ESG & Sustainability Insights

ESG in practice: The operational impact of embracing change

5 minute read time

Alternative asset managers are facing up to a plethora of operational changes and new demands.

 
  • For fund managers, the rising focus on ESG is forcing new approaches and creating extra work throughout the investment process
  • Asset managers may have to recruit or train up specialist teams in order to implement the EU’s new Sustainable Finance Disclosure Regulation (SFDR)
  • Asset managers are also likely to be burdened by the flow of information required to assess whether the performance of their underlying assets matches their regulatory obligations
  • There is a growing emphasis on the social and governance parts of the ESG equation, which go beyond traditional metrics such as carbon emissions

The coronavirus pandemic has sent tremors through the alternative assets sector by jolting the global economy. But its long-term impact on the fund management industry is being augmented by another massive change.

“The pandemic has been getting a lot of the headlines, but it’s actually the rising focus on ESG (environmental, social and governance issues) in investing that is causing the really seismic changes to the way fund managers operate,” says Sharyn Jaques, Sustainability Lead for Institutional Banking at RBS International.

“ESG is forcing new approaches and extra workloads at almost every stage of the investment process, and fund managers of all sizes are still working out how to adjust, because these are changes that are just not going to go away.”

Differing levels of impact

The operational response to the growing demand from investors, regulators and governments for more attention and information on ESG factors varies between funds of different sizes and asset classes, ranging from private equity to real estate funds.

While private equity funds are able to gather detailed information from the firms they invest in, and real estate funds have the benefit of holding a common asset class, other asset managers – such as a private equity fund of funds, a hedge fund or a private debt firm – can have a much harder time collecting relevant data and influencing the ESG performance of assets they invest in, Jaques says.

Almost every department of asset management firms is grappling with those changes, from marketing and investor relations to the legal, risk management and tech teams.

The pain points for asset managers can begin with the initial screening of investment targets and the signing up of investors who have their own growing ESG demands and often insist on negotiating their own detailed terms on compliance and transparency, Jaques says.

“Many funds are doing a lot of what I would call initial due diligence, like a private equity company doing negative screening when they’re initially looking at purchasing portfolio companies, and that gives them quite an opportunity to have an impact on day one,” she says.

“But you have to continue to push and drive change to influence management of that portfolio company, so you need to design, collect and make sense of a lot data about their ESG performance, and then act on that data to help shape your investment strategies and responsibilities.

“At the same time, you have to communicate with investors and keep them constantly informed about ESG performance, and an awful lot of work also goes into keeping up with and responding to regulatory changes.”

Resourcing to meet demand

Thomas Gidman from the ESG Advisory team at NatWest says the EU’s latest ESG rule, the Sustainable Finance Disclosure Regulation (SFDR), which came into effect on 10 March, “is a big change, and, when we speak to clients, it’s something that’s clearly high on their agenda.

“When you add it all up, there’s certainly a shift to a lot more work that needs to be done and that can be particularly challenging for small and mid-sized firms,” he says.

“Even though many asset managers prefer to run relatively lean operations, there will likely be resourcing considerations with respect to the regulation, whether that means setting up specialist in-house expertise or training up everyone to make it part of their new ‘business as usual’.”

“Corporates are already struggling with questionnaire fatigue and I think it’s only going to get worse unless there’s some standardisation”

Varun Sarda, Head of ESG Advisory, NatWest

Nathan Holland, a Director in Loan Markets at NatWest, says it’s hard to identify any alternative asset managers that can avoid major operational changes.

“Real estate, for instance, is one of the more advanced sectors when it comes to thinking about ESG because they are dealing with a relatively common asset class and many companies in the sector have been working for a while now with various sustainability ratings and scoring systems for those assets,” he says.

But even the most experienced real estate funds are hampered by the fact that their tenants have a major role in controlling and reporting emissions, he says, and there is a growing emphasis on the social and governance parts of the ESG equation, which go beyond traditional metrics such as carbon emissions.

Measuring success

Varun Sarda, Head of ESG Advisory at NatWest, has considerable experience of helping firms to set up ESG frameworks and report on key performance indicators. He believes that a fundamental challenge for asset managers is the massive flow of information that will be needed to help make the sustainability profile of their funds more comparable and easy to understand for investors. This will need to assess whether the performance of their underlying assets matches their growing regulatory obligations.

“The EU is largely setting the pace in this area; the SFDR regulation will place much more emphasis on entity-level and product-level disclosures, including product website and periodic product report disclosures in line with the technical standards,” Sarda says. “But how do you actually go about trying to identify the adverse impacts of products? Even with the help of mandatory and voluntary indicators that have been supplied, asset managers will have to navigate through a multitude of business activities with a plethora of ESG data points, so there will need to be some discipline applied to selecting the most material and representative impact metrics around them.

“And let’s not forget these regulations are designed to embed sustainability into decision-making and not simply check boxes, so asset managers are going to need to get better at assimilating the quantity and quality of ESG data that is available.”

Asset managers will inevitably need to seek more data from the companies in which they are invested to ascertain actual impacts; but, warns Varun, unless that information becomes more standardised, a crunch is looming because so many parties are already demanding different forms of ESG information from companies.

“Corporates are already struggling with questionnaire fatigue and I think it’s only going to get worse unless there’s some standardisation,” he says.

“A lot of these companies are getting bombarded with questions. They have to respond to investor and ratings questionnaires with different nuances, and they have to deal with their own stakeholders, civil society, regulators and benchmarks that all have their own surveys.”

Embedding ESG in the everyday

One of the most basic and urgent operational decisions for fund managers is the extent to which they try to delegate such challenges to specialist staff or embed ESG issues in the work of all their professionals. 

“The ideal solution is that ESG should not be a dedicated role per se; it should be part of everyone’s business,” says Sarda. “But many funds, especially smaller operations, are still at the stage where they are going to need a dedicated person or team to think about these questions.

“Some funds are turning to independent consultants to help them embed and integrate ESG because they realise that it’s impossible to ignore it or treat it as a side issue. We’re now at that stage where everyone in the industry is having to think about what ESG means for their own roles.”

By Peter Wilson