ESG: a primary concern for secondaries

The multi-layered nature of secondaries can make ESG issues difficult to address, but that doesn’t mean buyers can ignore them.

Environmental, social and governance (ESG) concerns were understandably the hottest topics at PEI’s Responsible Investment Forum in London last week. Investors on panels and in the audience agreed that managers must be able to demonstrate engagement on ESG issues.

Comments from Swedish pension AP2 that it would not invest in a manager if it didn’t take ESG into consideration, or from Aberdeen Asset Management that it had refrained from investing in two otherwise lucrative funds due to ESG concerns, highlight just how important the issue is.

ESG concerns have spurred sales: the New Jersey State Investment Council’s disposal earlier this year of its $50 million commitment to JLL Partners’ 2005-vintage fund was a notable example. But  how important is ESG to secondaries buyers, and how does it affect their dealmaking?

The nature of fund stake secondaries deals means buyers are one step removed from the investment process, which has pros and cons.

On the one hand, secondaries buyers aren’t committing to blind-pool vehicles, so they can look at the underlying assets of a fund and make decisions on whether they fit their ESG policies before purchasing a stake.

The question, then, is whether the market has reached a stage where ESG concerns have started blocking otherwise remunerative deals? Yes, in the case of Coller Capital, according to Adam Black, the firm’s recently appointed head of ESG and sustainability. Speaking at the Guernsey Funds Forum held in London in April, Black said ESG concerns had prevented the secondaries powerhouse from investing in deals in the past.

“The IC [investment committee] talks about every investment and an ESG conversation will occur,” Black said.

In the case of a fund stake acquisition, a sole asset that isn’t up to ESG standards in an otherwise compliant fund means buyers have several options. Either they walk away from the deal; they offer a lower price based on higher ESG risk, or they allow a non-compliant asset to slip in where the firm wouldn’t have normally made an active investment (something that does happen, I am told).

One area where ESG policies are much easier to apply is in direct secondaries. With no GP in between, direct secondaries firms can carve out assets that aren’t compliant and directly have a say in the policies of portfolio companies, according to Frida Einarson, investor relations director at Stockholm-based Verdane Capital.

“For that reason we can look for sustainability angles in the companies and we can impact their policies, which you can’t really do when you buy a secondaries stake, because you are one step removed,” Einarson said. “In addition, you have no say in the fund formation or the LPA, where otherwise you can introduce ESG requirements.”

The number of LPs in managers’ funds with ESG policies will only increase over time. The multi-layered nature of the secondaries market may make ESG principles harder to apply, but failure to do so is not an option. As one panellist at the Guernsey forum put it, “You cannot do business these days without having a policy around ESG.”

Have you ever walked away from a deal because of ESG concerns? Let me know: