Environmental, social and governance principles have been taken into account by institutional investors in some form or another for decades. The creation in the early 2000s of the Principles for Responsible Investment, following a worldwide call by the then UN Secretary General Kofi Annan to 50 chief executives of large corporations, has, together with other initiatives, brought ESG investment into the mainstream.

Winston Penhall

Strictly speaking, ESG principles should form part of the financial analysis of a prospective investment and be integrated into the investment process of the investor or investment manager. ESG can be distinguished from socially responsible investment; the latter includes ethical investing, or screening whereby an investor may take the view that it will not participate in certain sectors, such as alcohol, tobacco or the armaments industry.

A large number of companies report sustainability under the auspices of the GRI Standards, while investors themselves may be under a duty to report on their investment activities from an ESG and SRI perspective. Defined-benefit pension schemes in the UK have been under an obligation from 1 October 2019 to include in their statement of investment principles their policy on how they take into account financially material factors, including ESG criteria, in their investment decisions. The country’s Department of Work and Pensions has subsequently written to the 50 largest schemes on this issue.

Most institutional fund managers, discretionary investment managers and investment advisors will have their own ESG and exclusionary policies to give their investors comfort that their fund or investment selection processes embed ethical, ESG and suitable exclusionary principles. Some may, for example, incorporate the UN Global Compact Principles or the OECD Guidelines for Multinational Enterprises.

Industry and international organisations – including the PRI, the British Private Equity and Venture Capital Association and the World Bank’s International Finance Corporation – produce ESG monitoring and reporting criteria. Sixty international investment groups signed up to the IFC impact investing principles upon their launch in April 2019; these included Amundi, CDC, the European Bank for Reconstruction and Development, the European Investment Bank, LeapFrog, Partners Group and UBS.

ESG, SRI and ethical considerations are clearly here to stay and are of increasing importance to investors. Naturally, general partners are also taking note – but what happens if the ESG policies of GPs and LPs clash?

ESG principles and excuse rights

Some GPs have formulated their own ESG policies and guidelines for responsible investment. Others may take into account the policies of the larger investors or report under GRI, PRI, IFC or other published standards.

There is therefore no single set of standards to which all GPs have signed up. Even if two firms have signed up to the same set of criteria, they may not hold the same view in respect of a particular target investment.

This is because the application of ESG principles involves a degree of subjective determination and may depend, in part, on whether the investment is being made on a passive basis or with a view to improving the ESG footprint of the target business over time.

Some limited partnership agreements or investor side letters contain investment-related excuse rights, under which an investor is not required to fund a drawdown notice for a specified investment or category of investments. Investment-related excuse rights usually relate to named companies or defined sectors to which an investor does not wish to have exposure, for legal or other reasons.

The GP in these cases can prospectively identify when the excuse right may be in play and the extent to which granting an excuse right for those investments might affect its ability to implement the investment strategy set out in the fund documents.

ESG principles coupled with an excuse right would pose additional risks to the GP, given the potential for investors to take a differing view in any given scenario – even where the principles being applied are the same for all investors with an ESG excuse right. Granting excuse rights could therefore result in a reduction in the amount of lending available at the fund level.

Where a fund seeks a capital call lending facility, the GP has to play a balancing act: between conceding to reasonable excuse requests from investors, and the implications across-the-board excuse requests might have on the level of borrowing the lender will be willing to provide.

Unless it receives an excuse right, an investor is required to fund drawdown notices or otherwise be in default under the LPA.

Solutions? Some GPs may prefer to hardwire investment restrictions into their LPAs that capture the totality of the exclusions investors have requested and that the GP is willing to concede. This may be preferable from an investor perspective because an incoming investor will have visibility up front of the categories of investments that will not be made. In most cases, investors will not have other investor side letters disclosed to them before investing in the fund.

However, while this method works for targeted exclusions it will not remove the need for GPs to implement ESG principles and policies – for the reasons set out above.

The private markets industry is very much relationship-driven. GPs and investors work closely over the longer term, given the average fund’s life exceeds the typical ‘10-year term plus two-year extension’ model. Larger investors may also have seats on advisory boards and make co-investments generated by the GP.

As part of this long-term, relationship-focused approach, direct institutional investors and their advisors will naturally conduct detailed and advanced due diligence on a prospective GP and its investment strategy. This usually encompasses written operational and investment due diligence reports, on-site meetings and disclosure of prospective pipeline investments.

It is during this pre-investment due diligence phase that institutional investors should, and do, raise ESG considerations, investment exclusions and other investment-related issues.

If the due diligence process raises any red flags, those can be discussed with the GP in advance of investment, thus allowing potential solutions to be debated.

The GP may elect to revise the LPA or grant a side letter excuse right, provided the scope of the excuse right can be defined with sufficient certainty. If the GP is unable or unwilling to concede an investor request then, ultimately, it will be a matter for the investor and its advisors to balance implementation of their ESG principles with the investment return and strategy access that the investor is seeking to obtain.

Although ESG has been around for decades, the increasing attention paid to it in recent years means both GPs and LPs need to be aware of the strictures potentially placed on their counterparts. If the question of excuse rights is managed during due diligence, all parties can rest easy that the issue will not rear its head during later funding.

Winston Penhall is a partner in Reed Smith’s London office and co-leads the firm’s London investment funds practice