Managing complexity during growth

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No question, the private equity sector is still booming, with a number of factors driving that growth. With traditional investment options often disappointing in terms of return, investors turn more to PE than ever before – here, we are thinking among other family offices, pension plans and insurance companies. At the same time, we see more niche coming up, be that payment technology (fuelled by the pandemic), healthcare tech (driven by an aging population), etc.

“Private equity has been growing strongly in the past two decades, and this is a trend that isn’t stopping, particularly given the strong appetite for investment in ICT and healthcare,” said Katia Gauzès, Corporate partner at Clifford Chance. “Funds are growing in size fast, as is the desire to invest in a more diverse range of assets, such as debt, infrastructure and real estate,” she added.

Funds are growing in size fast, as is the desire to invest in a more diverse range of assets.
Katia Gauzès

Katia Gauzès,  Corporate Partner,  Clifford Chance

Diversity and compliance

It’s challenging for funds to incorporate increasing diversity while remaining compliant with the ever more varied national and European regulatory frameworks. “Increasingly, market players must have deep specialisation to deal with this growing complexity,” added Kristof Meynaerts, Investment Funds Partner at Clifford Chance.

An example of this range of complex client demands has been the growth of interest in using special-purpose acquisition companies (SPACs) as part of the private equity toolbox. These are publicly traded companies created for the purpose of acquiring or merging with an existing company. “These are technically sophisticated, legally complex vehicles,” noted Katia Gauzès. “When working cross-border, this requires working with legal teams and regulators in different jurisdictions and this is where Luxembourg makes the difference with its highly specialised workforce,” she added.

However, these vehicles remain a niche activity globally and in the Grand Duchy, but that Luxembourg has been able to adjust to this trend points to the versatility of its fund servicing ecosystem. “It’s also a symptom of the large amount of dry powder that private equity houses need to deploy and for which they are seeking new avenues,” she added.

Going green fast

Flexibility and openness have also been required to manage the boom in green investing. “More than the desire to be minimally compliant with basic ESG benchmarks, we see increasing numbers of private equity impact funds featuring projects that are working actively to achieve environmental gains,” said Meynaerts. In just a few years, green credentials have gone from a “nice-to-have” to being central to efforts to market funds.

Proof of this commitment is how investors see that there might be a price to pay in financial terms. “Clients have been telling us that ESG compliance is so important that they understand how investors are willing to make compromises with slightly lower returns,” he said. This pressure operates both in terms of private equity houses’ internal operations and what they expect from target companies. “You see this in the checklists, the investment committee memos – where once it might have been just mentioned briefly, this documentation now runs to multiple pages detailing processes and operations.”

ESG after transactions

Trends such as the burgeoning private equity secondary market and rolling investments over must also put ESG at the heart of considerations. Most PE funds tend to be closed ended which restricts the ability of investors to exit before the fund comes to maturity. Increasingly structures are being created to allow investors to sell their stake in funds on the secondary market. Conversely, sponsors might wish to remain invested in certain companies even after the maturity date, and a growing trend sees these assets rolled over into new funds.

Yet what of the ESG implications of these transactions, when legacy investments are transferred to new portfolios? Probably these companies will not have undergone the green compliance process that more recent enterprises have undertaken. “It can become complicated to ensure full compliance with new green investing norms, ensuring that the due diligence and paperwork is completed,” said Meynaerts.

It can become complicated to ensure full compliance with new green investing norms, ensuring that the due diligence and paperwork is completed.
Kristof  Meynaerts

Kristof  Meynaerts,  Investment Funds  Partner,  Clifford Chance

Controlled sustainability risk

Yet with this enthusiasm comes the concern that systems and data may not be sufficiently in place to avoid issues around greenwashing if ESG promises are not met over the long term. These concerns are particular acute as the sustainable finance declaration regulation requires funds to be explicit about their green investing strategy.

“It feels under control,” Meynaerts says. “The latest guidance and ESG taxonomy have been very helpful. Although the deadlines were short, we worked with clients to advise them on what they should expect and to adjust their positions accordingly.”

If in doubt, the advice in the private equity space has been first to be initially rather conservative, then explain this ESG declaration to investors, and finally work towards greening the portfolio over the medium term.

“It’s better to undersell and over deliver, going greener later,” he said. “Many clients are aware of the challenges and they are happy to cooperate.”