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ESG Investing: How Private Equity Fund Investments Are Affected

2021.05.17

Previously regarded as mere standards, Environmental, Social and Governance (ESG) investment and management practices are now evolving into a more substantive trend in the Korean private equity market.  Korean private equity fund (PEF) asset management companies (“Korean PE Managers”) should thus position themselves to actively and pre-emptively respond to how ESG investment and management is affecting private equity investments.  This article explores how this may be done. 
 
 
ESG Investing 
 
ESG investing refers to investment decisions that take into account ESG criteria.  ESG criteria create a set of standards for evaluation of a company’s non-financial performance and sustainability along the following individual factors: (i) the ‘E’ for ‘environmental’, encompasses environmental challenges such as climate change, greenhouse gas emissions, waste and pollution, renewable energy and waste management; (ii) the ‘S’ for ‘social’, includes social issues such as customer protection, data protection, health and safety, local communities, human rights and working conditions; and (iii) the ‘G’ for ‘governance’, embraces issues such as board composition, diversity, audit mechanisms, distribution policy and shareholder protection. 
 
 
Governance Structures Must Now be Disclosed by Listed Companies Valued Over 
KRW 2 Trillion 
 
With the (i) continued rapid increase in ESG investing around the globe, (ii) Korean investors’ recognition of ESG investing as a sustainable means of making investments with positive mid-to-long term profitability outlooks and (iii) recent Korea Exchange regulations requiring disclosure of governance structures of listed companies valued over KRW 2 Trillion, ESG investing has become a key focus for the Korean asset management industry.  In Korea, ESG investing has been heavily led by a number of pension funds and mutual aid associations that have been applying ESG investing factors in their investments in equity funds and debt funds.  However, most recent movement has seen ESG investing factors also being rigorously applied in investments in PEFs. 
 
 
The Export-Import Bank of Korea’s Notice on Asset Manager Appointment 
 
This ESG investing trend can also be spotted in the Export-Import Bank of Korea (the “Eximbank”)’s February public notice, announcing its intention to appoint an asset manager for its global ESG investments.  The Eximbank stated that it is looking to reform Korean companies’ governance structures to enable the embracing of ESG factors; the plan is to draw up improvement plans based on ESG-oriented evaluations of target companies in the investment phase and assess subsequent effects upon exit.  The key points of consideration for the Eximbank in appointing an asset manager to reflect this plan will be the asset manager’s (i) implementation of ESG factors in its internal investment regulations and decision-making processes and (ii) ESG investing strategies. 
 
The Eximbank has also made it widely known that it seeks to induce active implementation of ESG factors by target companies by providing partial returns (which would otherwise be paid out to the Eximbank) to the asset manager based on the results of independent ESG evaluations of the target companies’ implementation of ESG factors. 
 
The Korea Development Bank and a number of pension funds and mutual aid associations, including the National Pension Fund and Korea Teacher’s Credit Union, have recently been requesting their asset manager candidates to establish internal regulations reflecting ESG factors, specific ESG investing strategies, collection and evaluation of qualitative information and data concerning ESG-related issues and action plans (to be implemented should ESG-related issues arise). 
 
With such major institutional players as a driving force, it is fair to say that Korean PE Managers are under a good deal of pressure to provide ESG investing strategies.  Needless to say, we expect this shift to extend to regular investors in the Korean PEF market.  Accordingly, Korean PE Managers need to aggressively respond to this trend by formulating action plans which include ESG investing principles and policies. 
 
 
The Need to Consider Varying Requirements at Each Investment Phase 
 
In light of the above, the key question comes down to what specific action plans should be applied by Korean PE Managers to respond to this rapid increase in ESG investing.  Although it would largely depend on certain factors such as size, composition and key investment industries, Korean PE Managers generally operate their investments in 4 phases, comprised of: (i) fundraising, (ii) investment, (iii) value-addition and (iv) exit.  It would be prudent to sufficiently consider varying ESG investing requirements at each of the said phases. 
 
First, (i) ESG policies and regulations of Korean PE Managers need to align with the ESG policies and ESG investing philosophies of their investors and (ii) an adequate system is needed to enable investors to compare ESG policies, regulations and ESG investing philosophies in the fundraising phase.  Moreover, more positive responses from investors looking to engage in ESG investing can be expected by Korean PE Managers who successfully put in place an effective risk management system which readily responds to ESG-related changes through the fostering of their own internal specialists and co-ordination with external specialists. 
 
Second, (i) thorough due diligence into a target company is required to identify material ESG-related issues and (ii) active utilization of an ESG criteria checklist to examine and keep track of material ESG-related issues in the investment decision-making process is recommended in the investment phase.  It would also be beneficial to develop tools that can evaluate non-financial aspects (and the corresponding financial values deriving therefrom) of a target company and cultivate basic ESG policies, regulations and processes, including ESG management systems and ESG compliance and (non-compliance) prevention systems.  These tools and systems should then be considered in the investment decision-making process. 
 
Third, Korean PE Managers may need to (i) vigorously engage in ensuring transparent governance, fair human resources management and sustainable ESG-related products and services of a target company and (ii) take necessary measures to report on such matters to investors on a continuous basis.  As regards the relationship with the target company, various systems such as management guidelines and checklists that minimize ESG-related risks and enhance active involvement in the ESG-related issues of the target company may play a significant role in the management of (and value-addition to) the target company.  As regards investor relations, active and pre-emptive communication and ESG disclosures should be endorsed to enable investors to continuously monitor ESG-related risks and changes in material issues concerning potential opportunities. 
 
 
The Need for Pre-emptive ESG Disclosures 
 
For the final exit phase, Korean PE Managers should consider establishing an evaluation measure to properly examine the suitability of the target company through an ESG-factor implementation evaluation.  In addition, institutionalizing a fair and reasonable returns-sharing system based on the returns springing out of ESG investing is also an important measure to be considered. 
 
In many ways, PEFs are the most appropriate ESG investment vehicles, because they participate in, and derive value from, a target company’s management and operations.  Korean PE Managers should thus seize the opportunities presented by the current ESG investment flow to strive for and create positive social values from their investments.

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