Engagement by limited partners in private markets
Effective engagement has long been seen as a key component of any asset manager’s fiduciary duty, representing one of the two key pillars (along with voting) of stewardship or active ownership, as defined by the UN Principles for Responsible Investment (PRI) and consequently adopted by LPs and GPs alike. And while stewardship in ‘traditional’ asset classes, such as public equity markets, can often be relatively easily monitored and effectiveness quantified, an (until recently) under-publicized topic is engagement by Limited Partners (LPs) with General Partners (GPs) in private markets.
Effective engagement has long been seen as a key component of any asset manager’s fiduciary duty, representing one of the two key pillars (along with voting) of stewardship or active ownership, as defined by the UN Principles for Responsible Investment (PRI) and consequently adopted by LPs and GPs alike. And while stewardship in ‘traditional’ asset classes, such as public equity markets, can often be relatively easily monitored and effectiveness quantified, an (until recently) under-publicized topic is engagement by Limited Partners (LPs) with General Partners (GPs) in private markets.
LPs can (and do) define engagement differently, but the term is widely understood to encompass some form of two-way dialogue with GPs, with the aim of exchanging information, improving understanding and driving specific actions or outcomes. The ultimate goal of this engagement is to enhance an investment’s financial and non-financial performance, clearly benefiting all parties involved.
Although engagement is a long-standing practice and was never restricted to sustainability issues (such as net-zero targets, exposure to physical climate risks or health and safety track record), it has recently come under the spotlight as to how effective it can be in enhancing sustainability performance and delivering tangible non-financial outcomes, at the same time as improving the financial risk-adjusted returns and maximizing long-term value.
Despite private market LPs often holding a reasonable amount of influence over their underlying GPs, engagement (on sustainability topics but also more broadly) in these alternative asset classes is made more challenging by a lack of direct control and (sometimes) visibility over underlying investments (portfolio companies, real estate assets, etc.).
Additionally, the nature of underlying investments can vary greatly across private market portfolios, ranging from multi-family housing to software companies, from bridges to ferry operators. Market practices on sustainability-related engagement can also differ by LP size (for example depending on number of employees or assets under management in that LP), location and geographic focus of investments, and very often the LP’s wider environment alongside other general market conditions. Engaging with a GP on setting a net-zero target when faced with the prospect of jeopardized investment returns is a far more challenging exercise than the same exercise in a less volatile and return-steady market.
Client expectations are also evolving, with growing demands for improved sustainability practices and results; this is driven by a number of factors such as pressure for greater investment returns (and the belief of many that sustainability is linked to risk-adjusted financial returns) and fast-evolving disclosure regulations (e.g. demanding evidence of discussions with investee companies, monitoring and following up on discussed action points, etc.). These factors and pressures all add to the complexity of delivering and carrying out an effective engagement program in alternative asset classes for LPs and their GPs, but have also accelerated progress and improvement across the market too.
Effective engagement
Although practices differ, common success factors to carrying out effective engagement by LPs, based on our own experience and observations, include:
- Highlight the importance of sustainability: Effective LPs signal and communicate the importance of sustainability topics to their GPs throughout the investment lifecycle including due diligence, ownership, and during exit. GPs tend to prioritize sustainability (and implementing suggested initiatives) if LPs repeatedly communicate the importance of, and engage with them on, sustainability issues.
- Dialogue, not monologue: Successful LPs avoid ‘lecturing’ GPs on sustainability matters and practices, and instead understand how and why GPs’ sustainability targets and practices have been developed and implemented, before offering suggestions for improvement. Sustainability improvements in infrastructure assets in Japan may look very different from those carried out in Canada – GPs know this and may offer innovative solutions to the complex challenges unique to their asset portfolio providing LPs with an opportunity to learn as well as lobby.
- Prioritize topics of engagement: Engagement is most effective when it is performed periodically (frequency of engagement depends on a multitude of factors) and addresses key areas deemed material. Engaging with a port operator to improve its health and safety profile is probably more material (to both GP and LP) than engaging on their cybersecurity practices, for example.
- Build networks: Collaboration with industry bodies and associations, as well as peers, has often led to benefits including innovative solutions and approaches to problems common to other LPs. As an example, the GRESB Real Estate Assessment evolved to also cover the infrastructure sector, and has since been a useful tool for infrastructure GPs and LPs alike as demonstrated by increased manager participation over recent years.
- Acknowledge positive action: Successful sustainability practices and outcomes generated by GPs are recognized by forward-looking LPs in order to ensure continued efforts and prioritization of sustainability topics.
Sustainability is becoming an increasingly important topic for investors, regulators and other stakeholders. Implementing an effective engagement program to deliver value, including but also beyond sustainability, is therefore a key area not to be overlooked in favor of other (perhaps less-complex) initiatives.