Deep Dive: How ESG will become a CFO issue

ESG reporting in private equity will one day be table stakes and be firmly in the wheelhouse of the chief financial officer.

Every year a team from LGT Capital Partners, a global fund investor, collates qualitative data from more than 300 of its general partners and converts it into a quantitative scoring system. Managers emerge from the process with a grade of between one and four which tells them – and LGT – how they rate with regards to environmental, social and governance issues.

Deep Dive: How ESG becomes a CFO concern
Deep Dive: How ESG becomes a CFO concern

To achieve a score of one (the best), a manager must demonstrate “genuine” commitment to ESG and have institutional processes in place, applying ESG criteria to investment decision-making, ownership and reporting. Managers who demonstrate little or no commitment to ESG – scoring four – are “encouraged to improve over time,” according to the firm’s annual write-up of the results. Another global fund investor, Pantheon, applies a green-amber-red ESG risk rating to its managers. Ratings are arrived at through an operational due diligence questionnaire – around eight or nine “relatively open-ended questions” – and then further conversation with the GP’s investment team, says Alex Scott, a partner in the investment team and member of the five-person ESG steering committee.

That these two fund investors are Europe-headquartered – LGT on the edge of Lake Zurich in Switzerland and Pantheon in the City of London – is significant. Europe has been the epicenter of ESG.

“We have seen the greatest capabilities in being able to report ESG-related data out to investors among European GPs, because European LPs have been asking for it,” says Andrea Auerbach, head of private investments at consultant Cambridge Associates.

“It has now spread to North America and is going viral.”

“It has now spread to North America and is going viral.”

Andrea Auerbach

Cambridge Associates

This was certainly true for Genstar Capital, a San Francisco-based firm with $17 billion in assets under management and a history stretching back to 1988.

“We probably thought about ESG more in response to our European investors being thoughtful about it,” Genstar managing director and chief financial officer Melissa Dickerson explains. “Europe has done a good job of leading the way here.”

Joining the club

Genstar became a signatory of the United Nations’ Principles for Responsible Investment in 2015.

Being a UN PRI signatory requires a firm to formally apply and pay an annual membership fee. It also has to report on its responsible investment activity within the first 24 months of signing up. This has become an important indicator for many prospective LPs of a manager’s commitment to ESG; it is alluded to, for example, in both Pantheon’s and LGT’s assessments.

There are now nearly 2,400 organisations (both asset owners and managers) signed up to the UN PRI. This proliferation – ostensibly a good thing as it shows widespread engagement with ESG – is also making it less of a useful indicator and more of a “tick the box exercise,” said Maria Sanz Garcia, managing partner of Munich, Germany-based fund investor Yielco Investments, at an event in October. “Everyone has an ESG policy and is a signatory. Everyone does that in Europe.”

Sanz Garcia contrasted her dealings with European and US GPs: “We invest a lot in the US in smaller managers, and when you ask them about ESG, they often ask, ‘What does ESG mean?’ If you go to the southern part of the States it is worse.”

Sanz Garcia’s dismissive take on US GPs’ ESG engagement is reflected in the data that LGT publishes on its managers. In the firm’s 2019 report, 79 percent of European managers scored either one or two (the top grades), while only 49 percent of US managers achieved that grade. To put it another way, 25 percent of the US managers LGT works with demonstrate “little or no commitment to ESG.” A further 26 percent showed some commitment but lack institutionalised processes.

“Everyone has an ESG policy and is a signatory. Everyone does that in Europe.”

Maria Sanz Garcia

Yielco Investments

One reason that the adoption of ESG policies and procedures has been slow to take hold in the US is that systematic data-driven scrutiny by LPs of it is still in its infancy, even among some of the most sophisticated private markets investors.

No policy? No problem

At the Alaska Permanent Fund Corporation, Marcus Frampton, chief investment officer of the $65.3 billion state sovereign wealth fund, says evaluating ESG is “qualitative as opposed to formulaic.”

“At some point, we may look at formalising some sort of an ESG policy,” says Frampton. “But today, it’s simply that we review managers’ approach to ESG on their prior investments, just as we’d evaluate their responsible use of leverage, the reasonableness of the valuation decisions they make, etc.”

“The short answer is no,” to whether the $139.6 billion Washington State Investment Board looks at ESG ratings when evaluating a firm, according to Chris Phillips, a spokesman for WSIB.

“Our asset class teams individually are responsible for evaluating all material risk factors as part of their due diligence,” Phillips says. “The WSIB has not adopted a single position or practice regarding various ESG ratings or metrics systems.”

But the direction of travel is only in one direction. WSIB is reviewing its ESG-related mapping and measurement frameworks ahead of a planned hiring of a sustainability officer next year, adds Phillips. The Rhode Island State Treasury in October hired consultancy Wilshire to advise it on how to incorporate ESG into its private markets investment processes. Like Auerbach said: it’s going viral.

So what does it mean for a GP to integrate ESG reporting? The short answer is: different things to different firms.

