PE and ESG reporting: GPs juggle costs to shoulder mounting responsibilities

Key TakeawayS

• GPs prize industry leadership and stakeholder reputations as they absorb ESG costs
• Economies can be achieved where ESG requirements double as value-add exercises
• Balance of in-house and outsourced ESG resources still largely dictated by GP size

This content was originally published by ION Analytics.

Advent Partners is arguably private equity’s environmental, social, and governance (ESG) reporting leader in Asia’s strictest ESG jurisdiction. It was the first in Australia to implement the Institutional Limited Partners Association’s (ILPA) ESG assessment framework and to commit to the ESG Data Convergence Initiative (EDCI), a global standardised metrics and reporting programme.

The weight of the reporting burden is substantial; Advent, which has only 11 portfolio companies, estimates the workload is roughly equivalent to adding one more to its management duties. In a climate of increasing complexity for compliance, that overhead may get heavier still.

“If we can report to EDCI, we can easily report to some of our LPs because that’s their template. However, you’re also seeing other groups that have wider reporting requirements,” said Symon Vegter, a partner at Advent.

“Really the difference is between the US and Europe. European LPs are focused on climate and environmental-related issues. That’s where, to a certain extent, they’re requiring further information over and above EDCI.”

Advent is typical of managers active in Asia in the sense that it has largely absorbed the costs related to ESG requirements in-house and never hired a dedicated ESG professional.

Vegter, a member of the senior management team since 2007, has taken the lead in recent years, including the creation of an annual ESG report. He is supported by one senior investment manager and occasionally mobilises the firm’s finance team.

To some extent, reporting costs can be transferred to portfolio companies, such as with the rollout of Pathzero, a third-party technology platform for preparing carbon emissions data. Advent otherwise covers expenses tied to back-office reporting.

This appears to be the preferred approach for mid-market GPs. Japan’s Unison Capital, for example, has periodically experimented with outsourcing back-office work since its inception in 1998 but it decided to manage ESG in-house and as a GP operational expense.

Unison has likewise elevated an existing senior manager to head of impact investment initiatives; Junko Katayanagi’s duties are now 75% ESG. This work is largely about managing qualitative ESG reporting that is difficult to automate and keeping that reporting well ahead of the curve in terms of LPs’ specific demands.

“We have to have a very clear understanding of what our LPs are really looking for and a clear strategy on what would be the most meaningful way to communicate our efforts on ESG. That’s very different from the standardized reporting part of it,” said T.J. Kono, a partner at Unison.

“To do that with limited resources, we have to be a little bit more creative. Today, we have sufficient resources to meet our LP requirement and probably put more pressure on ourselves in ESG reporting to exceed those expectations.”

Large-cap leaders

These case-studies highlight an imperative to demonstrate industry leadership and corporate social responsibility (CSR) when setting an ESG policy, even on a limited budget. Furthermore, they suggest that abstract GP merits in this vein can be as critical to fundraising success as the practical ability to meet LPs’ ESG reporting requirements.

This mindset is all the more logical at the large-cap end of the industry. PAG, which has about USD 55bn in assets under management (AUM), divides a team of about five dedicated ESG professionals between strategy-specific compliance requirements and enhancing GP-level knowledge and leadership.

PAG is the only Asian manager on EDCI’s steering committee, which it sees as an opportunity to help Asia-based LPs and companies make sense of global standards while driving best practices for the broader industry in the region.

Derek Crane, a partner and COO at the firm, compares ESG to IT in terms of balancing in-house and external functions. Smaller shops typically start with one person in-house and significant outsourcing. As the firm grows, more people and capacity are brought in-house, although eventually outsourcing also increases.

“The focus on gathering data and following programmes in-house has enabled us to improve the quality of our understanding and reporting of ESG,” Crane said. “If we’re collecting specialised data, we’ll use external specialists, but when we’re making decisions based on that and analysing it, it’s important to have that connectivity and alignment in-house.”

Where ESG reporting is accretive to performance, there is scope to offload the expense of the compliance process to LPs, but PAG, like many GPs, is not playing hardball in these negotiations. The priority is ensuring transparency and enabling a partnership approach with LPs.

