Guidance and tools to identify key ESG risks and opportunities at the first stage of the investment cycle.
Click on the chevrons below to go through each of the stages in the investment cycle.
Objectives and benefits of early coverage of ESG
An overview of the activities included in the screening and categorisation ('screening') stage is shown by the graphic below.
2.1 Ensure compliance with lists of excluded/prohibited activities (‘Exclusion Lists’)
LPs such as CDC and other development finance institutions (DFIs) may require a fund not to invest in certain sectors or activities. Fund managers must ensure all the investments comply with any applicable lists of excluded/prohibited activities (‘Exclusion Lists’). If fund managers are unsure whether a potential investment complies with a fund’s Exclusion List, they should contact the LPs for advice.
2.2 Ensure compliance with key governance and business integrity requirements
Business integrity (BI) considerations are critical at this stage. The sector, location, sponsors or company may indicate challenging governance and business integrity issues, which could significantly impact the DD process (or even breach the fund’s policies and LP’s requirements). These should be highlighted early, as they may be considered ‘red flags’ or may require additional scrutiny during screening and/or DD.
2.3 Identify key ESG risks, impacts and opportunities
Fund managers must identify the key ESG aspects of an investment, taking into account the company’s particular characteristics including scale, location, sector, sponsors and supply chain. Screening is typically a desk-based exercise.
CDC Sector Profiles highlight typical ESG impacts, risks and opportunities associated with different sectors. They provide a starting point for fund managers assessing ESG aspects. Fund managers may also find CDC’s E&S Briefing Notes, Governance and Business Integrity (G&BI) section and CDC Environmental and Social Checklist and CDC Governance and Business Integrity Checklist helpful.
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Information and resources feed into the screening process
Screening is generally a desk-based exercise. Six types of information and resources may be useful in the screening process of a company: (i) a fund’s ESG Policy and Exclusion List; (ii) ESG guidelines and standards; (iii) publicly available information about the company; (iv) the fund manager’s/LP’s experience; (v) early discussions with the company; and (vi) informal referencing on the company and its promoters.
Using questionnaires at the screening and categorization stage
Using standard high-level ESG questionnaires can be useful at this stage. ESG questions may also be suggested by deal fundamentals (e.g. overall value proposition, a company’s strategy and business plan, use of proceeds from the fund’s equity investment, and presence of other investors).
Identifying applicable standards
Identifying key ESG factors also helps to establish the main ESG standards that are likely to apply to the investment. In addition to national ESG laws and requirements, the Fund’s Investment Policy and Environmental and Social Management System (ESMS) may also require adherence to IFC Performance Standards and/or other international standards (particularly when DFIs are LPs). If so, the fund manager should determine which are likely to be applicable to the company being considered for investment.
2.4 Build a common understanding
A key aim of early conversations with management is to build a common understanding of the main ESG factors to be managed and to assess whether a company is willing and able to address them. Therefore, fund managers are encouraged to present the business case to companies they are considering investing in.
Benefits of building a common understanding at screening
Building a common understanding early on how to manage ESG factors that may have an impact on the investment significantly contributes to achieving successful outcomes. Early discussions on key ESG aspects typically expedite the investment DD and legal negotiations. It can be helpful if the Investment Officer responsible for the deal starts the conversation around main ESG requirements at screening in order to make it clear that these are relevant. The inclusion of Environmental & Social (E&S) and governance and business integrity (G&BI) requirements in the Term Sheet may be a good way to engage with a company and start the conversation.
In order to assess a company’s willingness and ability to address ESG aspects, it is advisable to start a commitment, capacity and track record (CCTR) analysis at this stage and complete the CCTR at DD. Limited commitment to engage on ESG factors is often harder to address than limited capacity.
Presenting the ESG business case to companies
ESG factors can have significant positive and negative impacts on companies and investments. However, the management teams of some companies may not fully see the benefit of employing robust ESG practices. Therefore, fund managers are encouraged to present the business case to companies. It can be helpful to map the business case onto a table similar to the one shown below to structure the discussion and prioritise which ESG factors to address early on, as well as to highlight potential opportunities.
Further guidance on how to make and present the ESG business case to companies
Management resistance typically stems from:
Good ways to address this resistance are to:
2.5 Categorise an investment’s inherent E&S risks and impacts
Once the main potential E&S risks and adverse impacts ('impacts') have been identified, the proposed investment should be assigned an inherent E&S risk/impact category (e.g. 'Low', 'Medium' or 'High') in accordance with the fund manager’s ESMS. This categorisation may be revised later in the process as more information becomes available. At this stage, it is advisable to be cautious and if the category is unclear, assign a higher category rather than a lower one so as not to underestimate the time and resources that may be needed for DD.
Benefits of assigning an inherent E&S risk/impact category
Assigning an inherent E&S risk/impact category (‘E&S category’):
How to use the E&S categorisation system
There is no single correct way to assign E&S categories. Regardless of the E&S category, it is critical to properly identify and manage the risks and maximise the opportunities. Companies assigned to the ‘low risk/impact’ category will still require DD covering relevant aspects (e.g. labour rights, business integrity), commensurate with the level of risks and impacts to which they are exposed.
Moreover, the categorisation systems used by a large number of investors, do not always take into account some key E&S factors that could have a significant impact on an investment (e.g. management CCTR or liabilities associated with soil contamination).
The categorisation system presented in this toolkit only takes into account the potential risk and impacts of an investment, as well as mitigation measures that form part of the companies’ assets (e.g. wastewater treatment systems). The system does not take into account the ability of the company to address its ESG risks and impact (e.g. qualifications of the E&S team). Fund managers should always consider factors that are not included in the categorisation system, but that could significantly impact the investment.
Where the fund’s LPs include DFIs such as CDC, categorisation may also be important in the context of the limited partnership agreement and/or applicable side letters. For example, some DFIs may require notification or prior consultation before the fund invests in companies with high E&S risk/potential impacts. E&S standards that DFIs expect companies to meet may also depend on the E&S category.
Key factors that can inform the E&S categorisation
Proposed categorisation system
There is no single correct way to assign E&S categories. A typical E&S categorisation method for emerging market private equity funds is shown below.The system proposes categorising the deals as investments with ‘Low’, ‘Medium’ (may be split into ‘Medium-High’ and ‘Medium-Low’) or ‘High’ inherent risks/potential impacts.
2.6 Define the scope of and plan the ESG due diligence
One of the key outputs of the screening and categorisation phase is an understanding of the key ESG factors to be assessed at DD, as well as of the resources required to conduct adequate DD.
Main elements of typical DD that should be considered at screening include:
As indicated previously, some of the element above may be partially covered at screening.
Key outputs of the screening stage: