The case for an ESG-linked management ratchet

As LPs increasingly seek to achieve returns through investment in businesses that are good corporate citizens, GPs must think creatively of ways to incentivise behavioural change at the portfolio company level – to achieve the sustainability outcomes promised to investors and to improve value prospects. Increasingly, it is recognised that the ESG performance of a business is a financial matter as well as an ethical one.

Of course, private equity sponsors are well placed to promote sustainability and responsible practices through active management of their portfolio companies. There is already a strong focus on identifying key risk areas in due diligence and ensuring ongoing compliance with ESG-related laws and regulations.

However, looking beyond the downside risk, what else can be done at asset level to seize the chances that strong ESG performance may provide for a business to flourish? How can we encourage management teams, for example, to factor these opportunities into the day-to-day operation of the company?

Management teams in PE-backed businesses are usually motivated to achieve business growth objectives through share-based schemes, with the value of such schemes typically dependent on financial performance, growth in value and/or the returns achieved by the sponsor. However, as our industry increasingly associates strong ESG credentials with financial performance, we may see the emergence of ESG-linked incentivisation in legal documents.

Travers Smith recently worked with The Chancery Lane Project to create Bella’s Clause, a template equity ratchet provision designed to incentivise management teams to meet targets linked to climate change issues, as well as financial targets.

Focus on this area is growing, and it will be interesting to see how this ratchet mechanic will be used in practice. While the ratchet mechanic in Bella’s Clause is triggered on achieving climate change-related (as well as financial) targets, the same structure could be used for meeting any other ESG goals, such as workplace diversity. While some ESG matters are clearly financially material, the existence of a direct link between social goals and value creation may be less clear, and so a more structured approach to incentivisation may be particularly helpful in generating improved performance in that sphere.

ESG targets could also be used in isolation, with financial targets dropped completely, but this may not be a viable option until we have better confidence in our ability to benchmark ESG performance and measure impact. That said, the recently announced, industry-led ESG Data Convergence Project aims to standardise and streamline the collection and reporting of ESG data to help collate reliable and more transparent information on portfolio companies.

The authors are George Weavil, partner, and Carys Clipper, knowledge counsel, in the private equity and financial sponsors group at law firm Travers Smith