In the past years, the investment landscape has undergone a significant transformation. Regulatory bodies worldwide have started implementing stricter guidelines, emphasizing transparency, and pushing investors to integrate ESG factors into their decision-making processes. European regulations like the Sustainable Finance Disclosure Regulation (SFDR) and the Corporate Sustainability Reporting Directive (CSRD) are now making it compulsory for investors and companies to report on how they address sustainability risks in their activities, and what their negative externalities are.
In private markets, the rise of these regulations is shaping the way investors market and manage their funds. The goal is to show how they actively support sustainability. This brings in challenges, especially for indirect investors, whose financial products (funds of funds) differ from direct funds as they invest in multiple other types of funds rather than investing directly in portfolio companies.
As intermediaries, indirect investors, have the power to influence the investment behaviors of the funds they invest in. However, for a fund of funds, the path to sustainability is not always straightforward. The indirect connection with the underlying assets makes it challenging for investors to know what sustainability data to track and how to impact the portfolio’s sustainability performance.
This article provides recommendations for indirect investors to amplify their influence and drive greater sustainability outcomes within their investment portfolios. While indirect investors mainly impact the definition of strict funds selection guidelines/processes, they can also encourage fund managers to adopt sustainability policies during the holding phase. It is therefore essential for an indirect investor to define its sustainability priorities and develop an investment and active ownership policy that aligns with these objectives.
1. Define Your Sustainability Priorities
To champion sustainability effectively, indirect investors need to first identify the sustainability priorities they aim to tackle through their investment approach. These priorities should not only align with the management company’s fundamental values but also consider the interests of their stakeholders, including employees, investors, and the broader market while ensuring appropriate risk management with respect to sustainability factors. It will enable them to identify specific subjects rather than dispersing their efforts across a wide range of topics.
As a result, they can refine the essential sustainability priorities to be integrated into their funds or GP selection. This is part of a comprehensive strategy for sustainable practices and risk evaluation. By doing so, indirect investors not only prevent their efforts from being watered down but also position themselves for more impactful interventions. This includes interventions at the management level or within each investment, based on their specific goals.
For example, an indirect investor may have identified value sharing as one of the key elements of their sustainability strategy. This concept can be a criterion for selecting underlying management companies (e.g., access to employee share ownership) as well as for the policy of investment vehicles (e.g., automatic allocation of a portion of the capital gains from the sale of a stake to employees).
2. Decide What You Can Do Upstream of Fund Selection
By setting specific sustainability criteria for fund selection, indirect investors can ensure that capital is channeled into funds whose activities are in line with their sustainability priorities.
There are varying degrees to this approach: from ambitious negative screening methods that exclude certain sectors or practices, to positive screening that actively seeks out funds demonstrating superior sustainability practices. These practices help to mitigate sustainability risks and focus on specific priorities.
Negative screening typically employs an exclusion policy, which omits specific sectors, geographic regions, or practices. For example, an exclusion policy might stipulate that none of the underlying investments should derive more than 20% of their revenues from the petroleum sector.
Positive screening typically hinges on the commitments made by the GPs or the funds. For instance, an indirect investor might opt to allocate investments exclusively to funds that are classified as Article 9 with a specific environmental objective under the SFDR regulation. Another positive screening can be to select funds managed by GPs that are signatories to international initiatives such as the Initiative Climate International (ICI), or that have a public climate strategy with clear commitments.
Even before an indirect investor finalizes their fund choices, there lies a potent window of opportunity to shape the sustainability outcomes: the negotiation phase with GPs. This preliminary phase is a chance to lay down clear expectations, inquire about sustainability practices, and set the tone for the future partnership. During these negotiations, indirect investors must state their sustainability objectives clearly. They can pose targeted questions about the GP’s existing sustainability initiatives, their performance metrics, and any challenges faced.
Another actionable step is to discuss the integration of certain sustainability clauses or criteria in the fund’s governing documents. For example, commitment to provide data for the annual sustainability reporting, to cover sustainability as part of the 100-day-plans with portfolio companies, or to report on specific metrics (i.e. GHG emissions). This ensures that sustainability isn’t just a sideline discussion but is enshrined in the very foundation of the investment relationship.
