Last year was not notable for its optimism. However, as coronavirus swept the globe, in one corner of the private markets, investor sentiment remained in good health. Overall secondaries fundraising, including in real estate, infrastructure and credit, hit a record $95.6 billion in 2020, according to preliminary PEI data.

At the same time, in light of the pandemic, investors and other stakeholders across private funds have intensified their focus on environmental, social and governance topics. With hefty piles of capital stacked up ready to put to work in the year ahead and deals in the pipeline as the market wakes up from a pause, the question is: how do secondaries managers integrate ESG into their investment process?

A common assumption is that it is, if not impossible, then very restricted given that in a traditional LP sale of fund stakes buyers are distanced from the underlying assets. Market participants disagree.

“The industry holds a limiting belief that in secondaries you can’t have an influence on ESG,” says Adam Black, head of ESG and sustainability at Coller Capital, which is marketing its eighth flagship secondaries vehicle targeting $9 billion. “We aren’t managing the assets, but we have influence. It is just a different dynamic.”

Sitting within the investment team at Coller, pre-deal, Black’s ESG team “immediately starts thinking about sector risk, the questions we should ask and what we might be able to do post-investment”, he adds.

In GP-led transactions, close scrutiny of the underlying assets is easier as GPs are keen to engage with potential buyers. In transactions involving multiple fund stakes, investor investigations zero in on the manager. “You are always looking at the GP, and to the extent to which it makes sense, you examine the underlying assets as well,” says Black, adding that his team uses in-house and third-party databases to screen every deal “to alert us to any issues that are potentially problematic to our investors and ourselves”.

If they find one, the firm will take its concerns to the GP. “We will push on more challenging issues,” he notes.

Researching hundreds of underlying companies within a tight transaction window is a daunting prospect. However, Keimpe Keuning, executive director at LGT Capital Partners – which was in market last year with a flagship secondaries vehicle – argues that pre-investment, secondaries investors enjoy a key ESG advantage that primary investments do not: being able to scrutinise existing assets already in the portfolio. “That’s a significant difference,” says Keuning, who oversees the firm’s ESG programme for private markets. “You can filter for red flags, get a greater degree of insight and form an opinion.”

And if, at the portfolio company level, concerns around the industry, products or services cannot be addressed satisfactorily, there are options. “As a secondaries investor, you need to be careful and consider your commitment to the deal,” says Carmela Mondino, head of ESG and sustainability at Partners Group. “An asset could be subject to an exclusion. If we see something of concern relating to ESG practices [at an underlying business], we try to reach out to the manager to understand how they see the issue. Not so long ago, we made an exclusion after a call with a manager in which we realised that they didn’t see the problem we saw, so we couldn’t gain comfort. Once we have committed to a manager, we monitor.”

Given that managers are at different stages of ESG maturity, it is not surprising that risk perceptions and ESG standards vary. But, Mondino says, in her experience, “those that are trying to get on the journey are receptive” to the firm’s input. In general, the bigger the firm, the more influence you can wield, she adds.

The need for a responsible approach

Across the private equity industry commitment to ESG excellence is rising.

“The number of managers that have yet to get their act together has decreased over the years,” LGT Capital Partners’ Keimpe Keuning says. And that includes in secondaries as more firms embark on their own ESG journey. The opportunity is huge.

Secondaries investors, with their exposure to multiple GPs, have a role to play in percolating ESG best practice throughout the market. After all, beyond the reputational and branding benefits to the firm of demonstrating its ESG credentials, promoting ESG as a value driver has a positive impact on returns. “The more we can get people to embrace ESG, the better secondaries opportunities we are likely to see because they’ll be better run businesses,” says Adam Black of Coller Capital.

Experience and exposure also determine manager reach. “If you are a sizable capital allocator, you already have an idea about which GPs take ESG seriously and can anticipate their performance and openness to dialogue,” Keuning notes.

In deals comprised of multiple fund interests, there is the possibility of carving out a manager a secondaries investor does not wish to be exposed to, he adds. That said, “we are a strong believer in engagement and would not necessarily say no. With spin-outs or new managers, ESG may not be a priority, but we can talk to the team and get a view.”

Post-investment, the potential for engagement continues. Having stepped into the seller LP’s shoes, the secondaries investor has an opportunity to become an active LP and perhaps participate in the LP advisory committee, Keuning says.

“The majority of GPs we work with have been known to us for years and we understand how they do business,” says Black, noting that the firm keeps a database and ranks its managers on their ESG approach. While acknowledging it cannot tell GPs what to do at the portfolio company level, Black says his team seeks to share best practice and prompt conversations and thinking around specific themes by, for example, sending out topic notes.

“There have been occasions where a firm has a less formalised ESG approach and we’ll work with them to enhance their programme and policy and assist them with thematic issues and operationalising ESG within their portfolios,” Black notes. “We are looking for a GP that has the desire to engage on ESG, with the right culture and is open to a conversation about doing more.”

With the US Securities and Exchange Commission paying more attention to ESG, “you need to do what you say and say what you do”, Kline Hill Partners chief operating officer Louis Sciarretta told PEI last year. On the eve of the pandemic, the firm was closing a deal a week on average with an average size of $2.5 million across a range of fund vintages. “We have to be thoughtful about what we can influence and what we can’t. But ESG certainly plays into how we run our business.”

He added: “Once the fund comes on board and if an ESG matter comes to light, we’re on the phone to that manager.”

*Coller Capital has since held the final close on its CIP VIII on just over $9 billion.