Genstar works with consultant Malk Sustainability Partners. “With their help we worked with lots of investors to develop checklists and templates that are specific to different industries,” says Dickerson. This means that while an industrial business might be required to measure outputs relating to carbon or waste, a services business might be assessed on a different set of metrics. “It’s going to be different for different industries and it’s evolved to include lots of things like data privacy, diversity and inclusion etc.”

Genstar engages Malk whenever the firm is conducting due diligence. “They’ll talk to the management teams and look at the data rooms and give us an assessment,” says Dickerson, “which we’ll then incorporate into our investment committee process. If there are already red flags, we’ll know about them before we buy a company. But it gives us a good baseline, because if you do end up buying the company, this is where you start.”

Finally, there is an annual monitoring piece – again undertaken by Malk. Says Dickerson: “We’ll also engage them upon exit so that we have a picture of the round trip during our hold period. This shows the kind of impact we might have had on the ESG paradigm from start to finish.”

Dickerson includes summaries of the ESG updates in the firm’s annual report.

Oil-y adopter

Houston-headquartered EnCap Investments is one of the largest private equity firms in the world. The energy specialist closed its 11th flagship fund on $7 billion in 2017 and last year raised a further $3.25 billion for its fourth midstream fund. The firm first instituted a responsible investment policy in 2008 and then created a standalone ESG policy in 2012. The firm is now working on standardising ESG reporting from its portfolio companies so that it can aggregate the data and report fund-level ESG performance.

“For example, there is a standard template for diversity that portfolio companies can fill out,” Craig Friou, EnCap’s deputy CFO says. “By conforming to a standardised template we can add it up across all our funds – or by individual funds – to provide meaningful reporting to our investors.”

This year will be the first of reporting “and that will be the baseline data,” says Friou. “Just having that information is the first step to making good decisions.”

Says the firm’s CFO, Bobby Haier: “What it does is really focus on constant improvement of the ESG process in all areas and give us a base in order to measure that improvement and be able to determine that in fact goals are being met.”

“What it does is really focus on constant improvement of the ESG process in all areas and give us a base in order to measure that improvement and be able to determine that in fact goals are being met.”

Bobby Haier

EnCap Investments

The templates – which are 20 questions long – were based initially on the due diligence questions that some investors were asking for during fundraises. “If they were asking for information in a certain way, that was probably a good indication of how we should be collecting and reporting it,” says Friou. “In terms of examples, we are an energy manager, so the two top topics are greenhouse gas emissions and use of water.”

Friou road-tested the templates with portfolio companies and they fed into the design, highlighted where questions would be hard to answer or perhaps would not yield the right information. “I just took all the feedback and after going back and forth for a couple months, finally landed on the final version. I imagine it will always be updated and refined and improved every year,” he says.

The ESG data are gathered through OneSource, a Thomson Reuters-owned disclosure management software.

As of October, EnCap has joined the swelling ranks of PRI signatories. “I think there was a desire to do things as an industry rather than to be rogue and out doing things on our own,” says Friou. “When we looked at all of the different groups that were doing similar things, I would say PRI stood out as the most prominent one with the greatest amount of participation. They offer a lot of resources, a lot of networking opportunities. When we looked at the reporting, we thought it was balanced as far as having granular and meaningful information but not being too burdensome.”

Cloverlay, a mid-market private equity firm that invests in “adjacent private markets,” has had an ESG policy since 2017. “The reasons were two-fold,” says principal and CFO Omar Hassan. “We wanted to think about it critically and have an answer for our stakeholders. To us it just makes sense to have one, regardless of where you are in the spectrum of ESG, mainly for transparency. It is something we want to codify as part of our process.”

It was not something that LPs had specifically asked for, continues Hassan.

In terms of designing the policy, Hassan, the firm’s legal counsel and the senior investment professionals sat down and said: “Okay, what are we actually doing when assessing an energy deal or a transportation deal or something that can potentially run into some of these issues?

“We worked with our compliance consultant [Adherence] and our legal counsel to see what is acceptable from a regulatory perspective and we relied heavily on them to help us think through the actual language.

“We took the stance that we’re going to leave it high level. The policy doesn’t go into scenarios or specifics, but it lists out certain procedures where we could evaluate certain factors. We try to gather qualitative and quantitative information.”

ESG policy and implementation does not always fall into the CFO’s remit. Three of the firms Private Funds CFO spoke with say it is the domain of someone whose background is in external relations, marketing or IR. One such firm is Central and Eastern Europe-focused Abris Capital. Partner and CFO Steve Richmond is responsible for investor reporting, while IR and comms head Monika Nachyla has spearheaded the creation and rollout of the firm’s ESG policy over the last two years.

Richmond says that while he is not too involved, this could change if the firm gets to the point where it is doing “more frequent, more detailed” reporting to the investors.

That “more frequent, more detailed” reporting of ESG data is coming. The industry is at a stage now where “table stakes” for raising capital from sustainability-minded institutions is an ESG policy and willingness to engage. This will not be the case for ever.

