“[C]limate risk is investment risk … And because capital markets pull future risk forward, we will see changes in capital allocation more quickly than we see changes to the climate itself.” – Larry Fink, BlackRock, Annual Letter to CEOs
In recent years, there has been a trend in the financial markets towards greener, environmentally friendly investments, and private equity funds (“Funds”) are no exception. Such Funds and their limited partners are increasingly interested in environmental, social and governance (“ESG”) aspects of Fund investments. For instance, in 2019, $20.6 billion was invested by US investors in sustainable Funds, nearly four times more than in 2018.1 And even in these unprecedented times, investments in sustainable Funds for the first half of 2020 reached $20.9 billion, and total assets in sustainable Funds hit a record high of $1.1 trillion as of the end of June 2020.2 The COVID-19 pandemic and its effect on global economies has only intensified the focus on ESG principles, with many policymakers and investors drawing parallels between the unforeseen risks of a pandemic and issues such as climate change and calling attention to the importance of considering environmental, social and governance performance, together with more traditional financial metrics, in evaluating investment risks.3
While ESG investing still largely takes the form of “impact investing”—investments into companies or funds with the intention to generate a measurable, beneficial social or environmental impact along with a financial return—ESG investing is not just about aligning investment strategies with investor values but also the general principle that ESG-negative behaviors impact investment returns. This Legal Update will focus on the impact of ESG principles on the financial markets in the United States and their growing impact on the fund finance industry.
II. Definition of ESG
As noted above, ESG is shorthand for the environmental, social and governance criteria that, taken together, establish a framework for assessing the impact of the sustainability and ethical practices of a company on its financial performance and operations. The three so-called “ESG pillars” are summarized below:
- Environmental: This category tracks a broad range of environmental issues and environment-related actions. These include use of or dependence on fossil fuels, use of renewable energy, use of hazardous materials, and pollution levels.
- Social: This category considers factors such as conflict risk, human rights, workers’ rights, health and safety considerations, community engagement and relations, and equal inclusion.
- Governance: This category considers how a company operates and governs itself and looks at such factors as management of corruption, executive compensation, board diversity and board independence, ownership and shareholder rights, and transparency.
It is important to note that the three ESG pillars can be used to assess not only the risks presented by a particular company or investment but also the opportunities. For example, a Fund that invests in companies in areas of conflict might have a higher risk of financial or reputational difficulties, but those companies may also be taking positive actions to address social issues and improve their relationships with impacted communities. Similarly, a company using fossil fuels may be implementing positive policies or technologies to mitigate the impact of such use.
One of the greatest challenges faced by investors or Fund managers with incorporating ESG principles is the existence of multiple ESG reporting frameworks and the lack of consistency and comparability of metrics among them. This has resulted in concerns of “greenwashing” or investments misleadingly or falsely categorized as abiding by ESG principles.4 To address this concern, the World Economic Forum recently published a White Paper defining a common set of metrics to measure ESG performance.5 Regulators in the United States and the European Union have taken note of this as well. In June 2020, the European Parliament adopted regulations to establish an EU-wide classification system or taxonomy for environmentally sustainable economic activities6 that will impose disclosure requirements on Funds marketed in the European Union, and, in May 2020, the US Securities and Exchange Commission (“SEC”) published recommendations on ESG disclosure.7 Although US regulators have not yet imposed mandatory disclosure regimes or even recommended particular disclosure standards, given the increased investor attention on ESG and pressure to adopt certain ESG disclosure standards, US regulations on ESG should be expected and closely monitored. As the SEC stated in its May 2020 recommendations, the US capital markets are the largest and deepest in the world, and the SEC should take the lead on establishing a reporting regime that will provide investors the information required to make investment decisions on ESG criteria.
