A changing LP mindset: no more silent partner

Many limited partners (LPs) have changed their approach for their investments over the past 18 months. No longer satisfied with being passive investors, awaiting their returns in the background, they are demanding greater transparency from their general partner (GP) relationship and an increasing say in how underlying investments are managed.

Surging demand for ESG and DEI metrics

LPs are holding GPs accountable, not only for their financial performance but also for their adherence to non-financial criteria. Ensuring that their partners meet environmental, social and governance (ESG) and diversity, equity and inclusion (DEI) metrics, in particular, has moved up the agenda which, in turn, is influencing GPs’ deal-making priorities.

And far from accepting a tick-box approach to ESG and DEI initiatives, LPs want to be sure that they are investing in private equity firms and underlying portfolio companies that are integrating these principles into their corporate strategy. ESG is not just a ‘nice to have’ anymore, confirms research by Bain & Co, it is becoming a critical element in gaining market share, engaging employees and raising capital as pressure mounts from both LPs and the general public.

The Covid crisis has accelerated the pace of change. A Bain survey of more than 12,000 consumers in the US and EU showed that 44% agree or strongly agree that sustainability will be considered even more important in the wake of the global pandemic. This sentiment is reflected in the private equity market with 94% of respondents to BDO’s recent survey agreeing it was important to their LPs to incorporate ESG into investment criteria.

DEI has gained similar ground, with consensus swiftly building on the need for greater engagement. The Institutional Limited Partners Association (ILPA) Diversity in Action initiative, for example, was launched at the end of 2020 to bring together LPs and GPs who share a commitment to advancing DEI in the private equity industry. Signatories – which have grown from 46 at inception to 133 as of April this year – commit to undertaking specific DEI actions spanning talent management, investment management and industry engagement.

Non-financial criteria are differentiators

As well as becoming more purposeful in identifying and tracking these metrics, LPs allocate more weight to them in shaping their investment decisions. When ranking in order of importance, BDO’s research found that LPs place having more ESG investment options (19%) only slightly behind realising investment gains (20%) and co-investment opportunities (19.5%).

LPs see effective ESG and DEI strategies as self-sustaining. They indicate a ‘quality’ business that is creating long-term sustainable value from investing in human capital and generating energy efficiencies while avoiding the potential financial and reputational risks that might befall companies without cohesive strategies. These benefits, in turn, can allow increased access to low-cost capital or fundraising opportunities.

Private equity firms leading the charge are building ESG and DEI investing into a differentiating capability that can provide the edge in a market that has never been more competitive.

Europe leads the way

LPs in Europe are ahead of the curve in their adoption of non-financial data. According to Bain & Co, 80% of the top 20 EU-based institutional investors have committed to either the Principles for Responsible Investment (PRI), the UN’s Net-Zero Asset Owner Alliance or the Task Force on Climate-related Financial Disclosures. In contrast, less than half of the top 20 North American institutions have done so (see chart below).

Tightening regulations in the EU are one of the main drivers of increased adoption among European firms. The EU Taxonomy, which aims to encourage investment flows into sustainable assets by providing a framework for measurement, will take effect in December 2021. From that date, asset managers in the EU will need to disclose their share of taxonomy-aligned assets under management. Raising that share will inevitably be a differentiator going forward.

Although currently behind, the US looks set to follow the same path, with the Securities Exchange Commission announcing in March that it was working towards ‘a comprehensive ESG disclosure framework aimed at producing the consistent, comparable, and reliable data that investors need’.

Digitising the investment process

As LPs become more keenly focused on all aspects of these value creation differentiators, the need for quantifiable measurement has grown. Many firms are investigating how they can leverage digital tools to assess a combination of traditional and non-traditional data in the investment process. The largest GPs have already taken the lead, with take-up particularly strong in the real estate sector where investors have access to larger, more accurate data sets.

Platforms like Dealsuite make it easy to collate and analyse all relevant metrics, including ESG and DEI, drilling down to those that are relevant to your industry or specific deal.

“LPs expect GPs to be well-informed and make decisions based on a full overview of the market,” says Dealsuite’s CEO Floyd Plettenberg. “Those that can differentiate themselves early in the process by using accurate, targeted data will remain ahead of the pack.”