An introductory framework for PE/VC’s approach to ESG

Tarang Kumar. 5 September 2022. On behalf of AccelNorth Partners.

Introduction

ESG in Private Equity and Venture Capital went from moving at snail’s pace, to a pace where GPs, particularly those marketing in Europe, have barely had time to catch their breath.

It’s been no different for us at AccelNorth Partners. Until last year, most of our advisory in ESG focused on two key stakeholders — LPs and portfolio companies. Thanks to SFDR, a third stakeholder has gained increased importance in our work — the regulator. ESG went from being a ‘nice to have’ activity, with even the best-meaning GPs focusing on a handful of metrics which were meaningful (either from a financial perspective, a strategic perspective, or occasionally from a pure ESG perspective), to now all managers marketing to European LPs needing to have very clear frameworks, metrics, policies and processes, from sourcing and selecting to monitoring, reporting and through exit.

All that is well and good, if you have large AuM and can hire an army of high-quality ESG resource (which in itself is a scarce commodity and trades at a high premium these days). But what do you do if you are a small/mid-cap manager, and both management fees and time are more limited?

At AccelNorth Partners, we have spoken to dozens of GPs, LPs, companies, software providers, reviewed policies and regulation, led UNPRI sign ups from scratch, and developed methodologies to tackle LP ESG due diligence on GPs. We are providing outsourced ESG services to PE/VC GPs, from upfront diagnostic and upgrades, to ongoing support around monitoring and reporting. And our client GPs (or partner GPs as we prefer to call them) have been happy customers of this.

One Framework

As one of our founding principles is to democratise access to high-quality strategic advice to the industry, we decided to offer up one framework that we have used in recent months in this article. And before the ESG police raises its arms, let me caveat it myself — this is a basic, ‘starter framework’ for GPs who may still be in early discovery mode on their ESG journey, but are fretting about the fast-approaching SFDR deadline of January 2023 and/or LP pressure on ESG. For more advanced GPs, the depth of the ESG approach should be significantly beyond this framework. After all, to make a real difference to the world, it’s not just about pleasing a regulator or an LP, it is about doubling down efforts in doing the right thing. Even for GPs who are starting out with our frameworks, we strongly recommend that with each passing year, more to is done to enhance ESG and Impact at both GP and portfolio company level.

There are three broad elements to this framework: (1) define who your key stakeholders are in your ESG journey (2) design a step-by-step approach which optimises the practicality for the aforementioned stakeholders (3) figure out which parts you want to do in-house, and what to outsource.

One. The Stakeholders. In most cases, we have defined six core stakeholders for ESG.

Two. The Steps. (with a few hints thrown in!).

1. Determine your ESG Ethos.

a) What does ESG actually mean to your organization? What do you want it to mean?

2. Define your overall ESG Goal(s).

a) At bare minimum, adopt an exclusion policy…

b) … include specific ESG upgrade terms in your termsheet / SHA?…

c) … up to and including using ESG and Impact (different things) as value creation levers, and even having your own ESG or Impact fund products.

3. Figure out which SFDR Article you will align your fund(s) to.

a) .. and why. Remember this is regulation — once you sign up to it, you need to make it happen. Both regulators and LPs take regulatory breaches seriously.

b) Do you need to consider PAI and EU taxonomy?

c) Which pre-contractual disclosure language is most relevant?

d) Appropriate website disclosures.

4. Design your ESG policy.

a) What can you actually control vs what is on a best efforts basis? Eg VC and credit investment firms should have a different basis vs PE firms which have a higher degree of control and usually more resources to implement ESG enhancements at portfolio company level.

b) Which metrics are relevant? (long list of available options and of frameworks) How will these be implemented into the investment, monitoring, reporting and exit processes? Who will be in charge of it? Etc.

c) Which entities are you committing the policy to apply to? (gets particularly tricky if you are committing to SFDR alignment — is it your next fund, all active funds, or all activities of the GP, including but not limited to the investment portfolio?).

5. Backtest.

a) Before committing publicly (via a policy) or regulatory-wise (SFDR) to a certain policy, back-test elements such as metrics and collectability of data against an existing fund’s portfolio.

b) You may choose to use a software provider to collect and sometimes perform first level analysis — there are at least two dozen out there (we have interviewed and seen demos from all the key ones, as well as gathering industry feedback — ask us what we think of each of them…).

6. UNPRI.

a) Sign up.

b) Implement.

c) Report.

d) Any other industry standards that you want to sign up to? What aligns to your firm’s ESG ethos?

7. Implement & feedback.

a) Get cracking… it may take a couple of cycles to get perfect at it, but make a start, don’t over-commit, and once you see what the art of the possible actually is, go back, review and upgrade.

b) You may start with some basic metrics collation, and over time, grow to use ESG as a value creation metric, helping LPs, portfolio companies, the environment and society as a whole.

8. Prepare for LP ODD.

a) As GPs are getting smarter about ESG, so are LPs. The questions from LPs now go way beyond “have you adopted an ESG policy?”

Three. In-house vs Outsourcing. We generally believe that it makes sense for large and mega cap GPs to have in-house dedicated resource, given the affordability and the tailoring required across the breadth of products. For small cap GPs, outsourcing or a hybrid approach may work out significantly more cost effectively, while also benefiting from specialist expertise.

In summary

The introduction of SFDR has made ESG front and centre of priorities for private markets GPs who are seeking to market their funds in Europe over the coming years. A trend that was moving slowly in the right direction, has been springboarded significantly in time. As with the initial rounds of all regulation, it isn’t perfect yet, but the European Commission’s heart and mind are certainly in the right place.

As for GPs, it is important to figure out what the right level for regulation is right for you, but also not make ESG all about regulation. There are genuine business value creation opportunities available if this is done well. Moreover, there is a great ability to be a market leader in the space, and take your portfolio companies and LPs on the journey with you.

Most importantly, this is a marathon not a sprint — take your time, do it right, don’t over-commit upfront, and where required, seek help to help get it right.

Want to know more about how AccelNorth Partners could help you design and implement your ESG framework in an effective way? Reach out to us at info@accelnorthpartners.com. It doesn’t have to be expensive, it doesn’t have to be painful, and you do not need an army of permanent, full-time geniuses on your payroll to figure it out. That’s what we’re here for.