How to meet the diverse ESG needs of different investors without going crazy
This is for you, Fund Managers.
Picture this – you’ve been spending the better part of a year fine tuning your new impact forestry investment strategy. You have a Theory of Change that you’re really proud of – with clear financial and impact objectives, a team that is motivated to deliver and a pipeline of opportunities you’ve identified, having visited many of the projects on the ground. You’ve had several promising discussions with LP prospects, each hinting at their own impact wish-lists and investment requirements – some even providing you with clear instructions, for example – “the fund must comply with our XYZ Guidelines if we are to consider it.” As such, you’ve also diligently been following such guidelines as you construct the Fund’s ESG Policy, Investment criteria and restrictions, iteration after iteration of your portfolio model and so on. Then comes the time for negotiations. What often transpires, especially when targeting ESG risk elevated jurisdictions is the side letter – and in this case, I refer to the specific ESG requirements laid out by a particular investor for their participation in the Fund. It often goes above and beyond what is agreed by all LPs and ensures that said investor’s unique needs are met. The real challenge is – there can be several side letters. What this can result in is an ESG management nightmare, where you’re concerned that you need a large ESG team just to keep up.
In this week’s article, we’re going to unpack the side letter challenge, and I’m going to give you some ideas on how to streamline the process – based on a couple of recent client engagements, where we’ve done just this.
Where might you expect an ESG side letter to impact your Fund Management?
Before jumping into overwhelm, let’s take a step back and take a look at where and how an investor’s ESG side letter might appear (or pre-subscription, where it might threaten to).
- Fundraising / Subscription phase
This is where you will gain great insights into the ESG requirements of an investor prospect. Discussions will progress from investors asking you “how will you address xyz in the Fund’s investments” on to “we expect the Fund to follow our requirements on xyz”. An example could be that the investor requires that the Fund follow their anti-deforestation policy. This is not really in a side letter, because it needs to exist before you even subscribe the investor. However, its important to get this information early, and other such requirements to assess your ability to meet their requirements while also meeting the objectives of the Fund’s strategy.
- Pre-Investment (Deal sourcing and Due diligence)
This may include following the investor’s own screening or exclusion criteria (example, no-go countries), possibly with them having excuse rights – or the option to not invest in an asset that doesn’t align with their criteria. You might have a strategy that blends assets targeting timber and carbon markets. But you might have an investor – who requires assets to include timber production. In such a case, the investor may be interested in the strategy, but does not want exposure to pure carbon assets, and they will exercise excuse rights to not participate in that asset. It will often require the submission of ESG findings in the documentation shared with the Investment Committees and be made available to the investor.
- Investment Execution / Onboarding
This usually relates to an investor’s ESG risk or impact safeguards, where certain standards must be implemented in a certain timeframe after acquisition of the asset. Achieving certification within the first couple of years is now business as usual, and there is usually already this requirement built in to the LPA and ESG policy, but a common side letter might include that the assets needs to develop an Environmental and Social Management System (ESMS) aligned to the IFC Environmental and Social Performance Standards, or it might be very specific to the investor’s interest – such as carry out a biodiversity baseline assessment within the first 90 days of acquisition.
- Portfolio Management / Ongoing Oversight
This is a common place for side letter expectations to be raised – where investors have their own internal reporting requirements and thus, in addition to Sustainability reporting agreed to in the LPA or that is otherwise built in to Fund documentation, they may have their own needs. This can be using a specific methodology for calculating carbon emission removals, or a breakdown of jobs provided – disaggregated by gender, material ESG incident notification requirements and so on.
- Exit / Disposal
Some investors may have strong impact requirements and may have a side letter that prohibits selling to parties who have violated sustainability norms, such as environmental sanctions or human rights violations. Another example is where an investor wants to ensure that the impact they created through their investment will not be reversed, and may prohibit, for example selling the asset to a property developer or to a conventional agriculture buyer. In such a case, investors may reserve the right to be informed prior to the sale of high-ESG risk assets.
- Fund Wind-down / Post-exit
Some investors may require a final ESG or Impact Assessment of the portfolio upon exit, or documented lessons learned from ESG impacts and incidents that occurred over the life of the Fund.
How to effectively navigate your side letter requirements
Believe it or not, a side letter might be a saving grace to what otherwise might be an overly restrictive LPA that integrates the ESG wish list of every investor, making it impossible to find suitable deals. So in the event that side letters are inevitable, here’s how you can make the journey more smooth.
Subscription Phase – Negotiate smartly
If you know that your Fund’s investors are likely to have some specific ESG wishes, its good to anticipate this and bring it up early in discussions. Best if you can compare these requirements to that of other investors while still working through the draft terms and conditions. See if you can strike a compromise where there are similarities across investors (but be aware this might just not be possible). Where side letter requirements are inevitable, assess your financial model and your pipeline to ensure that these requirements are not going to have significant financial implications nor affect the ability for you to invest into the assets in your pipeline.
Map out your requirements and Execute Systematically
Once your Fund is closed and you’re in investment mode, its good to step back and map out your ESG requirements – those that are within the LPA or your ESG Policy and in separate investor side letters. I would suggest organizing them according to the categories listed above, so you can see when in the investment lifecycle they are going to appear, and what is required of you. With a good understanding of what needs to be done and when – Re-visit your ESG management procedures and management calendar and build a simple checklist that specifies the various ESG requirements at different phases of investment. Ensure that ESG requirements are built into DD checklists, risk assessments, 100 day plans, regular (and customized) reporting templates, management or board meetings, etc. With your quarterly reporting have another checklist that ensures all of your side letter needs are met. After this, perform a simple capacity assessment, and identify where you might have road blocks in meeting your requirements. It may be that your ESG Manager will be in the middle of several 100-day plan implementations across the portfolio, while also needing to support a biodiversity baseline assessment required by one investor. Identify these pinch points, and get support where it makes sense.
Need some help with your ESG side letter woes?
Committing to a large set of diverse ESG requirements can pose a capacity constraint within your management team and generates its own risk that you fall short on your investor commitments, jeopardizing an investor’s trust in you for future mandates. If your team is stretched and you need some help meeting your abundant sustainability commitments, reach out. I’ve helped Fund Managers meet both their Fund-level ESG requirements and their side letter commitments through building things like, customized ESG Due Diligence checklists, building ESG policies aligned to different Standards, creating risk management frameworks, designing Human Rights Policies and Procedures, designing ESG-integrated 100-day plans and more. If you’re at an ESG pinch point and you need some extra support – let’s have a call and we can see if there’s a fit for me to fill some of your ESG capacity gaps.
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