ESG is rising up the agenda for Asia’s regulators while LPs are becoming increasingly sophisticated in their approach to sustainability in their own organisations and those of managers they back. The region’s GPs should be prepared for much greater levels of engagement from their investors than they have experienced in the past.
Many of Asia’s markets have been taking tentative steps towards creating regulatory and disclosure frameworks to improve the environmental, social and governance (ESG) performance of their largest companies, most of them listed. China, Hong Kong, Singapore and Thailand, for example, have either put in place disclosure requirements over recent years or are incentivising public companies to improve ESG transparency, while India is in the process of putting together guidelines on this area and from next year, Taiwan will require that certain companies adhere to Global Reporting Initiative standards on ESG reporting.
These moves are clearly designed to shift company practices around ESG issues and their management. Yet while the regulatory environment is likely to have an impact on all businesses of a certain size, in private markets, it’s the LPs that are really seeking to make a difference as they seek out managers that align with their own values and mission.
“ESG is not a strategy for us; it’s a process,” says the Head of Impact Investing at an alternative investment asset manager. “It applies to everything we do and we have to ensure that all the right risk management processes are in place.” Yet he also draws a distinction between the terminology of ESG and impact investing – areas that investors often conflate. “We run separate impact strategies that deliberately aim to have a positive outcome on social and environmental issues,” he says. “The two don’t necessarily go together because you can have a very impactful investment that has poor ESG performance and vice-versa.”
Capital Dynamics has also fully integrated ESG into its decision-making processes. “We’ve developed a systematic approach that makes each investment professional entirely responsible for ESG considerations,” explains Manjia Guan, Head of Primaries, Asia, at Capital Dynamics. She explains that the firm has devised a ratings system, R-Eye, which is based on the 17 United Nations’ Sustainable Development Goals (SDGs). “It’s a comprehensive assessment process that enables deal teams to assign a score and rate companies around specific measures when they conduct due diligence and then track at least annually through the investment period.”
And Capital Dynamics is far from alone. In a survey conducted last year by Natixis Investment Managers, for example, 70% of institutional investors said they expected investing in line with ESG factors to become standard practice by 2025. While this is a movement that has historically had a stronger momentum in markets such as Europe and the US, many Asian institutional investors are increasingly integrating ESG into their decision-making. A recent survey of institutional investors by MSCI found that 79% of respondents in the region increased their ESG investments moderately or significantly in response to COVID-19. This resolve may be strengthened further by a stream of net-zero target announcements by a number of governments in Asia-Pacific last year, most notably in China.
Clearly, this means that GPs across Asia really need to take notice if they are to raise capital from the rising numbers of LPs actively seeking out firms with good ESG processes already or the capacity to implement them well. “It’s very important that GPs take ESG seriously,” says Masashige Ueno, Senior Chief Manager at Mitsubishi UFJ Trust and Banking Corporation. “Otherwise, our investment is exposed to unnecessary risks. We undertake formal ESG due diligence that helps us identify where improvements can be made and we also assign an internal rating to each fund. Our ratings show that Japanese funds are generally behind those in other developed countries.”
LP pressure or encouragement certainly seem to be prompting a step-change in the way GPs approach ESG. A 2019 survey by Preqin of Japanese private equity and venture capital funds found that 60% said that investor requests were the reason for developing ESG policies. Ueno, for example, has found that GPs are generally open to constructive discussions around the issue. “Our due diligence and monitoring are helping to improve ESG,” he says. “We provide our GPs with feedback and, in most cases, they work on this. We are keen to engage with them on how they can improve.”
Capital Dynamics takes a similar approach. “We look at our ratings as a roadmap, not a final score,” says Guan. “We continue to monitor and update the rating annually, since one of its purposes is to identify areas for improvement. We recognise that managers may not be perfect from the beginning, but we try and find ways of working with and supporting them to improve ESG over time.”
Some of this also requires an understanding of the nuances and differences in various geographic markets and fund manager size brackets. “You have to take the stance that no one size fits all,” adds Guan. “In emerging markets, for example, managers tend to be smaller and they can be at a disadvantage in terms of resources and because they are making minority stake investments. They can’t be leaders in climate reporting, but they could be a major force on SDGs by providing good education or improving healthcare outcomes, or they could be lifting the living standards of local populations by offering a better product, creating jobs or managing waste more effectively.”
With support from both international and local LPs, ESG looks set to become more of a standard practice among GPs in Asia as it has almost done in Europe. The next step will be an increase in impact investing beyond Asia’s emerging markets and into its more developed ones as sustainability becomes more embedded and as buyers actively seek out companies able to make a positive difference across measures such as the UN’s SDGs. “We are facing an existential crisis, especially in relation to climate change.” says the Head of Impact. “If we don’t figure out what to do with the trillions of dollars available to invest to reduce global heating, we are doomed. We have now resolved the argument about whether impact can generate market-rate returns. We’re now moving on to whether it can produce more attractive returns because of the pools of capital available for impact investments.”
He looks forward to the next step in impact investment’s evolution. “We may well have discussions in future about how much impact should we be getting for our money,” he says. “We’ll be looking at different investment strategies and assess on a per dollar basis, how much climate impact can we have in investment A versus investment B.”
Indeed, some believe that the market is evolving rapidly. “In a year’s time, we won’t be talking about ESG and impact,” says Gregor von dem Knesebeck, Managing Partner at Blue Future Partners. “The terminology will be outdated by then.”
If that prediction comes true, then Asia’s private equity and venture capital market will have come a long way. “There was a time when the focus in Asia was just on growth,” says Guan. “That meant that certain behaviours were tolerated as general market practice. Recently, we have seen some market turbulence in Asia as policy makers have tightened regulations to address some pressing social issues, reflecting a change of priorities on their agenda. Increased regulation and LP pressure are leading to greater focus on sustainability. In turn, it is becoming ever more apparent that this is not just about avoiding risk; it is creating new opportunities.”
This article was first published in our LP magazine: Asia insights.