III. ESG Investments/Green Bonds Market Trends
ESG spans multiple asset classes. There are “green bonds” and “social bonds,” ESG money market funds, “green” mortgage-backed securities, “green loans” and “sustainability-linked” loans. These types of products have recently received significant publicity, including the issuance in the United States of Fannie Mae’s Green MBS series and a variety of COVID-19-related Social Impact Bonds issued during 2020. So far, bonds have made up the majority of ESG financial products in the US market. In 2018, there were over $257 billion of ESG bond issuances globally,8 and, in the third quarter of 2020, ESG bond issuances reached $69 billion, more than any other third-quarter period.9 US issuers made up the largest portion of this market in 2019, contributing $51 billion to the total. The majority of ESG bonds are “use of proceeds” or asset-linked bonds, where the proceeds are used to fund projects that have positive environmental or climate benefits or which are backed by green assets (for example, a portfolio of residential solar systems or mortgage loans for energy-efficient homes). Compared to ESG bonds, ESG loans make up a much smaller sector of the ESG asset class, with only $10 billion in new loans reported globally in 2019.10
Although the principles are voluntary, generally to qualify as a green or social bond an issuance would need to follow principles published by the International Capital Markets Association (“ICMA”), and in the loan market green or social loans would need to follow principles established by the Loan Market Association (“LMA”) or the Loan Syndications and Trading Association (“LSTA”). The ICMA, LMA and LSTA identify four core components that should be included in legal documentation for ESG bonds or loans:
- Use of Proceeds. Proceeds of the financing need to be used for green (e.g., renewable energy, energy efficiency, pollution prevention, clean transportation) or social projects (e.g., affordable housing, basic infrastructure such as water or sanitation, food security or socioeconomic advancement), which should be described in the financing documentation.
- Process for Evaluation and Selection. Particular green or social objectives, the process by which projects fit green or social criteria and the process to manage environmental and social risks should be clearly identified.
- Management of Proceeds. Proceeds of the financing should be tracked by the issuer or the borrower to ensure application to green or social projects, and proceeds should be adjusted to match allocations to eligible projects.
- Reporting. Issuers and borrowers should maintain information on use of the proceeds and provide annual reports on the financed projects and the expected impact using qualitative and quantitative performance indicators.
IV. Fund Finance Impact
In recent years, limited partners in Funds have become increasingly prominent in bringing forward the desire to invest in Funds with ESG objectives and many are now monitoring whether the Funds they invest in align with their focus on the social and environmental impacts of various investment strategies. This trend is now evident in many limited partnership agreements (“LPAs”) and letter agreements between limited partners and Funds through various provisions that either require or encourage the Fund to consider ESG objectives/factors when sourcing new investments.
The Institutional Limited Partners Association (“ILPA”) has also recognized the importance of focusing on sustainable investments. In June 2019, ILPA released its Principles 3.0: Fostering Transparency, Governance and Alignment of Interests for General and Limited Partners. The updated principles encourage general partners of Funds to consider “maintaining and periodically updating an ESG policy…[which] should include information sufficient to enable an LP to assess the degree to which the GP’s investment strategy and operations are aligned with an individual LP institution’s ESG policies.” While limited partners may seek to narrowly define ESG metrics to align with their own internal policies, Funds will prefer a more flexible approach that will allow the Fund to meet the ESG expectations of differently situated limited partners, as well as provide room for growth and adaptation of evolving ESG metrics and policies over the life of the Fund. And as further evidence of the evolution of ESG in the context of Funds, recent fund finance transactions in both the United States and Europe have focused on ESG funds that invest in businesses that contribute measurable progress toward one or more of the United Nations Sustainable Development Goals.
We expect that this area will be one of further interest to Funds in the US market, such that we will see more credit facilities tailored to meet certain ESG criteria with respect to how loan proceeds are used (rather than for general corporate purposes). Additionally, we will see more Funds qualify for such financings, as partnership agreements and investment strategies become more tailored to include ESG investment focus and ongoing monitoring and reporting on sustainability factors. We expect to see similar sustainability-focused products offered by other banks in the fund finance market as we move forward in the next few years. In particular, with the changing political environment in the United States and calls for the implementation of new green deals, we anticipate increased focus on ESG principles over the course of the next four years.
Sustainable investing is no longer a bespoke niche in the private equity market, and it seems likely an increasing number of Funds will emphasize ESG investment policies moving forward. In a competitive environment for attracting new capital, incorporating ESG-focused policies into LPAs and more general fund investment objectives may not only help to increase marketability to existing and potential limited partners but also promote the important objective of increasing the number of sustainable investments. This has been a growing trend globally, as well as increasingly prominent in the United States in connection with its changing political landscape and overall recognition of the importance of ESG principles.