Those who see ESG as only necessary for meeting LP requirements are missing out on the commercial value it creates, says Tim Clare of Anthesis.
Speaking at the Real Deals Mid-Market conference I was taken by one attendee’s Tweet: “ESG. More to it than just the UN PRI; surely a need to explain how ESG is actually implemented within portfolio companies.” What grabbed me was that its sentiment was correct and that solely focusing on meeting LP requirements ignores the true commercial value of ESG.
UN PRI: Driving the ESG Agenda
Guidance published by the UN PRI, as the leading proponent of responsible investment, has enabled LPs to effectively scrutinise the management of ESG issues by GPs. This has helped drive the recent momentum within many funds to establish more formal systems of ESG management. Becoming a signatory to the UN PRI’s principles is also itself fast becoming one of the key indicators of a GP’s commitment to ESG.
The UN PRI continues to have an important role driving the agenda. For example, its most recent report centres on the need to focus on ESG issues in supply chains. This encourages management teams to think beyond their direct portfolios to their supply chain, where often the greatest risks and opportunities for improvement lie.
ESG: A Burden or Just Sound Business Management?
Despite the benefits of a well-designed ESG system, there is still a tendency in some circles for GPs to focus on LP requirements as a basis for implementing an ESG framework and this often surfaces when we meet prospective clients for the first time. On these occasions, strict compliance is their starting point, and this has the potential to dominate the framework they develop.
The focus on satisfying LP requirements can fuel a sense that ESG management is an additional business burden, overlooking the fact that once established, ESG will add value in terms of risk reduction, operational improvements, smoother exits and enhanced fund-raising ability.
A well-designed ESG policy framework can be achieved with a light touch. It is not a question of drafting long and bureaucratic procedures, and it soon helps the process of completing those LP questionnaires.
ESG: Future Proofing and Adding Value
Recent media coverage and trends in sustainable development have re-emphasised the need to incorporate ESG into core operations as first and foremost it simply makes good business sense from both a risk and opportunity standpoint.
In the last few months we have seen increasing media and public scrutiny over issues such as plastics waste, following Blue Planet II and the Chinese decision to greatly reduce imports of plastic. The continued issue of gender pay gaps and most recently the collapse of Carillion have focused the lens on governance. The plastics example has shown how quickly markets can be disrupted by consumer preference and regulatory policy that have and will continue to have significant impact on the operations of a business.
Good ESG policies and frameworks will identify potential future impacts, such as climate change resilience as well as unacceptable historical business practices, before they become both a financial and a reputational cost. Your ESG framework should ask you to undertake an early phase screening of an investment to identify such risks and ensure they are further assessed prior to acquisition if required and then managed post-acquisition.
Such screening is light touch, using checklists, initial advisers’ advice and increasingly software solutions such as those we provide at Anthesis. With plastics, a screen should identify the consumer preferences and recyclability factors and other potential issues like chemicals regulation, and not just the potentially more “obvious” risks of contamination and compliance at the factories.
An ESG framework however is not just about minimising risk, it will also seek to create opportunities for a business. Your ESG framework, seeking to ensure compliance and improvement, will ask you to work with your portfolio companies to determine what their key ESG issues are and then set some KPIs and performance targets, perhaps five to ten in the first instance.
Some targets will be about maintaining performance, such as staying compliant, others will seek improvement. Again, the process of setting these can vary, ranging from using pre-prepared questionnaires to running short workshops; the key points are that it’s a dialogue with the aim of setting realistic targets.
Every business is different and so are its key ESG issues and its ability to manage them. But it is likely that all will wish to focus on those opportunities that will significantly support their P&L and their corporate values. One specific area of focus is likely to be energy reduction and energy generation.
There are often significant savings and revenue creation opportunities to be made with attractive returns on investment with third party sources of capital available to exploit these specific opportunities. There are similar financial return and corporate values opportunities associated with carbon, waste, recycling and water reduction.
The Commercial Value of ESG
Looking at social concerns and back to the shop floor, your KPIs may include staff retention and absenteeism rates. Both issues have direct costs and productivity consequences. ESG’s value here is often just shining a new spotlight on the issues and encourages action which the management may otherwise have not prioritised.
Here the GP’s wider experience, and shared experiences from “sister” portfolio companies can be invaluable. Many of the more advanced funds host events for their portfolio companies to provide them with know-how from in-house or external advisers and share their experiences.
On an annual basis the ESG framework will ask the portfolio companies to report on their performance on these targets, so that they can be reviewed, re-set or replaced. Often it will be fair to conclude that no further improvement can be economically made on a particular KPI and others can take its place. The process provides valuable metrics to put in front of the LPs and other stakeholders and over time the process can be streamlined with a software platform if preferred.
Many of the ESG aspects are just about good management and we have found that management teams are pleased to adopt them, and grateful for the assistance their GPs have provided in that process. The return is that at the point of exit, a better managed, more efficient firm can be presented, with metrics to back the statements. Positive ESG performance is attractive to buyers.
To conclude, the Real Deals conference finished with an audience poll that included the question as to whether attendees felt ESG was important; only 11 percent felt it was not. Clearly that cannot just be because people are worried about LP questionnaires.
This article was first published on Real Deals.