“What will probably end up happening is standardised metrics will start being more regular.”

Omar Hassan


According to EnCap’s CFO Haier, the future is “providing more quantitative data where you can show measurable improvement across the portfolio by fund. That’s what LPs want to see. They want to see an improvement quarter to quarter, year to year.”

“What will probably end up happening is standardised metrics will start being more regular,” says Cloverlay’s Hassan.


The current state of affairs allows flexibility for GPs to choose how much to report and how often to do it, which leaves the door open for managers to cherry-pick examples of favorable outcomes, while burying unfavorable ones.

While pressure from investors is forcing some firms to acknowledge the need for a framework around ESG considerations, it is unlikely that this pressure alone – patchy as it is – will move the needle. Less than a quarter of investors surveyed as part of sister title Private Equity International’s LP Perspectives survey described evidence of ESG consideration as being a “major” part of due diligence. Most (55 percent) said it forms a minor part, while 22 percent said the matter was not covered at all in due diligence at all.

So what will convert ESG into a data-centric exercise? Regulation will likely play a large part.

At a high level there is evidence that the Securities and Exchange Commission is taking an interest in how managers describe and adhere to ESG policies. Elsewhere, it is likely that individual elements of ESG will be the subject of issue-specific law. Take for example the law in the UK that now requires companies with more than 250 employees to publish the data on gender pay balance. How long will it be before mandatory reporting requirements are brought in relating to energy or water usage?

“Discussion of ESG reminds me of the early days on the internet, when it was talked about like an amorphous unified cloud-like entity,” says Cambridge Associates’ Auerbach. The needs for accurate and timely data will coalesce around individual topics, rather than ESG as a uniform concept.

The concept of integrated reporting of financial and extra-financial data is discussed frequently among ESG specialists, says Keimpe Keuning, an executive director at LGT heavily involved in its ESG efforts: “We are a long way from global standards, but it is getting a lot of attention. This should be the ultimate goal.”

There is also the prospect of financial rewards – beyond the benefits of good risk management – linked directly to sustainability performance. In October Dutch bank ING launched what it described as the first capital call facility with an interest rate pegged to ESG performance targets for the fund portfolio companies. In Spain, the private equity association, ASCRI, is currently working with local governments to see if there is a way of linking tax incentives to sustainability.

Further into the future, the influence of impact funds will start to be felt. Mainstream private equity investing could include a direct link between the attainment of sustainability goals and the amount of carried interest a GP is entitled to. This is already the case with some impact funds, said Yielco’s Sanz Garcia. “We would like to see funds having measurable goals in the way that impact funds do. They have impact goals that are measured, and they are linked to their compensation,” she said, adding goals could relate to any ESG measure, such as energy usage or diversity. “As we move forward, this could be the next step of ESG.”

For now however, it is up to individual GPs how far up the ESG data curve they travel. As one CFO put it to Private Funds CFO: “We are implementing a new portfolio management tool at the moment, and at the back of our mind is that at some point we will have to collect that [ESG] data … but it isn’t something we need to do immediately.”

Is the SEC interested in ESG?

One of the great things that our colleagues on Regulatory Compliance Watch do is share with subscribers recent document request letters (redacted) from the SEC’s Office of Compliance, Inspections and Examinations.

In a recent batch was a letter digging deep into one advisor’s approach to socially responsible investing, or environmental, social and governance-related investing.

One item requested by examiners from the SEC’s Los Angeles regional office were details of any proprietary scoring system or third-party scoring system.

“I would suspect the SEC would focus on three fundamental questions relating to scoring systems,” says Ken Berman, partner at Debevoise & Plimpton. “Do you have a scoring system? Have you represented that you will have a scoring system and if so, did you follow it consistently?”

Another focus of the letter had to do with whether the advisor “adheres to the UN Principles for Responsible Investment,” and if so, provide documentation of the use of these principles when making investments and managing portfolios. The wording for this inquiry is key, says Berman. “I don’t think this is a tacit endorsement by the SEC of those principles. I think they’re focusing on a set of principles that they may sense are either being widely used or that people are suggesting that they’ll follow. If you use the principles as guide but don’t exactly follow them, the SEC will likely want that explained.”

Other aspects of the letter included questions on the advisor’s definitions of the terms ESG and SRI, their policies and procedures for deciding whether an investment fits these criteria; a list of clients with ESG/SRI investments; research and due diligence files from the advisors three best and three worst ESG/SRI trades; and any ESG-related marketing materials or industry award wins.

In this letter the SEC is clearly focused on transparency and disclosure but is that enough to prove the agency is now focusing on ESG matters? Private Funds CFO requested clarification from the commission, but it did not respond.

“I don’t have the sense that this is a high priority at the SEC right now, or that it’s at the top of their regulatory priorities,” says Isabel Dische, a partner at Ropes & Gray, who has received similar questions from clients that were issued a similar letter directly or came across them indirectly. “I think to a degree the questions of investment strategy, marketing materials, and policies and procedures are questions that the SEC has raised independent of ESG.”