“How you deal with the cost of it comes down to your corporate view of ESG and CSR as a group, as well as what’s additive to the funds,” Crane added, “Data collection by and large can be looked at as a cost of the fund when it is value accretive to the underlying investments, but decisions we make to go above and beyond that will be a manager cost.”

The financial burden of ESG reporting is a finer point for smaller managers. Matthew Nortcliff, a fund formation lawyer at Goodwin Procter who mostly addresses the sub-USD 500m VC fund space, observes that GPs are not typically able to push the cost of third-party ESG service providers onto LPs as a fund expense.

A cost passed

ESG reporting expenses to be borne by LPs as fund expenses will include wide-ranging policies such as the EU’s Sustainable Finance Disclosure Regulation (SFDR) as well as particularly onerous requirements that get written into side letters.

“As you have more family offices investing into Asia, they often bring with them specific ESG guidelines and parameters, especially around the S and G. In most instances, we’ve seen that funds can align and agree to those principles. The negotiation comes when there’s a significant cost involved,” Nortcliff said.

“In this region, some of the metrics that US or European family offices are looking for are not readily available, so there’s a mismatch sometimes between what is asked and what can be done. That’s less of a negotiation and more of an education process.”

Other institutional investors – including development finance institutions (DFIs) targeting smaller managers with stricter requirements – insist that their templates are added to limited partnership agreements (LPAs) as appendices rather than side letters. The practical implication is that ESG policy becomes enshrined in the fund documents for future vintages and can be enforced by all LPs.

“Most of the energy I’ve seen put into negotiations is around the practical question of whether minority investors are able to fulfil ESG reporting obligations that basically require them to know of any portfolio company ESG violations,” said John Fadely, a fund formation lawyer at Gibson Dunn & Crutcher active across buyouts, growth and venture.

“Can the fund manager learn of or prevent violations of ESG policies when it lacks control over the portfolio company?”

The simplest solution in these instances is to include provisions in the LPA requiring GPs without control positions in companies to make a commercially reasonable effort to obtain the necessary information or to enforce compliance.

Then the question boils down to proving the GP tried to extract the necessary information and influence the companies where it has a minority position. A “best effort” standard can be based on case law, but this compromise will still not be accepted by some LPs, particularly DFIs, which must adhere to rigid policies.

“This is exacerbated if the ESG policy extends to the portfolio company’s third-party service providers,” Fadely added. “Remedies can also be unmanageable. Can the fund manager realistically allow an investor to exit the investment if there is an ESG violation?”

In many cases, third-party ESG providers can be treated as a fund expense although sponsors still opt to absorb the costs themselves. As one regional non-impact GP with global LPs put it: “We err on the side of undercharging because it’s reputationally a real blow if you’re seen as putting costs into the LPs, so we just absorb it.”

A cost absorbed

This practice is even more prevalent where costs are considered de minimis. For example, Affinity Equity Partners pays USD 2,500 a month to GZA GeoEnvironmental to use a calculator that tracks indirect emissions across a given company’s supply chain. This is a new area of ESG reporting activity for the PE firm, which is responding to LP requests to pilot the measurements on a best-effort basis.

Affinity, which has about USD 14bn in AUM, has tracked a consistent increase in LP requests for ESG data in the past three years. In 2023, the number of LPs making their first ESG request was 14; that number is already 13 so far this year, or around 15%-20% of the firm’s LP base.

The costs of meeting these requirements are borne by Affinity, including any costs incurred to collect ESG key performance indicators (KPIs), prepare LP reports, and prepare sustainability reports.

Reporting that is done at the portfolio company level – such as collecting portfolio-level KPIs or preparing a portfolio company sustainability report – is covered by portfolio companies. Some cost management is achieved through EDCI, which can provide free feedback and verification checks on anonymised data.

Affinity worked with EY to set up its initial framework for data collection three years ago, but since then has become increasingly independent. The underlying philosophy is based on the idea that this work is about more than compliance and LP communication.

“Being able to collect data directly from portfolio companies gives us more insight into where, for example, there might be energy savings or carbon savings,” said Sarah Pang, Affinity’s head of ESG and sustainability.

