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How LGT applies ESG filters to secondaries deals

Partner Martha Heitmann discusses ESG-driven secondaries sales and what to do if a portfolio sets off alarms.

As a secondaries buyer, how easy is it to apply ESG filters? 

When LGT Capital Partners is looking at portfolios of private equity funds on the secondary market, we always perform bottom-up due diligence on underlying companies and therefore have a view early on in the process whether ESG issues would arise. Potential risks in the portfolio are identified by pre-defined ESG filters and then discussed at the ESG committee. If the transaction comprises multiple funds, which are often mature portfolios that are partially or fully invested, this can at times add considerable extra work compared to a single primary fund ESG due diligence.

Next to assessing individual businesses, in secondary transactions we also review the private equity manager by leveraging the ESG analysis carried out by our primaries team. This process evaluates the manager’s ESG practices in an institutionalised, systematic way. Over the years, we have developed a structured process to assess managers, which is aligned with the UN Principles for Responsible Investment.

In short, any investment opportunity that is ultimately recommended to our investment committee for approval will have been reviewed for ESG issues in advance.

If something in a portfolio of stakes raises a red flag with a secondaries buyer’s ESG policy, what are your options?

Any material ESG issues identified during due diligence will be flagged to LGT’s ESG committee for further investigation. If the committee is of the opinion that the ESG risks are too high, it may be grounds for declining the investment. As we are often dealing with multiple funds with different portfolios of companies, we would either carve out a specific fund line item or potentially step away from a transaction entirely. Before doing so, we would try to find a solution with the manager of the fund (ie, potential opt-out of the company) or the seller to address the identified issues.

How big is the opportunity for ESG-driven secondaries sales?

The opportunity is rather limited as ESG drivers are not often the primary reason for secondary sellers to divest a private equity fund position. Through engagement, many LPs are more focused on working with the managers to improve their ESG capabilities. That being said, LGT’s private equity secondaries team has seen a few sales processes driven by the lack of general transparency- including on ESG – of a given manager. The fact that such situations are becoming more common on the secondary market suggests that ESG is becoming mainstream and increasingly important for LPs. It also creates new opportunities for engagement with fund managers to further improve their ESG processes.

In terms of diversity, how do secondaries firms stack up against other PE firms? Does the fact that it’s such a niche market make it even more difficult to hire a diverse workforce?

We would expect that secondaries firms face the same challenges in building up a diverse pool of employees as traditional private equity buyout managers. In fact, it is really a topic that affects the financial industry as a whole. In our ESG Report 2019, we learned that 45 percent of the more 200 private equity managers in our assessment already have a diversity policy in place. This can range from a simple acknowledgement of the importance of a diverse workforce to policies that actively seek to adjust the balance towards greater inclusivity.

By comparison, 36 percent of our managers consider diversity in their investment process, seeking to ensure that the companies they own reflect the full range of talent available.

LGT is proud of the gender diversity on its team, as two of the five secondary partners are female, and among deal leads/mid-level secondary employees, 60 percent are female.

How developed are the ESG policies of most secondaries firms? Where is improvement most needed?

In our annual assessment we look at the extent to which the private equity managers have demonstrated their commitment to ESG through actions such as defining a policy, committing to an industry initiative like the PRI and engaging with their portfolio companies. Across the assessment, we see a range of different ESG policies at different stages. Some, especially larger managers, have very detailed and binding guidelines, whereas other managers that are less advanced in ESG sometimes have more high-level ESG commitments in place.

One area where we see potential for synergies is between due diligence processes at fund manager level and underlying portfolio companies. This could speed up the secondary sales process significantly. Secondary transactions often have short time frames with limited time for due diligence compared to primary investments. If managers already adhere to high ESG standards, secondary buyers would face less hurdles in acquiring portfolios with potential ESG issues.

Martha Heitmann is a partner at LGT Capital Partners based at its headquarters in Pfäffikon, Switzerland. She has been with the firm since 2007.