ESG scrutiny hits private markets

Over the last decade, listed equity managers have grown used to demands from major institutional clients for proof of their management of environmental, social and governance risks. Listed debt managers are growing accustomed to the same demands. Now major asset owners are turning their attention to getting a clear view of the ESG risks embedded in the unlisted assets within their portfolios.

This can be particularly challenging in the traditionally opaque world of private equity.

The Future Fund, Australia’s A$134.5 billion ($101 billion) sovereign wealth fund, first introduced a system to assess the capacity and commitment of its managers around ESG issues in 2015. At a recent gathering, Future Fund head of ESG, Joel Posters, shared how the processes and protocols were implemented, particularly with regards to managers operating in private markets.

As a first step, the Future Fund evaluated its more than 100 investment managers to identify those that required critical attention. There were three criteria: whether ESG moved the dial in terms of the performance of the investment; how much influence the Future Fund had in making demands of a particular manager due to the size of its investment; and the duration of the investment.

“We recently put down an investment of $1.1 billion for the privatisation of Port of Melbourne,” said Posters, speaking at the Responsible Investment Association of Australasia’s (RIAA) annual conference, held in Sydney, November 15-16, 2017. “We might hold that asset for as long as the fund survives, be that 10, 20, 25 years. Clearly it’s in our interest there to make sure we manage those ESG issues to the best of our abilities, versus a hedge fund manager we have a relationship with that trades in and out of its holdings every week or every month.”

Eyeballing managers

Posters and his team identified 50 managers for priority assessment, a process that now begins whenever the fund adds a new manager, and have conducted periodic evaluations since then. Evaluation templates are tailored to the relevant asset class, and sometimes to the underlying strategy.

“Among private-equity managers, we would have different questions to ask an emerging-market buyout manager versus a developed-market venture capitalist,” Posters said.

The Future Fund does not share its assessment templates with managers in advance and prefers to conduct discussions via face-to-face meetings or conference calls, rather than email.

“I think you get the most honest responses when they don’t know what’s coming,” Posters said. “You can learn a lot more from an investment team if you’re looking them in the eye.”

It is also essential, he said, to have the right people around the table and often that’s not the dedicated ESG team.

“I want to talk to the senior portfolio managers,” he explained. “Those are the people who have to fulfil the mandate, those are the people who are making the investment decisions on a day-to-day basis, and those are the ones who are the most relevant for the discussion.”

Once ESG assessments are complete, that information is incorporated into existing manager evaluations, which are based on a dozen criteria, including track records and fees, as a qualitative overlay. Managers are marked as either above expectations, meeting expectations or below expectations.

“I think if you become more granular than that, it just ends up adding a lot of noise,” Posters said.

Feedback keeps managers engaged

For the most part, the Future Fund’s managers are at least meeting expectations. Where they are not, the amount of risk in a portfolio is taken into account before decisions are made about escalation. For example, there is greater risk tolerance for a US venture-capital manager that is just starting on its ESG journey and investing primarily in cloud computing companies in California, than for the industrial sector buyout manager operating in emerging markets.

Managers are ranked according to performance and advised of their ranking. That feedback loop is important to keep managers engaged in the process, because they want to see how they stack up against their peers.

For managers who aren’t meeting expectations, Posters prefers addressing the issue privately first. If that doesn’t work, the Future Fund has had success raising concerns in collaboration with other investors. In one case, a private-equity manager operating in emerging markets retained an environmental consulting firm to upscale its risk management after concerns were raised with the limited partner advisory committee (LPAC).

Other corrective options include hosting workshops with fund managers, and providing them with tools to screen for ESG issues relevant to their portfolio. Where the Future Fund doesn’t have the leverage to force change, it will reconsider the entire relationship, Posters said.

Renewables bear fruit

While the pre-investment stage is a critical time to communicate expectations around ESG issues, in most cases the Future Fund will have a governance structure in place to ensure it has access to, and influence over, managers throughout the investment period.

“For example, [along with] the $400 million commitment we have towards AGL’s renewables fund, we have two of our infrastructure guys on the board,” Posters said. “Within most of the private-equity deals that we do, we want a seat at the LPAC.”

He said that, while the Future Fund probably has taken on many renewable energy private-equity deals in the past, the space is really coming to fruition now.

“When we invested $400 million in AGL’s renewables,” he told the conference, “it wasn’t necessarily about the fact that it was renewable, it was about the fact that it was a brilliant opportunity.”

Improving monitoring and reporting is an ongoing exercise. For the Future Fund, part of that effort includes signing up to the Global ESG Benchmark for Real Assets, to guide its relationship with infrastructure and property managers.

“We want to receive information about ESG that moves the dial,” Posters said.“But we don’t want our managers to have to report to us in a different way than they’re having to report to the 20 other investors on exactly the same issues.”

First State Super’s focus

Joining Posters for the RIAA conference panel on ESG in private markets was First State Super head of research Ross Barry.

Barry said First State Super has processes in place similar to the Future Fund’s for assessing the performance of its external managers in listed markets; however, the challenge of assessing ESG compliance in private equity makes the fund cautious about how it allocates to the sector. Since private-equity funds are typically blind pools, First State Super has a zero allocation to it in its socially responsible investment options.

Even so, First State Super was eager to explore what it could do in private equity in a manner that was aligned with ESG practices, so it turned to impact investing.

“We wanted to have one piece of the portfolio that was skewed towards finding things that had a very strong, positive social, economic or environmental impact,” Barry said.

First State Super worked with alternatives manager ROC Partners to become a direct shareholder in companies and other assets that promise to have a positive impact.

Barry addressed concerns that impact investing requires asset owners to take a haircut on returns, saying that there is enough deal flow for the platform to offer a well-conceived, diversified and compelling return proposition for members.

“The opportunities have to present a compelling reward for risk, or they just get filtered out along with everything else,” Barry said. “There are enough really clever, smart things that people are doing, that employ people, provide affordable healthcare and affordable energy, and