At the global level, funds of funds (FOFs) are playing an increasingly important role in environmental, social and corporate governance (“ESG”) by incorporating ESG systems into the risk identification and management systems of their sub-funds. In the field of equity investments, there is a growing demand from USD funds to localize their ESG-related investment systems and from RMB funds to build their own ESG-related investment systems. In this article, we provide our thoughts on some common questions asked by private equity funds (each, a “fund”) to help you understand the necessity of building an ESG-related investment system for funds and other investors engaging in equity investments, and certain key issues related thereto.
These views are not intended as legal advice on specific issues, and some of the thoughts may be controversial. By publishing this article, we hope to stimulate more discussion of ESG-related topics.
I. Why is it necessary to build and implement an ESG-related investment system?
ESG is an important tool in measuring the sustainability of a company. Studies show that companies with higher ESG ratings are more competitive and have a greater potential for returns. This sends positive signals to the market and investors and improves a company’s financing capabilities. It also assists in preventing risks that could reduce the cost of capital, thereby improving the intrinsic value of a company. The control of systemic risks becomes more important in the context of “carbon peaking and carbon neutrality” as well as the improved legislation and stringent governmental regulations in China. The positive correlation between ESG on one hand and the financial performance of the portfolio companies of a fund and the performance of the fund itself on the other hand, is relatively certain in the long run. The establishment and implementation of an ESG-related investment system is a requisite for a fund to fulfill its due diligence obligations in the process of making investments. Therefore it is necessary for both USD and RMB funds to build and implement an ESG-related management system (especially an ESG-related investment system).
II. As a fund, what kind of ESG-related management system do we need to build?
A fund needs to build an ESG-related management system covering the entire process of its operations including fundraising, investing, post-investment management and exit. As to “investing”, we expect investors to make their investment decisions with ESG considerations in mind, build an appropriate model to determine “what is good”, and establish a full set of ESG-related investment systems to screen potential investment targets. Some funds have already established their own ESG-related investment policies and procedures (such as management guidelines, investment SOPs, lists of the permitted or prohibited industries or projects, due diligence questionnaires and score sheets). In relation to the management of its portfolio companies, a fund should strive to be an active (or responsible) investor, cover ESG issues in their corporate governance policies and practices of its portfolio companies, and influence their corporate governance and operations, even if the fund does not hold majority interests in a portfolio company.
III. As a US fund, can we directly adopt our group’s ESG-related investment system for use in China?
No. Limited partners of many USD funds require or expect general partners to have ESG-related investment systems in place, and USD funds therefore have their own ESG-related investment systems. However, the ESG-related systems of US funds and the policies and procedures composing those systems are usually developed based on international standards and laws and the regulatory requirements and conditions of their home countries; therefore they need to be localized in accordance with PRC laws, regulations, policies, regulatory requirements and local characteristics, in order to be used in China. If such localization is not done properly, those ESG-related investment systems will not be able to be implemented correctly nor function properly, and in some cases their effectiveness and function may be reduced.
IV. Can ESG due diligence investigations be conducted by a fund on its own based on the policies and procedures of its ESG-related investment system?
This should be decided on a case-by-case basis. If the ESG-related investment system of a fund is composed of a complete set of policies and procedures, and its team has a deep understanding and rich experience in the identification and management of ESG risks, then we believe the fund can conduct ESG due diligence investigations with respect to its investment projects (other than high-risk projects) by itself based on the policies and procedures of its ESG-related investment system. It is otherwise advisable to engage an ESG attorney or advisor to conduct ESG due diligence investigations with respect to those high-risk projects.
V. How can a fund determine whether the risks of a specific project are high and whether the assistance of an ESG attorney or advisor is needed for a due diligence investigation?
A fund needs to define a high-risk project based on the industry characteristics of its specific project and the size of the investment. Whether a specific project is a high-risk project depends on whether its ESG issues are material. We are of the view that if, among the identified material issues, the high-priority issues are beyond the fund or its investors’ knowledge, then the due diligence investigation should be conducted with the assistance of an ESG attorney or advisor (as well as the involvement of the relevant technical consultants and experts if necessary). In addition, various factors should be taken into consideration in order to determine whether an issue is “material.” Please contact your ESG counsel or advisor if further assistance is needed.
We hope that our responses have answered some of the common questions regarding the ESG-related investment system that a fund/investor might have. We will discuss the importance of the ESG-related investment system for funds and investors from multiple perspectives in subsequent newsletters. We believe that if we can include bespoke ESG investigations in the legal due diligence investigations for M&A transactions and take the findings of the ESG investigations into account when drafting transaction documents, our clients will avoid many investment risks and become “responsible” investors widely recognized by the international community.
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We offer various services to establish or improve the ESG-related investment or management systems of funds and investors, as well as legal and ESG due diligence investigations. Additionally, if you need assistance in deal structuring, the drafting and reviewing of transaction documents in relation to your M&A transactions or investment projects, or you need ESG training or any other ESG-related services, please contact us via email: [email protected]
About JunHe’s EHS Practice and ESG Team: JunHe is among the largest, internationally recognized law firms in China providing a full spectrum of quality legal services, and we have a team of more than 900 professionals. We are a pioneer in the ESG practice area in China and have one of the largest EHS teams in the country, advising clients in the areas of EHS and ESG. With sustainability in mind, JunHe provides EHS compliance reviews for corporations in various sectors either alone or in cooperation with third-party agencies, depending on the particular needs of the client. Our professional legal team provides services including ESG, EHS, labor and employment, intellectual property, trade and data, banking and finance, tax, and compliance. We provide ESG due diligence investigation services for supply chain management and M&A transactions, assist companies and third-party agencies in drafting ESG reports and advise our clients on ESG-related issues arising during their day-to-day operations. We help our clients draft and review ESG-related clauses in contracts with their business partners, help investors and companies build and improve their ESG-related systems, and provide full ESG training and other ESG-related services.
*We appreciate senior translator Mr. Zhenghua Wang’s assistance with this article.
For further information, please contact:
ZHU, He (George) , Partner, JunHe