Checklist for a Private Fund to Incorporate ESG Metrics
February 18, 2022
By Angela Veal
If you are a private fund manager who has heard about ESG, an acronym for environmental, social and governance, and contemplating if ESG practices are something you would like to explore for your fund, the recommendation would be “Yes.” Actions should be taken now because if you indeed decide to incorporate ESG standards and metrics into your reporting, the process is robust and takes time. A summary checklist of your next steps in incorporating ESG is as follows:
#1: Understand Why ESG-Readiness May Be Important for Your Fund
ESG is no longer just a novelty or new concept that a fund manager should consider. In fact, many investors have been voicing concerns on whether their investments, including hedge funds, have considered ESG as part of their overall investment strategy. Sophisticated investors have even signed up with Principles for Responsible Investment (PRI), a United Nations-supported network of investors that promotes responsible investing.
The SEC has also responded to such investor demand. On February 26, 2021, the SEC issued an investor bulletin informing the markets of the fundamental role that reliable assurance will play in climate and ESG disclosures. Sustainable investing has been around for decades, but the ESG boom has only taken off during the last five years or so. This trend has yet to experience a recession and will continue to influence investor demands going forward. Funds that integrate it have attracted record inflows amid market turmoil, with many of them outperforming the broader market. ESG represents a fundamental shift in investing, creating ample opportunity to set up funds that focus on it and make an early entry into a niche market with lots of potential. Many have also viewed developing sound ESG practices as the key to longer-term success of their funds.
#2: Assess Investor Expectations
Before determining your investment policy and approach for a fund incorporating ESG practices, you need to understand investor expectations in terms of the extensiveness of the ESG component in your overall investment approach. Your fund may focus purely on ESG or be a hybrid of ESG and other traditional investment strategies consistent with your investment objective.
Investors are increasingly prioritizing social and environmental stewardship in addition to good returns on their investments. However, certain investor perspectives may vary. For example, there are investors who prefer a well-balanced ESG investment portfolio that invest in the “best-of-class” from different sectors, whereas others may state specifically that they do not want to invest in a portfolio that consists of investments that are inconsistent with their belief or value system.
#3: Formalize Investment Policy and Approach
A policy should be formalized to clearly document your investment approach, how you have determined which ESG metrics are material to your individual business, and how each of these metrics are considered during the investment process. It should also document your rationale for adopting a policy that endorses responsible investment. When designing the investment portfolio relating to ESG investing, there are three categories from which you can select the securities to invest in, namely environmental (e.g., investee’s environmental impact), social (e.g., investee’s community involvement or focus on certain human rights) and governance (e.g., investee’s transparency and reporting compliance).
Your fund does not necessarily need to focus on purely ESG, and it can be a balance of ESG and other traditional factors. Ideally, this should also be disclosed within your policy.
Lastly, if you are complying with certain codes or initiatives (e.g., PRI), it is encouraged that this disclosure be made in the policy as well.
#4: Establish Overall ESG Investment Process, Oversight and Organizational Structure
To maintain proper execution of the investment strategy, there should be adequate monitoring and oversight. Examples include oversight by an investment committee or board of directors. There should also be regular reporting on how the ESG components have been incorporated in the investments that were made.
Investment professionals with a background in and understanding of ESG can be instrumental in helping an organization keep its eyes on its standards, whether on the environmental, social or governance side.
Therefore, the fund manager should also ensure that some of the investment professionals are experienced with ESG investing, and firm leadership is educated on ESG policies with respect to employee training, employee engagement, talent attraction and talent retention. In fact, more new hires have also been inquiring about ESG fund options with their benefit plans.
Meanwhile, on the firm level, there should also be sufficient ESG data and tools made available to employees on how leadership is integrating ESG.
#5: Examine and Understand ESG Reporting Requirements that Are Consistent with Industry and SEC Guidance
Currently, there is no formal authoritative guidance regarding reporting and disclosure requirements for funds that have an ESG-focused investment portfolio. In fact, there have been concerns about the lack of consistency in reporting and ability to measure performance of ESG funds within the industry. As you are aware, regulatory rulemaking in the U.S. is very robust and takes several reiterations before the final rule is communicated to the public.
Due to lack of standardized guidance, we see many boilerplate disclosures being adopted by funds. Where, when and how you report the performance of the ESG components may also vary – it can be on your financial statements, websites or within your prospectus; it can be monthly or quarterly; and it can be in the form of a written report or via shareholder meetings.
Additionally, it gets very tricky in terms of measuring how well an ESG fund is performing against a benchmark due to a) a lack of other similar ESG funds or ESG funds with similar investment strategy and b) a lack of industry consistency of metrics that fund managers can use to track and measure their fund performance. For a fund which is exposed to climate risk, the fund manager would also need to figure out a way to measure and monitor the carbon footprint of its investment portfolio.
ESG is becoming a phenomenon that should not be ignored. Fund managers should take actions now by a) understanding who their target investor is and evaluating their expectations; b) considering if the funds should incorporate ESG principles within their investment strategies (partially or fully); and c) determining the appropriate performance metrics for measuring fund performance and ESG reporting requirements. Please note that fund managers should consult with their advisors on their respective considerations of incorporating ESG strategies based on specific facts and circumstances.
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