The evolution of ESG in secondaries

Despite the recent politicization of ESG investing, it is clear that ESG considerations have broken through into the mainstream and are here to stay. Following the insights we shared in this post, “ESG: What we're hearing from Asia investors ,” we wanted to delve into the evolution of ESG’s role in secondary transactions.?

Historically limited role of ESG in secondary deals?

Historically, many market participants didn’t feel there was a significant role for ESG in secondary transactions. In a typical LP portfolio purchase the secondary buyer is acquiring a comparatively small stake in one or more underlying funds from an existing LP. These purchases occur after the underlying funds have completed fundraising and, given the context, secondary buyers usually don’t have leverage to negotiate ESG or other side letter provisions. Rather, a secondary buyer acquires those interests effectively on an “as is” basis.?

Further, secondary buyers are buying fund interests after the underlying funds have made many (or in some cases all) of their investments, meaning that a secondary buyer has no ability to influence what investments are made. As a passive LP in a fund, a secondary buyer also is structurally removed from the underlying assets themselves and typically has no ability to influence how the underlying fund or its portfolio companies approach ESG risks (and often the asset-level reporting received by LPs is fairly high level).?

Given that dynamic, many secondary buyers’ ESG processes have historically been limited to a cursory check on whether or not the underlying managers had ESG policies and procedures in place, without probing much further.

Increasingly meaningful ESG screening in due diligence?

Approaches have evolved in recent years both in response to heightened attention from LPs and as secondary buyers have realized that there is a more meaningful role for ESG in their investment processes. While there’s still a range of approaches followed by secondary buyers, a general theme today is that ESG plays a more significant role in many secondary buyers’ deal screening and diligence processes at both the fund sponsor- and asset-levels. Some inquiries and considerations for secondary buyers include:

• Evaluating sponsors’ ESG risks: Beyond simply asking if a fund sponsor has an ESG policy, secondary buyers are more likely to evaluate underlying fund sponsors’ own ESG policies and procedures, probing how integrated ESG is into their investment processes and ongoing portfolio management. Secondary buyers are trying to understand existing ESG risks within the portfolio they are acquiring, typically seeking to determine where there have been issues in the past and, if so, how has the sponsor handled these.?
• Reviewing policies and making recommendations: Secondary buyers are checking whether the funds in which they are acquiring interests have ESG policies. Where they do not, they are encouraging those fund sponsors to adopt appropriate policies. ?
• Portfolio composition: Depending on the portfolio composition, a secondary buyer’s inquiries may be more focused at the fund sponsor and/or asset level. For instance, a secondary buyer acquiring interests in a fund where a single underlying asset comprises a large portion of the value, may ask more probing asset-level questions, whereas for an investment in a broad-based fund, a secondary buyer may focus more on the fund sponsor’s own policies and procedures.?
• Underlying fund’s strategy: The questions asked by the buyer will depend on the underlying fund’s strategy. For example, a secondary buyer may probe deeper on certain KPIs for a fund with a more concentrated strategy than it might for a fund with a broader-based investment focus.?

Enhanced ESG screening in GP-led transactions?

ESG screening is particularly developed in the GP-led space, where the secondary buyer is often not only acquiring a more concentrated position in various known assets, or in some cases, a single asset. ? For the reasons discussed above, the more concentrated portfolio makes an understanding of related risks and opportunities, including ESG risks and opportunities, that much more crucial for a secondary buyer’s underwriting.?

Further, the typical transaction dynamic of a GP-led fund restructuring lends itself to a secondary buyer having a bit more leverage as it considers how to address ESG risks. It isn’t uncommon for a secondary buyer to hold a very significant portion of the LP interests in a continuation fund and accordingly many secondary buyers will negotiate more robust side letter protections.?

Indeed, in the GP-led space, some secondary buyers’ approach to ESG-related diligence has started to drift closer to what lead sponsors undertake in the direct investment space. For example, we have seen secondary buyers focus on appropriate historic and projected KPIs and undertake a more robust diligence process both vis-a-vis the underlying sponsor and the underlying assets themselves.?

Post-investment engagement and involvement

Because of the deal dynamic in a GP-led fund restructuring, the secondary buyer often plays a more active role with the fund sponsor and/or asset post-closing than it does after completing a portfolio purchase. After a GP-led investment has been made, secondary buyers may be more engaged with the fund sponsor, asking for more detailed reporting around ESG, continuing a dialogue with the sponsor about their own approach to ESG risks and opportunities at the underlying asset level, what mitigating measures make sense, among other requests.?

We have also noted more active post-closing involvement by secondary buyers in LP stake deals and GP-led fund recapitalizations. Buyers are collaborating with GPs to enhance their ESG policies and the GPs’ integration of those policies into day-to-day portfolio operations, among other things. They also are using the unique lens they have across fund sponsors to advocate for promoting best practices across GPs.

The evolution is ongoing

Most secondary buyers’ approach to ESG – both at the investment stage and post-investment – continues to reflect the fact that they are passive LPs in underlying funds, but the evolution of ESG approaches in secondary transactions is ongoing. The heightened role that ESG factors now play for secondary buyers in their own investment processes and portfolio management, is notable and will continue to evolve.?

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The original article can be found on Ropes & Gray LLP 's website here .

Isabel Dische is a partner at Ropes & Gray and chair of its Alternative Asset Opportunities group. Ranked globally?by?Chambers Global?for investment funds, Isabel primarily focuses on advising asset managers and institutional investors on matters that span alternative asset classes. Among the clients she counsels are ten of the top 15 secondary buyers and sovereign wealth funds across the globe, including Australia, Canada, China, Japan, the Netherlands, Nigeria, Singapore, and South Korea.

Alexandra Chauvin is a partner in the asset management group in London. Alex’s practice focuses on various areas of corporate law, including representing investment managers in all aspects of their business and operations and with a particular emphasis on the formation of U.S. and European private alternative investment funds and structuring and executing secondaries transactions.

Vincent Ip is managing partner of Ropes & Gray’s Hong Kong office and?a partner in the firm’s asset management group. Vincent is a trusted advisor to top asset managers and sovereign wealth funds worldwide. His cutting-edge work?for investment advisors and sponsors includes counseling on all aspects of their business, with a focus on the formation and ongoing representation of Asia-focused private investment funds.