than traditional environmental or governance issues, and now includes cybersecurity and privacy, for example.

Alison Fenton-Willock, director, sustainable investing at KKR, said because ESG is a broad term, one of the firm’s steps in mitigating potential issues is figuring out which issues are material, relevant or important for investment team members to understand as they assess potential investment opportunities.

One area of concern for investors, sponsors and companies is human rights and potential supply chain issues. According to Sprenkel, there has been a great deal of focus on issues of modern slavery, supply chain diligence and transparency, and the impact a company has on local communities.

Companies are also facing increased scrutiny about potential human rights violations in their supply chains, and regulations have been implemented to ensure companies do appropriate due diligence with their suppliers. This means PE firms have to ask portfolio companies, or potential investments, about the possible risks and ongoing diligence they are doing.

Avoiding greenwashing claims

With ESG being ubiquitous with investment managers, investors, companies and regulators, there are also greater compliance and litigation risks associated with greenwashing and not being able to verify ESG data. The issue is a top priority for the Securities and Exchange Commission’s Division of Examinations this year, and according to Susan Mac Cormac, global chair of the both the energy and the social enterprise and impact investing practices at Morrison & Foerster, there are now more than 20 enforcement cases against firms regarding their ESG claims.

To avoid greenwashing claims, Beth Lowery, a senior adviser at ERM, said firms should “go through a systematic approach to understand” ESG issues and how they relate to their businesses. “And, it’s very important to develop new policies and procedures and practices for ESG and not just re-label some of your existing practices as ESG,” Lowery said.

Madeleine Evans, director of private equity at Generation Investment Management, stressed the importance of looking at the current regulatory landscape to make sure your firm’s ESG program meets its legal requirements. Firms should understand and clarify their goals and the metrics they will use to assess their ESG programs.

“Firms also need to consider what their LPs are looking for, what data portfolio companies are providing and then build their programs around what is expected and what they can realistically do,” Evans advised.

A good place to start when developing an ESG program is to look at guidance offered by industry groups such as the Institutional Limited Partners Association.

“This would give firms a good roadmap of where to start and key elements of an ESG program,” Mac Cormac said. “Once you have that roadmap and identify the goals of your ESG program, you can start to implement something that will help you meet your legal and compliance requirements.”

Mac Cormac added that the most important thing is that firms don’t commit to an ESG goal until they fully understand what it means to comply with it, because non-compliance could put firms at risk for greenwashing claims.