This article is sponsored by BKD
Gone are the days when a GP can draft some pleasant language about their commitment to ESG and post it on their website over a photo of a budding pea shoot. Bodies like ILPA are spelling out what they expect from ESG programs, as are others. While the common theme is that GPs should be living up to the language in an ESG policy, it’s unclear what that policy should be.
So, Private Funds CFO sat down with managing director Coleman Rowland and national practice leader Brian Matlock of BKD CPAs & Advisors, who argue that the best ESG programs aren’t being designed to comply with one specific standard. Instead, they are built in close collaboration with investors to ensure that ESG priorities are respected in a way that’s tailored to each portfolio company under the GP’s watch, and to each LP’s goals.
Every fund manager knows they need to address ESG, but how can they determine which policies will fit for their specific situation?
Brian Matlock: To co-opt a famous phrase, they should “follow the money.” Big institutional investors like CalPERS and Texas Teachers’ have been vocal proponents of ESG, and ILPA has issued an ESG road map, which includes guidance for members on organizational policy and infrastructure, due diligence and investment decision-making, managing GP relationships, and reporting and benchmarking, as well as communications to internal and external audiences.
But the group itself refers to it as a “clearinghouse of best practices and resources that reflects the ongoing development and evolution of successful ESG in LP organizations.” So, it’s more a report on the priorities and concerns members have, rather than a system of hard and fast rules.
Coleman Rowland: And as much as some boilerplate process would simplify things, there is no one-size-fits-all ESG program, because every fund and every portfolio company faces issues and risks unique to them. Having worked with many energy firms, there’s a difference between the ESG program for a heavy oil company and a natural gas one, and groups like ILPA understand this. But this doesn’t mean that any one industry participant can short-change their ESG effort.
BM: If there is any hard and fast rule, it’s that an ESG policy can’t be a document that gets written and then gathers dust. Investors are going to want to make sure that GPs are living up to the standards and practices they’ve developed. Investors are applying real scrutiny to ESG metrics, and managers need to be prepared for that.
That still begs the question, how can GPs know they’re doing enough to tailor their ESG programs?
BM: I don’t want to discount how hard this is. There are so many different sets of standards at the moment, from the international GRI to the US-based SASB, that it can feel like an impossible task. This looks and feels like the period of time just after the enactment of the Sarbanes-Oxley Act of 2002 in the wake of the Enron situation. There was so much confusion around compliance, it was hard to know what the “new normal” would look like. It’s the worst of both worlds, in that ESG is a hot topic and a moving target.
CR: Some companies are using their peers for guidance, or a “birds of a feather” approach. What does that massive public company in my industry do on the ESG front? BlackRock developed its gold standard for ESG a few years ago, and there’s a trickle-down effect, where emerging managers are aiming to match it. This can be helpful, since, for example, there’s no way any company can follow the hundreds of recommendations contained in SASB, because many simply aren’t relevant.
BM: Our sense is that over the next few years, the various groups will come together for a more uniform standard, and I wouldn’t be surprised if there is a rise in third-party validation for ESG policies, where, like one has audited financials, they’ll have audited ESG programs. But until then, there’s a lot of room for interpretation, and confusion.
That’s why the focus right now needs to be on collaboration, not compliance. An energy company might be able to gauge the amount of emissions, but for the “S” in ESG, the social element, the metrics aren’t so clear cut. This can lead some corporate leaders to resent ESG efforts by taking every sound bite from a politician or activist as something that redefines the metrics on a monthly or weekly basis.
CR: That’s why GPs should be having comprehensive conversations with their stakeholders, and the stakeholder that matters the most are their investors. Talk to them about their priorities and concerns around ESG and invite them into the process of crafting that policy. These conversations will help establish a target that doesn’t always move with the headlines. Or simply put, don’t just “follow the money.” Listen to it.
Even if a manager knows LPs’ goals for a specific company, how can they ensure expectations are met?
CR: We recommend a four-phase approach to building an ESG program: assess, design, implement and monitor. We’ve talked about assessing the ESG concerns from the investment community, but executive leadership needs to play a role in defining what success looks like, and the company needs to identify the risks, opportunities, KPIs and reporting framework.
CR: This means developing a plan for the ESG narrative and messaging, identifying data sources, ensuring reliability of that data, designing the ESG report and developing a communication plan for all stakeholders: investors, customers, employees, regulators and the media. Then it’s time to ensure the transparency of the reporting and look for tech solutions to help in that reporting. Afterwards, it’s time to implement the messaging and communication plan.
BM: The larger private equity firms, say with more than $5 billion AUM, will tend to bring an ESG expert in house who will then co-ordinate other outside experts in guiding the effort, while those with less than $1 billion AUM will rely on outside consultants, with those in between alternating between both approaches. Then, it’s time to “design” the program.
BR: The effort doesn’t end there. They need to monitor the program, measuring and refining the reporting and messaging with feedback from stakeholders. It requires constant dialogue to the ensure that it’s working as it should. According to our research, there’s a growing appetite for third-party assurances from an independent accounting firm to validate the effort, precisely given the elusive nature of measuring ESG results.
CR: We don’t discount the labor involved, but the GPs that build the most successful ESG programs won’t treat the process as a reporting burden. They’ll see it as a chance to create even more value at that portfolio company, ensuring that ESG risks don’t jeopardize the health of the company or the possibilities to exit the investment profitably – because that’s still a priority for that most important of stakeholder: the LP. n