Why does ESG matter when raising funds?

LP investors are increasingly scrutinous


Paul Woods, director of sustainability & ESG, Arrow Global Group

If it seems to you that the general question of “why does ESG matter?” is repeatedly asked, then that is a good indicator of its increasing prominence across the alternative assets industry.

This is, of course, in conjunction with countless topics that can be included under the ESG umbrella depending on who you are engaging with in the private equity space. In the private debt and real estate markets, an increasing focus on environmental considerations may take precedence over social and governance issues for many, all depending on the nature of the investment and the type of counterparty or opportunity they are assessing. Is climate change more important than diversity, equity and inclusion (DE&I) when raising funds from an increasingly scrutinous field of LP investors?

Put simply, that will depend on a number of factors, not least those which are most important to the same LP investors who themselves are beholden to their stakeholders.

So, why continue to wrestle with such uncertainty? To understand why LPs and GPs alike place such time and effort on these topics is to understand key drivers of societal and economic change. From an investment perspective, this boils down to risk assessment and reputational risk management for the modern era – and the outcome can mean finding upside opportunity as well as avoiding unacceptable risk

The fact remains that whether by internal choice and alignment with a firm’s purpose or driven by external pressures – be that from governments, regulators, shareholders or customers – the ESG fact-finding and decision-making process is neither uniform nor entirely consistent from one asset manager to the next. There are though, increasingly common approaches taken to fund due diligence, reporting and the embedding of ESG considerations into a broader mindset across firms’ core processes. The move to include ESG factors and KPIs directly into fundraising and portfolio management is evidence of this shifting approach.

Taking a step back from all of this and viewing this landscape through the eyes of an investor makes it easy to empathise with the scale of the challenge, notably at the due diligence stage of the fundraising process. Increasingly, ongoing updates and metrics are shared throughout the life cycle of the process so that each counterparty can report in a timely and accurate way to their own stakeholders. Defining these key areas early on will be critical to long-term success.

Where perfect data does not exist, it is easier to close gaps when reporting priorities are clear and – ideally – aligned between investor and investee. If the information requested is truly useful and actionable, one would expect management teams on both sides of the table to take a keen interest. It is clear that the ability to deliver on investor expectations in that regard is critical to the success of the specific transaction, a key driver for any future ability to do business together, and an overall marker of the alignment in culture and business goals of the two parties. There is a need for asset managers to understand what really matters to their LP investors and improve transparency in those areas, as well as each LP being able to adjust their own due diligence and reporting requirements to suit the materiality and risk profile of the manager. When neither occur, the end outcome is unlikely to be successful in the long term, and when aligned the increased insight is invaluable.

Of course, this brings us to a pivotal question – where does all this data come from and who is responsible for it? If it is commonly understood that it is to the benefit of all parties to ensure transparency over pertinent issues via agreed metrics and KPIs, then it follows that robust data capture and reporting processes should support this. The exact nature of this may differ from one structure to another, but thematically this requires clear ownership within functional or business teams, agreed definitions and timings for data and metrics, and a process for collation and assurance of the outputs. For many organisations, not just in private equity, oversight through a central sustainability team can help instigate these processes and support ongoing alignment between investor and manager.

From a fund manager perspective, maturing quantitative assessment of ESG characteristics provides invaluable support during fund raising by proving more detailed insights for potential investors, yet it also has the additional benefit of delivering management information to assist with the delivery of programmes across the ESG focus areas that the leadership team are committed to.

Being passionate about the quantitative assessment of these aspirations is key for any asset manager – by providing reliable measures they can assist investors in determining what matters to them, how the manager reacts and responds to changing environmental, societal and economic challenges, and how these matters are a fundamental part of any financial risk assessment.

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