Aaron Filbeck, CFA, CAIA, CIPM, FDP, Director of Global Content Development at CAIA Association.
The second session of CAIA Association and Nuveen’s ESG in Private Markets Series covered the important topic of general partner (GP) and limited partner (LP) alignment around delivering environmental and social outcomes.
Watch the second session, “Private Capital Alignment of GPs and LPs ,” with Jennifer Wong, CFA, Jennifer Choi, and Allison Spector. The session was moderated by Carol Loundon.
What Are You Trying to Accomplish?
“It's hard to talk about investor expectations of GPs in a monolithic way because LPs are not monolithic.” – Jen Choi
What does ESG even mean? One of the biggest struggles of ESG integration, beyond data collection, is the way LPs and GPs approach the very important, but different, issues under the ESG label. LPs answer to their stakeholders and constituents, and GPs answer to their often-multiple LPs. It’s probably not surprising to hear how common it is for GPs to be approached by LPs on ESG issues during the due diligence process, and it’s probably even less surprising that the level of sophistication and intensity of how LPs approach these issues has wide dispersion.
Nevertheless, pressures from all stakeholders seems to have caused both parties to ask for metrics, but don’t know why they’re asking for them. We may have reached a point where we are so focused on collecting and standardizing the unstructured nature of ESG data, that we’ve lost sight of the bigger picture. How are we going to use it to make better decisions? While not rare in quantity, high quality and actionable data remains one of the biggest challenges in ESG, especially in private capital where little is available.
Focus On What Matters Most
While it’s great to see a request for more data on ESG issues, the pendulum has swung in the direction of esoteric requests for data transparency that are often unique to the LP situation and may not necessarily tie to industry standards. She suggests the industry focus on developing minimum basic indicators, perhaps similar to the SASB Materiality Mapping Framework, that would allow some kind of standardization from which GPs could prioritize and LPs could request. Everything is customizable, and standardization for the sake of standardization does more harm than good, but at the very minimum, there should be a common starting point. Some initiatives have already taken hold, such as the ESG Data Convergence Project and the International Climate Initiative (ICI), two examples of collaborative efforts to move beyond the common estimation approach that is often taken by GPs.
“Perhaps the investment industry could sort of look towards our corporate peers and see if we can find some answers.” – Allison Spector
Perhaps we can revitalize the old corporate social responsibility (CSR), which was effectively thrown aside for the ESG moniker, and rediscover how portfolio companies conduct themselves in a sustainable way. After all, private and public companies don’t live in a vacuum based on whether they are listed or not. In fact, many private organizations live in the supply chains of major, blue-chip organizations and therefore are subject to the same risks. Like a good marriage, your supply chain is my supply chain, and your carbon emissions are my carbon emissions… ‘til death do us part. If corporations can speak a similar language to one another, perhaps different investment stakeholders can do the same.
Manager Selection and Greenwashing
Since this generation of ESG is so new to many investors, it’s likely that our industry has put much weight on the front-end of the due diligence process, but little on the management and oversight part of the GP and LP relationship. The big questions remain: Are you able to evaluate whether there’s been meaningful progress with consistent application? Most tangibly, how should we evaluate a manager during a re-up period, three years from now?
In the United States, this question may be even more complicated. It’s more common to see a manager adopt an ESG approach through a side letter rather than utilize it as an integrated part of the investment process. How should an LP approach a GP that only does ESG part time? This is less common in areas focused on sustainability issues, such as the European Union, where these issues are considered material, not just exogenously but to the business models of the underlying portfolio companies. In the United States, the world is much more segmented, save for impact investing which, by definition, is far more targeted. Impact investing in private markets may be the only place where greenwashing is almost non-existent – these managers explicitly embrace focused themes, value creation within those themes and tangible non-financial returns.
“I think there's a clear demarcation in the private markets because there has been this cohort of impact investors that have led the way.” – Jennifer Wong, CFA
Since impact is more targeted and thematic, the ability to measure social or environmental value creation and outcomes should be far more straightforward. Since these managers are the incumbents, it’s likely that mainstream private equity firms have been more cautious to make claims before integrating. This is the opposite strategy of many public market managers where marketing strategies have been somewhat of a driving force.
Private capital, impact or not, can also match buyers and sellers, as opposed to public markets where buyers and sellers are effectively nameless. While adoption has been slower in private markets, the interplay between buyers and sellers across the different capitalization ranges has required GPs to think more purposely about ESG issues when making transactions. Small managers sell to middle market managers, who sell to large cap managers, who sell to megacap managers. ESG issues will command cooperation and focus as companies grow and managers pass the baton to one another.
Opportunities For Better Alignment: Carried Interest
The boldest proposal came at the end of the discussion: time to rethink carried interest and adopt impact incentive fees. Arguably, the best form of financial alignment between GP and LP interests comes from the carried interest component of a GP’s fees. Why not, as Wong suggests, dedicate a portion of carried interest to the measurable impact goals? If GPs meet the financial hurdle but miss the impact hurdle, that portion of the carried interest gets channeled to other charities or foundations. This started in impact investing but, as one might expect, broader adoption may be difficult for GPs until there’s 1) better data to measure environmental and social outcomes and 2) LPs and GPs better understand what the other is trying to deliver.
Avoiding Analysis Paralysis
As we’ve covered here, and previously, there’s a lot of opportunity for improvement in high quality and actionable data, but we first must figure out what we want to be measuring in the first place. Only after we’ve established a common language for what’s material, can LPs and GPs work together to solve some of the most material issues in our society. It’s great that people care, but garbage in, garbage out.
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