Rules From the Kitchen That Will Change the Way You Talk About ESG

For investment managers who are broadly marketing their funds and advisory services, the significant political backlash may cause many to question whether ‘ESG’ as a term continues to be a useful concept. We’ve found ourselves in a kitchen with not only more cooks, but more dishes on the menu, and a variety of diners with very specific questions and allergen requests. Managers must balance being specific in response to ESG queries, considering their stakeholders, and avoiding the risks associated with saying too much or too little about their policies and practices.

Talking with your mouth full

Since its initial mention in a 2006 UN Report, the attention given to ESG has steadily grown. Inclusive of environmental matters, social issues and corporate governance, an array of issues fall under its umbrella – for example, whether a manager rents space in a ‘green’ building, has adequate policies to retain diverse talent, or considers whether portfolio companies have adequate anti-bribery policies.

These issues arise at various levels within an investment management organization – including recruitment and retention practices of the manager itself, policies regarding factors to be considered in making investment decisions, and the generation of various reports in response to investor requests.

Historically, conversations about ESG were driven by investor demands and responses were generated by marketing teams. Over time, as ESG discussions evolved in response to multiple types of stakeholders, a similar expansion of its footprint took hold within organizations, extending across marketing, compliance, human resources, and the investments function.

Various categories of stakeholders are seeking to engage with managers on these issues; these parties include regulators, a manager’s employees and potential hires, investors in its funds/advisory clients, and customers/acquirers of its portfolio companies. Each stakeholder comes to the table with its own priorities and concerns – all of which vary by geography and can shift over time.

Zooming in on ESG policies at the investment level, the level to which investment managers take ESG factors into account can be categorized into three flavors:

1. Impact investing: an investment program targeting a particular issue (even if it is at the expense of profitability or increases risk) – not particularly typical for commingled vehicles;
2. Anti-ESG: an investment program purposefully not taking ESG considerations into account – even less typical;
3. Flexibility: an investment program containing flexibility to consider ESG factors in a manner consistent with manager’s fiduciary duty – by far the most common approach.

Even a manager with a customarily flexible approach to ESG will find themselves in a position of having to say a lot about its approach. Narrowing the focus further to just one type of stakeholder, a manager engaging with a fund investor can expect:

1. Due diligence questionnaires, including granularity regarding its operations and policies;
2. A discussion of the disclosures in offering documents about the extent to which a manager can consider ESG factors;
3. Possible requests for ongoing reporting or other preferential rights that arise from the investor’s own ESG policies (such as excuses from particular investments).

Funds with a flexible ESG program are often marketed globally. Managers seek to retain maximum flexibility to consider factors they deem relevant during the investment process. In a competitive fundraising environment, managers seek to design products that are both broadly appealing and can accommodate tailoring for particular investor requests. However, the political headwinds pose a challenge to discussions about their ESG practices.

Not at the dinner table

The political debate associated with ESG has been growing, and is driving managers to evaluate their use of the term. In the US, certain states are announcing ESG priorities, while others are passing legislation that seeks to limit ESG investing. In both cases, managers are seeking to hold the line against measures that seek to control their investment discretion.

Anti-ESG legislation often targets why, and not what, a manager invests in. It is challenging to identify the impact of a statute such as that adopted in Florida, which seeks to prohibit managers from investing in a way that prioritizes a social, political or ideological agenda while increasing risk or jeopardizing profitability. For managers who already view those factors – to the extent they are being considered – as linked to profitability or risk analysis, it seems they can continue business as usual.

Conversely, California has proposed a bill requiring its retirement systems to divest from fossil fuel investments. Pushback against this legislation highlights the tension that will result if this proposal is adopted between the free exercise of fiduciary duties and restricting investment in various sectors.

Pushing managers to take a general stance for or against ESG investing in the course of marketing their products may result in new risky behaviors. The industry has long been concerned with ‘greenwashing‘ – in which managers announce but fail to comply with various ESG measures. New discussions express concern about ‘greenhushing‘, in which managers say less about their ESG measures than what they are enacting in practice.

Proper table setting

In light of the ambiguities and controversies associated with ESG, managers should consider a few practical items:

1. Ensure policies are appropriately tailored to the nature of the organization and its specific goals. Discussions about policies and practices should similarly be focused based on the audience and the specific inquiry.
2. Periodically evaluate descriptions about policies and practices for conformity with actual practices, and adjust accordingly as practices change over time.
3. Records should demonstrate compliance with policies and practices as described. For example, managers with flexibility to consider ESG factors often reserve space in investment committee memos for notation as to whether ESG factors were considered (and if so, describing what was considered).
4. Adapt to changing priorities by maintaining flexibility as to when and which factors will be considered in the investment decision-making process.
5. Understand the importance of clarity to each stakeholder – this information is material to investors, is a key part of recruiting and retaining employees, and may be relevant to customers/acquirers of portfolio companies.

Caution: wet floor

One of the more significant risks relating to ESG resides at the organizational level vis-à-vis employees. Collecting and publishing demographics data, and communications about policies designed to recruit and retain diverse talent, should be carefully considered.

Concerns around data privacy and other actionable legal claims await if companies do not develop proper means for delivering and measuring their ESG efforts. Prior to the public release of any diversity-related employee demographic information, steps should be taken to ensure data integrity, and consideration should be given to any impact on current or potential employment discrimination litigation.

Save room for dessert

In reconsidering the use of ESG, the related policies and practices remain a source of opportunity – both as organizations evolve, and given the inextricable link between many of those factors and managers’ fundamental analysis of risks and rewards.