Indirect investors can act as standard bearers for sustainability integration in the investment world. By establishing clear sustainability criteria for their investments, indirect investors signal to the market that sustainability is not just a ‘nice-to-have’ but a core component of modern investment practices. This can have a cascading effect, encouraging underlying funds to adopt robust sustainability strategies, which in turn influences the companies they invest in. The negotiation phase with GPs is not just a preparatory step in the investment process but a strategic juncture, as it allows indirect investors to infuse their sustainability vision right at the outset.
3. Monitor Progress
To ensure the progression of their sustainability priorities, indirect investors must define KPIs both at the GP level (to assess governance practices, gender equality, employees’ wellbeing, etc.) and at the fund or underlying asset level. It also involves regularly reviewing and assessing the sustainability performance of portfolios. To do so it is necessary to implement a system to monitor the sustainability performance of the funds under management, provide regular feedback, and encourage continuous improvement in the GP and/or funds’ sustainability practices.
By collecting sustainability data, indirect investors can incite GPs to report and analyze this data themselves, paving the way for greater transparency and accountability in the investment landscape. While a few pioneer GPs started collecting sustainability data voluntarily already more than a decade ago, the broader private equity market has witnessed an important increase in the number of GPs implementing a sustainability reporting process over the past 5 years mainly in response to their LPs reporting requirements, and the evolving regulatory landscape.
Indirect investors can also play a pivotal role in helping GPs comply with regulations and raising awareness about these topics through their annual sustainability survey. This compliance and awareness-raising can be strategically aligned with the investors’ priorities by incorporating focused themes, which are paramount to them, into the monitoring process. For example, during the monitoring process, an emphasis could be placed on specific sustainability aspects such as reducing carbon emissions through the definition of climate trajectories. These trajectories set a long-term framework for the objective, along with an action plan for its realization. Investors can encourage GPs to monitor the progress toward this overarching goal, not only within their own company but also across their portfolio companies.
Another powerful outcome of the monitoring process can also be the assessment of the GPs and underlying funds’ performance through a scoring system. This approach can be used by indirect investors to benchmark the sustainability performance of their funds and funds manager with respect to their investment universe and provide them with personalized feedback that can serve as a foundation for their annual engagement meetings.
4. Act as an Active Sustainable Investor
Active engagement emerges as a powerful tool in the arsenal of indirect investors who seek to influence sustainability practices within their investment holdings. Given that indirect investors don’t typically have the leverage of direct day-to-day decision-making post-investment, it becomes crucial to find other avenues to assert their sustainability aspirations.
One such effective method is the annual sustainability feedback meeting with fund managers. These meetings offer a dedicated platform for dialogue, allowing investors to discuss the fund’s sustainability performance, share concerns, and gain insights into the fund’s sustainability strategies and actions. Another impactful approach is organizing or participating in sustainability-centric events. Such events can serve as a congregation point for multiple stakeholders, fostering shared learning, and collaboration, and setting new sustainability benchmarks. Furthermore, indirect investors can play a guiding role by providing actionable guidance on the implementation of sustainable strategies. This can be in the form of sharing best practices, and resources, or even collaborating on pilot projects that can later be scaled.
While the nature of indirect investment might pose challenges in exerting direct control, it certainly doesn’t limit the avenues through which meaningful influence can be channeled. Active engagement, through various modalities, ensures that the sustainability vision of the investor permeates through the layers of investment structures, ensuring alignment and driving positive change.
In summary, the influence of an indirect investor, although seemingly constrained by their position, does not preclude them from wielding significant impact. Their strategic choices and advocacy can shape the practices and policies of the funds in which they invest. Primarily, their impact is felt during the selection of underlying funds, where decisions are made. However, the role of these investors is not confined to the selection stage alone. During the holding period, they possess an opportunity to incite the GPs of these funds towards adhering to sustainable practices and policies. The strategic importance of sustainable strategies for indirect investors is set to escalate in the foreseeable future. As the investment landscape becomes more dynamic and complex, the emphasis on transparency in reporting will intensify. Indirect investors, therefore, stand at a pivotal point where their decisions and influence can markedly shape the trajectory of sustainable investing.