“For Fund V, we are at 14 portfolio companies, so it’s still manageable to have that bottom-up approach with internal resources. After three years of collecting, we’re starting to get a lot of data, so we’re exploring migration to a technology platform to better manage it. It’s a journey and an evolution.”

Pang, who has a background in law, joined Affinity in 2021 from Temasek Holdings, where she was a vice president focused on ESG and sustainability for five years. She is one of two staff dedicated to ESG full time alongside an analyst, although the programme has enjoyed significant buy-in from senior management, in turn mobilising team-wide support.

“It really goes beyond just responding to a lot of LP requests. I can put a dollar amount on that and hire a third-party administrator to handle it,” said Queenie Ho, a partner at Affinity who was involved in Pang’s recruitment.

“What Sarah and her team does is really portfolio engagement, going into value creation, and being involved in the portfolio companies’ sustainability strategy, as well as integrating ESG into our entire investment and due diligence process. That’s why we want this to be in-house. It’s more top-down integration than simple reporting.”

Talent management

This is where the availability of talent plays a significant role in decision-making around how much to invest into in-house ESG reporting capacity.

Pang’s background with Temasek gave Affinity comfort that she was sufficiently exposed to private finance. And from Pang’s perspective, Affinity’s longstanding commitment to ESG – it launched its policy in 2012 – provided comfort that she could meet her personal career goals at the firm. That match isn’t easy to achieve, especially for smaller GPs.

For example, ShawKwei & Partners, a USD 1bn AUM industrials specialist, followed the prevailing path of firms its size in 2021 by hiring Brian Gu, a vice president with a background in risk analysis and business auditing, to take on ESG duties. This is seen as more compatible with PE workflows than employing a specially credentialed ESG expert.

ShawKwei, which focuses on control deals and heavy operational involvement, also sees ESG reporting less in terms of LP communications than portfolio support. Founder Kyle Shaw notes that although LPs are mostly US and European institutions, they have been happy with the level of information they’ve received and have not asked for additional reporting.

“We basically try to use best practices. Whatever portfolio company has the best standards, we try to get the other companies to adhere to that,” Shaw said.

“The person who coordinates that in-house needs to have other responsibilities as well, because ESG can be a bit of an island. You need to be relevant to the rest of the firm. I worry that if you hire people with big titles in sustainability to do that kind of work, they may not be aligned with the firm’s primary objectives.”

It should be noted that most of the GPs contacted for this story framed ESG reporting as part of a portfolio company value-add strategy.

Indeed, Advent has been able to pass the cost of Pathzero to its portfolio companies because the emissions platform is seen as adding significant value during the holding period. The GP said that by 2027, most of its portfolio will be required by the Australian government to report emissions. In its two most recent exits, this information was specifically requested by the prospective buyers.

“It was very useful to be able to provide that Pathzero information to overseas bidders because they see it as an absolute requirement,” said Robert Radcliffe-Smith, Advent’s managing partner. “If we didn’t have it available, they would have had to go back and measure it, so it’s quite useful to portfolio companies.”

Minimal disruption?

The case for managing costs by outsourcing as much as possible is perhaps best represented by India and Southeast Asia-focused Everstone Capital. The manager, which has an AUM of around USD 7bn, limits resources in this area to one or two full-time professionals.

Rajesh Mehta, chief business officer at Everstone, said that being active across multiple strategies with varying reporting needs has underpinned the logic for outsourcing back-office activities. For ESG reporting specifically, it deploys Updapt, an India-based data management platform, across both the portfolio and the GP itself.

The data captured by Updapt is processed by a third-party advisor. The heavy lifting of drafting ESG reports is outsourced, but review and control processes are managed by an approximately seven-strong fund administration and compliance team whose duties span all back-office functions.

“If you rely on too many internal resources, you have to manage that team and the continuity of that team. We also want to make sure we are able to scale and that there is stability for our LPs. An outsourced model allows us to make sure there is no disruption,” said Mehta.

“Also, because the requirements keep evolving and technology is playing a larger role, outsourcing allows you to be flexible in getting the best software services. All these tools are pay-as-you go, so our view is it actually costs the LPs and us less to use this model.”