Debevoise: Directors have a duty to take ESG into account

What are most the important ESG issues to private equity firms in 2020?

It’s important for firms to understand how climate change may impact their portfolio. They need to have a strategy in place to manage those impacts and take advantage of opportunities. Private equity firms that have signed up to the UN-backed Principles for Responsible Investment will have to report on certain climate risk indicators from 2020.

Cybersecurity and data privacy are more of an issue for private equity, because of the GDPR but also because society at large is focusing more on these issues. And, of course, anti-corruption is a perennial concern.

Any issue that affects a firm’s risk profile can fall within the environmental, social and governance category. In my view, a lot of this is about governance – it doesn’t really matter if you classify an issue as being part of ESG. What matters is ensuring good corporate governance and proper risk management.

Do firms have a fiduciary duty to take ESG issues into account or is their duty to prioritise returns?

I don’t see ESG and financial returns as a trade-off. It’s hard to see how it is not part of a firm’s duty to investors to take financially material ESG issues into account when making investment decisions, if these issues could result in damage to the underlying business. Certainly, directors of underlying companies should consider all material risks and opportunities, including those that arise from so-called ESG issues.

I am also not convinced that there are very many – if any – material ESG issues that are not financially material to the fund’s risk-adjusted financial returns. To take an example: if a portfolio company is undertaking an activity that has a materially negative impact on the outside world, then it seems unlikely that governments or regulators will allow that to continue indefinitely. It will either be banned or taxed. In the longer term, it clearly isn’t sensible for a firm to base its business model on an activity that is causing significant harm to the outside world – for example, to rely on being able to continue to emit high levels of greenhouse gases.

I think that the term ‘fiduciary duty’ is overused and often misunderstood. Its meaning varies between jurisdictions and is dependent on context. For private fund managers, their fiduciary duty depends, among other things, on what they have agreed with their investors.

How will the new EU disclosure regulation affect private equity?

The regulation requires a wide range of asset managers to disclose, among other things, their policies on the integration of sustainability risks. The next step is for the EU authorities to draft detailed implementing measures. It’s quite hard to know precisely what firms need to do until these are published.

Most firms already have a policy on integrating sustainability risks. They should certainly be getting ready to publish these policies on their websites if they haven’t done so already. We can’t be certain at this stage, but I think many firms will already publish most of the information required by the regulation, although some changes may be needed.

Whether UK-based firms will have to comply with this EU law depends on the timing and terms of Brexit and any transition period, and on whether the UK government decides to implement it anyway. In any event, firms will probably have to comply if they have EU investors, even if the firms are themselves domiciled outside the EU.

The EU is also drafting a ‘taxonomy’ regulation, that would establish common language for classifying investments as sustainable. What impact might this have?

It’s becoming more and more difficult to invest in a carbon-intensive business for many reasons, and the taxonomy regulation won’t change that.

I think the main effect will be to make it easier for investors to identify businesses that are making a positive contribution to resolving the climate crisis. Fund managers that comply will be able to attract more capital.

Having been subject to some disagreement between various interested parties in the European Council and Parliament, the taxonomy regulation has just been agreed at a political level and so it will now move forward at a good pace, I think.