The silent due diligence metric that may cost you in the long term

Kenny NG & Derrick LIU

Most investment decisions made by fund managers and corporate investors have been primarily focused on a traditional set of frameworks involving competitor analysis, market assessment, tax, legal and financial returns. Jamie Coombs who leads market development efforts for Refinitiv’s investing and advisory business, talks to three investors at the annual Shanghai Summit of the Asia Investment Conference on how they are going beyond the checklists to integrate responsible and sustainable practices in their portfolios.

Since its founding in 2006, the United Nations-supported Principles for Responsible Investment (UNPRI) – a global network of organizations committed to responsible investing – has grown from a 100 member network to over 2,300. While the significant growth over the past 13 years underscores increasing ESG disclosures by investors and companies, it also indicates how ESG has become more mainstream, especially over the past few years as more responsibly.

Beyond just doing good.

According to Paul Milon from BNP Paribas Asset Management, one of the founding signatories of the UNPRI, ESG is still a relatively “new topic” in the broader Asia region and it was only within the last two years that there had been an increasing trend of companies establishing frameworks and disclosures for responsible investing. The trend is very different from Europe where regulation and disclosures in relation to ESG are relatively mature and in some cases even mandatory.

“If you look back in 2012, in Asia, there were only 30 signatories to the UNPRI. Right now we are looking at 194. And in China, Ping An signed the PRI back in August, becoming the first asset owner signatory in China.”

From an ecosystem perspective, there are three important cornerstones for driving this:

• Regulation, which mandates companies disclose and ensure that their investments and operations are compliant with the principles of ESG

• (ii) Investors proactively asking questions relating to responsible practices during the evaluation and due diligence process

• (iii) Companies taking the initiative towards ESG disclosure and compliance

These factors working together create a cycle in which one drives the others. And if the ecosystem relies purely on regulation to drive disclosure, then ESG becomes an additional burden for reporting.

Sabita Prakash, Managing Director APAC at ADM Capital, a Hong Kong based investment manager which also operates a foundation dedicated to looking at ESG investments, said that a “triple bottom line” approach focusing on people, planet and profit is one way to go, but investors can also apply ESG using a purely commercial mindset with the longer term in mind.

“You can look at profitability alone, it could also suffice, as long as you look at profitability in the long term.”

The focus on near-term profitability as part of the race to build up infrastructure quickly over the last decide could explain why Asia might be lagging behind in terms of adhering to ESG practices. Rather than going in with a “tree-hugging, do-good” approach, Sabita believes it is equally important to motivate the companies by highlighting the potential risks and costs of not adhering to ESG principles.

“Not following certain practices represents huge risks to their bottom line in the long term – whether it’s food security, data security or even climate related changes to the buildings that they build – in each of every sector, we can identify the risks associated by not adhering to ESG principles.”

But Asia is not lagging behind.

According to a global ESG report by Capital Dynamics (CapDyn), a USD 16+ billion global private asset manager, the number of managers in Asia who incorporate ESG practices in their due diligence processes are comparable to those in the US, which go against the general consensus that responsible investing in Asia is lagging behind.

“About 3 years ago, about two thirds of Asia respondents were saying that they had an ESG investment policy in place, the number has increased to three quarters today, which represents a substantial increase over three years.”

Manjia Guan, Director of Primaries at CapDyn said that the firm also adopts different scoring systems for primary and secondary fund investments. For primary investments, the lead time for GP evaluation and due diligence tends to be relatively longer, allowing them to communicate their ESG expectations to GPs so that they can be better prepared. For secondaries deals, very often the process is time sensitive and in order to overcome this, CapDyn employs a simplified and adapted version of the scoring system.

According to Manjia, there are also some unique features in CapDyn’s scoring systems for newer fund managers, which allows GPs to adopt a more progressive implementation and monitoring of ESG practices, both before and after investment. Value creation is also analyzed through constant communication with GPs in terms of the latest ESG trends and alerts, collecting other indirect metrics such as job creation as well as the observations on the long-term sustainability of the industry that the business is operating in.

In fact, ESG practices have become so mainstream that many fund managers are including these clauses in their fund documentation.

“We also try to include ESG into the documentation process as well. Most of these are still done through provisions in side letters although we are also seeing more fund managers being open to adding these in their PPM or LPA.”

The challenge of data: quantifying ESG to justify better returns

Without understanding how ESG drives value, it can be challenging for managers to incorporate them into their portfolio. With more corporate disclosures and data being readily available, managing the big data of ESG becomes increasingly important.

Paul believes that at the end of the day, it is about integrating the wealth of information into the decision-making process to generate better risk-adjusted returns. A lot of ESG data today tends to be policies and disclosure metrics rather than “performance” type metrics, and in order to use that more effectively, BNP Paribas Asset Management applies only the most material data based on different internal scoring systems across different industries. In the case of equities, this could mean using frameworks from the Sustainability Accounting Standards Board to determine how and which ESG metrics could potentially impact a company’s valuation.

Instead of approaching ESG from a returns-driven perspective, one of the alternative ways of quantifying this would be to estimate the costs of non-compliance. From a private credit standpoint, Sabita said that neglecting responsible investing could have a much more severe and tangible impact.

“Not factoring in ESG could mean the loss of principal or income on our investments.”

In addition to using the traditional credit analysis frameworks and leveraging the firm’s impact investing foundation, ADM Capital has recently started to engage external ESG specialized consultants to as part of the due diligence process before making any investments. The firm has also started to actively measure the level of impact these portfolio companies have on the environment as compared to previously just mitigating the potential risks.

One thing for sure is: amidst the shifting dynamics of energy sources, pervasiveness of technology and globalization of value chains, responsible and sustainable investing will become the norm. The costs can be high if these are managed poorly, as funds and companies who lack the necessary ESG frameworks in place, may eventually be punished by investors.

This article is compiled from the panel “Hard Truths and Honest Conversations: Leading the Charge Towards Real Impact” at the 2019 Shanghai Summit of the Asia Investment Conference