PE firms seen facing growing ESG challenges

Responsible investing tends to be low on the agenda for private equity firms in Asia, but that seems to be gradually changing. Growing PE investor demand for transparency is being reflected in a rising number of requests for ESG-type factors to be incorporated in investment strategies.

ESG trends are more prominent than they were 10 years ago, as a younger generation of GPs is more aware of these issues, said Kyle Shaw, managing director of Shaw Kwei & Partners, a Hong Kong-based PE firm. They are therefore more likely to come up as part of the due-diligence process, he added.

“Any GP in Asia has to deal with a whole range of ESG issues,” noted Melissa Brown, partner at financial advisory firm Daobridge Capital in Hong Kong. By its nature, PE involves committing capital to imperfect companies, typically for three to five years so limited partners don’t expect perfection, said Brown – but they do want GPs to become more proactive in their implementation of ESG policies.

One challenge for LPs is identifying those GPs with experience of evaluating ESG criteria. There are very experienced mid-market and early-stage investors in Asia who have dealt extensively with these issues, said Brown, but they often don’t use the same language as practitioners in the West when talking about them.

Moreover, a "whole bunch of PE firms [in Asia] like to swim naked" when it comes to ESG – by not taking these factors into account at all. However, in light of leadership changes in India and Indonesia and an anti-corruption drive in China, fewer LPs appear willing to do so, some have suggested.

To that end, some investors are insisting on including in their LP agreements opt-out clauses from deals that do not meet their ESG requirements, noted sources. Such 'unbundling' – as one investor called it – can be a headache particularly for fund-of-fund managers that fail to retain LPs' confidence in the thoroughness of their due-diligence process.

Indeed, even PE firms and FoF managers that are on board with ESG-focused investing are often not keen on such opt-out requests from LPs, as they impose more constraints and make due-diligence more difficult.

Yet ultimately, greater transparency seems inevitable, given reports this year that some PE firms have been systematically overcharging clients and regulatory pressure for GPs to improve their practices in areas such as corporate governance.

Investee companies certainly seem to be responding to such trends.

“For the longest time it was compliance, compliance, compliance,” said Jamie Allen, secretary general of the Asian Corporate Governance Association (ACGA). “Companies are starting to approach CG less from a compliance mentality.” Put another way, companies are increasingly doing more than the bare minimum required for CG compliance purposes. 

A good thing too, since, as Brown noted, “most complex ESG issues don’t fit neatly into a compliance” framework.

Indeed, corporate buyers may be willing to pay more for assets with relatively strong green credentials. Some are aware that one way to negotiate a lower price at the final stage of acquisition talks, said Brown, is to “bring in their ESG compliance people” to assess their practices in this area.