Travers Smith's Sustainability Insights: Sustainability-linked incentives in private markets

Travers Smith's Sustainability Insights: Sustainability-linked incentives in private markets

Overview

A regular briefing for the alternative asset management industry. 

Investors, regulators and stakeholders increasingly require sustainability issues to be integrated into investment decision-making. In many cases, such issues are financially material, and private fund managers already have powerful incentives to consider them – although, of course, they need good data, and sometimes specialist support, to assess them. In fact, alternative asset managers are particularly well-placed to take account of financially material issues, generally having an intensive pre-acquisition due diligence process and a multi-layered investment approval process. Long-term prospects often translate directly into exit value, and effective corporate governance during the ownership phase can ensure that strategy and risk management responds to sustainability opportunities and risks.

It is also clear that the financial drivers for a focus on environmental and social issues will continue to increase. The climate emergency is catalysing technological change and policy decisions that will have a dramatic effect on the profitability of certain economic activities, even many that are not themselves exposed to the physical risks.  But other environmental issues – loss of biodiversity and the need to move towards a circular economy, for example – as well as several pressing social concerns, will change the business models of a wide range of companies in the decade ahead.  Firms that respond quickly to those changes will likely benefit. Once again, the private markets can thrive in such a world – having a financial imperative to be ahead of change, given the need to find a sophisticated buyer for an illiquid asset in, say, five years from now.

However, the financial case for responsible investment is only part of the story. As has become clearer in recent years, investors are concerned about the impact of the activities they are financing – and are increasingly asking about non-financial outcomes. Even where the financial case for "doing the right thing" is not fully made out, companies and financial intermediaries are being implored to do it anyway.  (This thought-provoking piece by the London Business School's Professor Alex Edmans from 2018 suggests that, in some areas, attempts to make out a financial case can crowd out the more compelling moral one.)

...As has become clearer in recent years, investors are concerned about the impact of the activities they are financing – and are increasingly asking about non-financial outcomes... 

Fund managers, responding to demands from investors, lenders, regulators – and, indeed, from powerful voices within their own firm – are evolving their approach. Most already collect and report on various non-financial metrics, but firms are, rightly, reviewing and re-vamping those data collection processes. 

No doubt, shining a light on such metrics, and plotting their development over time, will spur action, but many are going further and asking whether financial rewards should be more closely linked to non-financial targets, as well as to financial ones. We recently published a note exploring recent market developments, and greater focus on pay for sustainability performance is clearly on the way.

Long term incentives in large public companies now often include an "ESG" (environmental, social and governance) target in their annual bonus and the Long-term Incentive Plan (LTIP) or both. Meanwhile, regulators in the EU already require asset managers – including EU-regulated alternative asset managers – to explain how their remuneration policy is consistent with their stated approach to the management of sustainability risk. ESG-linked financings are now prevalent in private markets, including both subscription lines and asset-level lending, although there remains significant diversity in the KPIs that trigger a margin adjustment, mechanisms for testing and reporting compliance with the relevant KPIs, and what happens to any savings or profits – which, often, must be donated to charity or re-invested in sustainability projects. At the portfolio level, an equity ratchet that gives management extra upside if they hit sustainability targets is not yet prevalent in deal terms, but could be a tool for certain companies if there is a particular need to focus minds.

More fundamentally, some impact funds have designed carried interest schemes that are only triggered if certain impact goals are achieved, and we expect to see more innovation in this market. Development of the technology has been slow since the GIIN (the Global Impact Investing Network) published a paper on Impact-based Incentive Structures in 2011 but, according to placement agent Campbell Lutyens, there are now 15-20 global private equity and infrastructure funds with impact linked carried interest. With standard form clauses emerging, we expect to see further development.

But linking financial outcomes to sustainability goals is far from straightforward and can deliver perverse incentives if not done very carefully.  Complex quantitative targets, usually requiring external audit, would be hard to set at portfolio level. On the other hand, a few focused metrics that act as a trigger for the payment of financial rewards – or a margin adjustment in an ESG-linked loan – can be effective to ensure that fund managers remain focused on some key objectives, both in their own business and in the portfolio. Requirements to deliver on specified sustainability initiatives – for example, to ensure that all investees have a credible plan to transition to zero carbon and a science-based target for achieving it – may be a good way to make progress.

Meanwhile, arming relevant people with the right data and skills to make progress on sustainability matters is not a trivial challenge.  Training for investor directors and external Chairs, as well as senior portfolio company executives, can help. Defining KPIs relevant to the business and its strategy, and putting the board in charge of monitoring them, shows leadership and adds impetus.  Pre-acquisition (and pre-exit) ESG health checks, including a review of relevant policies and procedures in key areas, are useful to set the agenda. 

These are all areas of focus for many firms as they seek to move to Sustainability 2.0. Service providers, industry associations and sustainability-focused organisations, including the PRI, are working hard to help them.

Read our note on the evolution of ESG-linked financial incentives in private equity.

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TRAVERS SMITH'S ALTERNATIVE ASSET MANAGEMENT & SUSTAINABILITY INSIGHTS

A series of regular briefings for the alternative asset management industry.