Asian private equity firms grapple with tougher ESG demands
Private equity firms and portfolio companies should prepare for an “onslaught” of regulation associated with the overseas customers of portfolio companies in the coming years, according to Marcia Ellis, a Hong Kong-based partner and global chair of the private equity practice at US-headquartered law firm Morrison Foerster.
“As more European Union and United States companies are subject to regulations that require them to report on – for example, the carbon emissions of each of their vendors and suppliers and even the suppliers of their suppliers – Asia-based portfolio companies of PE firms that directly or indirectly provide products or components to these companies will be put under mounting pressure to reduce their own emissions or risk losing significant amounts of business.”
Morrison Foerster
An example of new requirements is the European Union’s Corporate Sustainability Reporting Directive (CSRD), which came into force in January, as well as a proposed US Securities and Exchange Commission Scope 3 emissions disclosure rule.
Ellis said Asian portfolio companies need to prepare to meet more demanding regulatory requirements within the next two years, particularly with respect to carbon emissions.
“Larger EU companies are going to have to include [CSRD-relevant data] in their reporting for fiscal 2024,” she said. “The reporting will come out in 2025, obviously, but during 2024, they’re going to be going to every business in their value chains and saying, ‘What are your carbon emissions?’, so it’s coming down the pipe really quickly.”
RULES MISHMASH
She said that the increased regulatory pressure to comply with ESG standards coincided with ramped-up ESG demands from investors.
“North American and European LPs s are gradually increasing the ESG-related requirements they’re imposing on Asia-headquartered private equity funds,” she said. “Those funds are also often struggling to keep up with the ESG-related policies and regulations being adopted in all the different jurisdictions in Asia in which they, their limited partners and their portfolio companies operate.”
She said that in addition to carbon emissions, other issues included in the CSRD will also come into focus, notably the treatment of workers.
“In Asia, many portfolio companies are in the value chain of EU companies covered by the CSRD, and thus will be required to produce transparent reports on both carbon emissions and their more human rights-related issues,” she said.
Complicating matters for ESG managers, not just in Asia, but around the world has been the lack of common standards despite a broad, if sometimes ill-defined, consensus as to what ESG should entail.
Liang Yin, Head of Private Equity for Asia-Pacific at advisory company WTW, said the absence of common, credible and recognised standards and the current mishmash of regulations and requirements is perhaps the most pressing issue for PE companies operating in the region.
WTW
“Asia doesn't have a single, unifying, governing body on sustainability,” he said. “We don't have an EU taxonomy equivalent. And also, there's a wider range when it comes to economic status, social norms and expectations, so that makes it challenging. Without that sort of common standard, it's really hard to benchmark.”
Ellis expressed optimism, however, that, informed by the work of the International Sustainability Standards Board, regional finance hubs Hong Kong and Singapore could provide guidance for PE firms and the broader investment community.
“Now that the ISSB has given standards for disclosure, PE firms should to a large extent be focusing on those, because what [regulators] in Hong Kong and Singapore are heading towards is likely to be close to ISSB standards,” she said. “Once we have standards in place, then at least we’re all talking about the same thing and collecting data in the same way.”
MATERIAL RELEVANCE
The EU’s CSRD, in particular, sets out a wide range of reporting requirements on ESG-related issues, from environment to board diversity to bribery and corruption, which, taken as a whole, could seem daunting to many PE firms and portfolio companies. Yin said that the key to achieving the results the directive seeks is to break them down.
“There are so many ESG issues, such a wide spectrum, so how do you focus? How do you make tangible changes?” he said. “Our approach, which is in line with what most companies do, is to focus on materiality assessments.
“There might be 250 ESG factors, but you need to focus on the 12 that are material to your business, to your region, to your market. We don't expect our managers or their portfolio companies to spend weeks and months on trying to cover the entire universe of ESG. It doesn't make economic sense.”
Ellis echoed that view, saying: “We advise PE funds to look at the areas they invest in, at what's most impactful for the areas in which they invest. I've talked to a lot of LPs and they say, ‘I want to see incremental advancement. I don't expect everything to be done on day one’.
“Also, it can be an economic bonus. The valuation of the portfolio company can increase based on whether they’re focusing on certain aspects of ESG, so you might, from an economic standpoint, decide, ‘Okay, I'm going to focus on these targets first, because they're going to have an economic bang for the buck’.”
She said that the export-oriented companies that make up such a large part of Asian economies would face a clear economic choice when it came to implementing ESG measures like those set out in regulatory frameworks such as the CSRD.
“If your company is in the value chain of any EU company or any California company, for example, it's going to be a simple dollars-and-cents proposition. Because if an EU company turns to you and says, ‘Okay, report to me your carbon emissions’, and your company has massive carbon emissions and the EU company can choose another vendor that has much lower carbon emissions, it’s going to choose that other vendor. And the EU firm is probably going to be willing to pay a premium to a vendor that takes its carbon footprint and reduces it.
“So, the role that PE funds can play is in working with their portfolio companies to help put them in a place where economically they'll be better off because they’ll be chosen as the vendor or the service provider thanks to having lower emissions.”
DATA COLLECTION
Yin said that PE firms and other investors could also help when it comes to issues such as ESG data collection, which can be very resource-intensive, sometime prohibitively so for smaller businesses.
“One of the things we do is connect our managers with ESG data providers that they can rely on in terms of doing reporting and measurement duties,” he said. “A lot of private equity managers over the past few years have come to us, saying. ‘We get that this is important, but where do we start? How do we get those data collected and reported, because LPs are asking us to report on those metrics’.”
“Overall, there’s a need to ramp up resourcing and ramp up understanding to meet the increasing regulatory requirements and increased requirements from customers and LPs. But there's another side of the equation, which is that this creates tremendous opportunities for companies like ESG data providers,” he said.
“They’re also backed by private equity, and they’re growing very fast. That’s just one example, of course. Also, climate solutions generally is a hugely interesting area, and there’s a lot of investment opportunities in that space. There’s both pressure to comply, but also tremendous opportunities,” Yin said.