By Alex Wise and Jon Deneuville, Castle Hall Diligence

Published: 14 June 2019

Environmental, Social and Governance issues have rapidly become central to the stated priorities of many large Asset Owners around the world, leading the asset management industry to increasingly offer responsible investment strategies to their clients. Today, new ESG, SRI, and Impact funds are being launched weekly, with alternative investment firms now participating in the trend. Though responsible investing is more common in long only, private equity and real assets, AIMA, in its recent ESG Primer, has highlighted how hedge funds are increasingly seeking compatibility with responsible investment strategies – from screening the investment universe to short selling companies due to poor ESG performance.

Given the myriad of ESG strategies and the lack of agreed definitions around ESG criteria, however, investors are acutely aware of the risk of “greenwashing”- when an Asset Manager exaggerates integration of ESG factors into their investment decision making process, or merely offers “green” platitudes without any real substance behind them. Distinguishing virtue signaling from a genuine commitment to sustainable investment has become a new focus in the external manager selection process.

Against this background, investors are transitioning to more detailed “trust but verify” due diligence on the ESG capabilities of Asset Managers in their portfolios or proposed for new allocation.

Castle Hall has observed a bifurcated approach emerging in ESG due diligence. First, as would be expected, investors are reviewing the sustainable investment strategy of an Asset Manager during the investment due diligence process. At Castle Hall, we don’t believe it is enough to simply ask whether the manager has implemented a responsible investment policy or if they are a UN PRI signatory. Though these matters are important and may demonstrate a firm’s opening commitment to ESG, it is merely a starting point. Can the Manager actually evidence the application of their ESG policy and the 6 UN Principles for Responsible Investing throughout their investment approach (at a more basic level, a Manager may say that they update their ESG policy every year – yet the document supplied is dated from early 2017). Key questions posed by Allocators include: Who is responsible for gathering and analyzing ESG data to integrate into risk management and valuation models? What data is obtained? When does the Manager consider ESG during the investment process – at the very beginning, or only at the end as a negative screen? Where does the manager source their data from?

Second, investors are also moving to assess the governance, culture and behaviours of Asset Managers themselves, entirely separate from the ESG characteristics of their investment mandates. For Asset Owners, it is increasingly important to ensure cultural alignment with the Asset Managers to whom they delegate capital. Large pension and sovereign wealth investors have begun to question, for example, whether their beneficiaries would support plan assets being allocated to a manager with little gender diversity and one or more examples of #MeToo allegations. Equally, would plan members (the ultimate asset owner) support buying a product from an asset manager who has failed to adopt policies related to whistleblowing, workplace harassment or provision of same sex benefits?

One immediate example: virtually every large, institutional investor we have spoken to has, over the past year, conducted systematic training around issues such as workplace bullying, unconscious bias, microagressions and mental health. Equally, virtually none of the independent asset managers we have spoken to appear to have implemented formal training programs in these areas, as of yet. This illustrates a clear gap between investor and asset manager priorities.

For hedge funds, relatively modest changes can work towards improving ESG culture.  For example, carbon offsets on flights are relatively cheap and could easily assist towards decreasing environmental footprint.  In the S, or social, area, a policy on sexual orientation discrimination could be beneficial to attract employees that might otherwise feel excluded. The Manager could also conduct a formal gender pay gap survey (this is increasingly required by law in certain countries) to address any disparities in pay within the organization.  From a governance perspective, a documented training policy on HR matters could also be beneficial not only to external perceptions but also to improvements in culture at the firm.  Indeed, we believe Environmental, Social and Governance criteria can be used as a valuable proxy for assessing the culture of a manager.  A large hedge fund we spoke to recently put it this way: many of their staff are highly talented and have a choice of where to work, thus having an employer with strong, positive, culture characteristics is highly important.

In this nascent space, “best practices” are a journey: investor expectations today around ESG issues are likely greater than they were five years ago. Equally, five years from now, Asset Manager practices which are likely “acceptable” today may have been superseded. However, the starting point to due diligence is a baseline understanding of current behaviours across the Asset Managers included within an asset owner’s existing portfolio. With that information, investors can enhance their decision making, helping better align the external manager selection process with the values of the Asset Owner.