European private equity fund managers are well aware that demonstrating a commitment to responsible investment is becoming an essential component of a smooth and successful fundraising. Regulation is only one of the drivers for that change, but it is an increasingly significant one, and two recent developments are characteristic of the changing regulatory landscape. They also highlight an opportunity for private equity fund managers – many of whom are already focused on ESG (“environmental, social and governance”) considerations when making and managing portfolio investments.

The first development comes from the UK’s Financial Reporting Council (FRC), a body that regulates accountants and oversees corporate governance in large companies. Since 2010 – partly in response to concerns that listed UK companies were effectively “ownerless”, because institutional shareholders did not exercise their ownership rights in a considered way – the FRC has maintained a “Stewardship Code”. Over 200 asset managers and asset owners have signed up, including many who invest in private equity and venture capital funds.

Until now, the private equity community was hardly affected by the obligations imposed by the Code because – even if some investors in private equity funds were signatories – those investors did not have to apply the Code to their private equity investments. However, a consultation launched last week could change that. The proposed amendments to the Code will require investors to incorporate stewardship into their investment processes and decision making, whatever the targeted asset class, and to consider ESG factors more extensively. Firms can therefore expect affected investors to ask more questions during due diligence.

In fact, this proposed change to the UK’s Stewardship Code is merely a taste of regulatory things to come: the European Commission is proposing that most European asset managers – including pension funds and insurance companies – will have to incorporate sustainability factors in their risk management and decision-making processes. That means that an even wider group of European investors may soon be asking their private fund managers more detailed questions about responsible investment.

Which leads us to the second recent development: as part of its package of measures to encourage asset managers to focus on sustainability, the European Commission also asked the pan-European securities regulator, ESMA, to suggest some changes to the Alternative Investment Fund Managers Directive. In December, these proposed changes were published for consultation and the industry has until 19 February to give its views.

In general, ESMA suggests changes to the Directive to make it clear that regulated alternative investment fund managers (AIFMs) must consider sustainability risks – defined as the risks of “fluctuation in the value of positions in the fund’s portfolio due to ESG factors” – when selecting and monitoring investments. The changes are principles-based, but will, for example, require firms to assess whether they have sufficient resources and expertise to assess sustainability risks. Firms will need to look again at their due diligence procedures, and senior managers will be responsible for ensuring that consideration of sustainability risks is integrated in the firm’s operations. ESMA does acknowledge that these issues need to be addressed proportionately, which may help smaller firms to argue that their size, relative simplicity and investment strategy allow a lighter set of procedures than would be appropriate for larger firms. Nevertheless, greater focus on material ESG factors throughout the life cycle of a portfolio investment will be required of all regulated AIFMs.

Rarely do regulated firms welcome more regulation, but changes that affect firms and their investors in this area may actually provide an impetus to the asset class. As an industry, private equity firms have the financial incentives and the wherewithal to have a meaningful impact on how portfolio companies address ESG risks and opportunities. For investors seeking asset managers who can demonstrate a commitment to responsible investment, and deliver measurable success, private equity funds are a good place to look. If the industry continues to embrace the challenges of the 21st century, it will help to secure its continuing success.

This post comes to us from Debevoise & Plimpton LLP. It is based on the firm’s memorandum, “European Funds Comment: Responsible Investment: An Opportunity for Private Equity,” dated February 8, 2019, and available here.