ESG impact - a limited role for limited partners?

Although the last two years were overshadowed by the COVID-19 pandemic, the move of investors into private markets has not slowed down. Institutional investors, among them insurance companies and pensions funds, are searching for long-term and stable income streams. For them private markets are not a niche anymore but an integral part of their portfolio allocations.

The pandemic revealed significant differences in the sustainability and resilience of private markets assets depending on the sector. The fact that most alternative assets managed to weather the pandemic storm well made them even more appealing for many institutional investors. The tragic events following the invasion of Ukraine are generally not directly affecting most asset classes within private markets but second order effects due to increased volatility in power, commodity and financial markets as well as further disruptions of supply chains need to be closely monitored.

Investors remain committed to their alternatives programs. The Preqin “Alternatives in 2022 report”1 from January 2022 foresees this “private markets trend” to continue with a focus on infrastructure, private equity and private debt. More than a third of limited partners (35%) according to the report plan to invest more in private capital over the next 12 months. ?

In the private equity sector in particular, closed-end funds have traditionally been set up as limited partnerships, the Anglo-Saxon equivalent of a limited partnership, which is particularly suitable for bringing together a large number of investors. While the fund manager as general partner (GP) manages the day-to-day business and makes the investment decisions for the fund, the investors as limited partners (LP) assume the role of a passive minority investor without significant rights of influence under company law, whose liability is, however, limited to the original capital commitment. However, the term has moved away from its original legal meaning - the abbreviations GP for the fund manager and LP for the fund investor have now become established as generic terms, irrespective of legal form and asset class.

In recent years, more and more institutional investors have sought access to alternatives through indirect strategies, where they participate alongside fund managers in primary funds and co-investments. More than one-third of limited partners (LPs) plan to invest more in private markets over the next 12 months, according to the aforementioned Preqin survey.

The following section will focus on the role of LPs and the ways in which they can influence the issue of ESG.

ESG (Environment, Social, Governance) ?regulation and its impact

The European Sustainable Finance Strategy aims to support the financing of the transition to a sustainable economy. Over the past years, the EU has been building a sustainable finance framework to support the flow of private finance towards sustainable economic activities and make the transition to a carbon neutral economy by 2050 possible. Much discussed, it is aimed at companies and financial market players and defines criteria for sustainable investments.

?The Sustainable Finance Disclosure Regulation (SFDR) aims to bring a level playing field for financial market participants and financial advisers on transparency in relation to sustainability risks, the consideration of adverse sustainability impacts in their investment processes and the provision of sustainability-related information with respect to financial products.

With the development of the EU Taxonomy in particular, which looks define for environmentally sustainable investments, the EU Commission has also created the first standardized criteria for climate-friendly business.

LP and GP – it is all about partnership

While the fund manager as general partner (GP) manages the day-to-day business and makes the investment decisions for the fund, the investors as limited partners (LP) assume the role of a passive minority investor without significant rights of influence under company law, whose liability is, however, limited to the original capital commitment. As a result of the increased focus on ESG aspects, the requirements of LPs and their GPs have developed. Fund managers increasingly have to make sure they consider a wide range of ESG issues and think about how to apply these to their product offerings.

Influencing outcomes via indirect and direct investment strategies differ. A direct investor has direct means to actively influence the ESG framework of portfolio companies given associated governance rights. However, the role of a limited partner (LP) is not as limited as one might think. Larger LPs can typically push for changes in documentation and behaviour, such as the appropriate integration of ESG in investment and asset management processes.

“Typically, fund managers will be receptive to the reasonable requirements of their large investors as both sides are interested in good relations. In addition, cornerstone investors who commit early to funds are in a strong position to make themselves heard. Specifically in terms of ESG, fund managers understand that Allianz cannot compromise on its strict ESG requirements”, says Yves Meyer-Bülow, Head of Infrastructure Funds & Co-Investments at Allianz Capital Partners.

Over the years, the industry has come a long way in its understanding of ESG and has invested more time and resources to respond to institutional investor demand for ESG. Indeed, Preqin’s survey of alternatives investors (Preqin, ESG in Alternatives, October 2021) found that investor demand is the most prominent reason why fund managers are establishing ESG policies – ahead of political pressure and moral imperatives.

The larger the more influence

With fundraising records, more institutional investors allocating capital into private markets and new market entrants there are more players and interfaces to consider. Larger investors who can make large transactions and are invested over several fund generations will have more opportunities and weight to voice their ESG requirements.

“We are one of largest private debt fund investors in the world and follow a long-term partnership approach with all our GPs. This includes an active and systematic ESG engagement process. In that process we clearly do voice our expectations and often agree on specific steps to improve together. So far this has always been a constructive dialogue that has been appreciated by our partners. If we however have the impression that ESG considerations are not sufficiently taken into account we will not invest in a fund.", says Sebastian Schroff, Lead Portfolio Manager at AllianzGI.

In 2021 alone, Allianz has deployed around 10 billion euros across infrastructure, private debt and private equity funds and co-investments around the world. In 2020, Allianz started to open its investment programs for indirect investments also to third party investors allowing them to invest alongside Allianz in its infrastructure equity, private equity and private debt programs.

Limited partners with long-standing experience

For Allianz, it does not make a difference whether it is a direct or indirect investment when it comes to ESG guidelines. The same ESG rules apply for fund investments as for direct investments. There are LPs who still put less emphasis on ESG aspects, or who have started only recently to incorporate ESG in their due diligence. These LPs will probably not raise the ESG-related questions an experienced LP would do. Most European LPs with a longer investment history, have gained a lot of experience and are often in a better position to evaluate the answers provided by a GP.

“We have been investing in private equity for a quarter century and have been partnering with our GPs and the broader industry in order to creating awareness and developing ESG frameworks further. Jointly with many of our fund managers we introduced relevant changes and implemented improved ESG processes and will continue working on those based on dedicated engagement and knowledge sharing”, says Michael Lindauer, Head of Private Equity at Allianz Capital Partners.

Depending on their relationship and size, LPs can play an active role and support the further development of an adequate framework of a portfolio company. This is the case when a LP will co-invest with a GP. These co-investing opportunities are usually offered to LPs who already hold a relevant stake in a fund and are regarded as like-minded and reliable partners.

LPs to drive the challenge

Despite the progress made with regards to the integration of ESG policies, there is also room for improvement. Be it for the definition of targets, data collection, or reporting methodology and tools to assess the data across different sectors and strategies – very often a common set of standards and guidelines is not available yet. This will not be an easy task, neither for direct nor indirect investors. With increasing awareness for the importance of topics such as governance, social responsibility and decarbonization, we can expect further progress to come. And GPs are already putting a lot of effort to tackle these complex and challenging topics.

Industry organizations such as ILPA (Institutional Limited Partners Association - ILPA ) and GRESB (GRESB | Global ESG Benchmark for Real Assets ) play an important role in setting standards and monitoring the implementation of those standards over time.?Convergence of those standards across specific sectors and asset classes will also be important in the future to create consistency and scale for LPs and GPs as ESG becomes an increasingly important factor in investment and client decisions.

Looking back ten years and comparing the data available then with the ESG framework and guidelines that GPs apply today, it is clear that fund managers and fund investments worldwide have made remarkable progress - also due to the demands of LPs. LPs will not stop here but continue to challenge their GPs work with them to drive further development - for the benefit of all of us.

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1?Alternatives in 2022 (preqin.com) ?2 ESG in Alternatives: Navigating the Climate Crisis (preqin.com)

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