Get ready for responsible reporting

Fund managers have been increasingly under pressure to establish an internal framework to evaluate and monitor environmental, social and governance (ESG) issues throughout the life cycle of an investment – from origination to exit. 

Also referred to as ‘responsible investing’ by many, the momentum has been less about barring certain types of investments and more about GPs creating a process-based approach to ESG, documenting it throughout the life of an investment and sharing the information with LPs.

Last week, fund managers and investors converged in Brussels to discuss related best practices at the European Private Equity and Venture Capital Association Responsible Investment Summit. While delegates and speakers agreed that adopting responsible investment practices was a positive step in the asset class’ continued institutionalisation, many also worried about the European Commission’s stated desire to eventually require fund managers (and other financial institutions) to disclose and report their responsible investment policies and what actions have been taken to meet them. 

In theory, it sounds like the same sort of data an ESG-savvy fund manager might provide to its investors, nearly all of which are asking GPs for such information these days. But in practice, it’s unclear whether the Commission has in mind a prescriptive set of rules for standardised ESG reporting, or a more favourable ‘principle-based’ approach, which is what the UN has advocated for with its ‘Principles for Responsible Investment’ since 2006.

Either way, a number of complexities exist in measuring and managing ESG policies. Below are a few of the repeat concerns delegates raised at the conference:

One size doesn’t fit all – Coming up with standardised templates for financial reporting remains a challenge for the private equity industry, whose depth and breadth make it difficult to take a uniform approach that satisfies all parties. There’s not much reason to think EU Commissioners wouldn’t experience similar problems in crafting a mandatory ESG disclosure report. Aside from LPs and GPs having different information needs, they may also have divergent views, for example, on what constitutes a ‘material’ social issue at a portfolio company and how to handle it.

Managing what you can’t measure – We’ve seen evidence of firms successfully tallying the environmental triumphs at portfolio companies and linking them to IRR (Kohlberg Kravis Roberts, in particular, has done a good job banging the drum on this), but measuring the decisions taken that relate to the other letters in the ESG acronym aren’t as straightforward. As one EVCA delegate asked: “How do I tally how many strikes we’ve prevented by improving working conditions?”

Small firms, big costs – A number of the industry’s larger firms have been making in-roads on the ESG front, with dedicated internal staff or third-party partners leading ESG efforts. But all that comes at a cost, and for smaller firms, a mandatory ESG disclosure report would have a disproportionate hit on their bottom line. 

Despite these concerns, there’s little doubt responsible investment is transitioning from industry trend to industry standard. Developing ESG reporting standards, however, might progress at a slower pace than EU policymakers hope.