ESG investing for family offices: due diligence over external managers

More and more family offices are integrating environmental, social and governance (ESG) concerns into their investment strategy, whether that be through direct investments in businesses with sustainable business models, screening of listed equities, or through investing in externally managed funds with ESG mandates, amongst other strategies.

Due diligence is a routine part of the investment life cycle, and it is important that this includes integrated due diligence over the “E”, “S” and “G” outcomes that are defined within the family office’s ESG investment strategy. However, for externally managed investments specifically, it is crucial that the right questions are considered at the due diligence stage to not only determine whether the fund manager shares the same financial return objectives, but whether they are compatible with the family office investment strategy from an ESG perspective. If the manager’s sustainability objectives are not understood from the start, monitoring ESG performance becomes an impossible task. After all, if a family office has ESG in its investment strategy this should be integrated into the entire investment process, including monitoring through to disposal.

But in practice, what are the key questions that should be asked around ESG prior to investment in externally managed assets? And what are the warning signs of potential greenwashing or incompatibility with the investment strategy?

A coherent investment philosophy

Firstly, the family office should consider how the manager describes their sustainability objective in simple terms. A clear understanding of their approach to ESG investing is the first step in determining whether it aligns to that of the family office. Have they used complicated terminology and jargon to refer to their ESG goals, or included cautions and conditions in their description? It is important that the manager’s approach to ESG investing is clearly defined, consistently applied across their portfolio and that it contains a high level of intentionality, i.e. it is embedded in their investment philosophy as opposed to being a reactive side effect.

Evidence of engagement

Secondly, how do they practice shareholder engagement? The divestment versus engagement debate is an important one with robust arguments from both sides, both from a financial return (e.g. stranded asset risk) and environmental ethics perspective. However, there is no denying that divestment is easier to evidence. If the manager chooses an engagement strategy when investing in oil and gas, for example, how do they engage with the businesses that they invest in from a sustainability perspective, and is there evidence of transition as a result of their actions? Does the asset manager have an engagement policy or publish its voting track record, and if not, why not? The family office prospective investor should understand the answer to these questions in order to decide whether to invest as well as to be able to effectively monitor progress against their ESG targets.

Effective performance monitoring

Thirdly, it is crucial to understand how the manager itself monitors and evaluates compliance with its prescribed ESG investing approach. Interpreting information provided by external managers in the due diligence process is often difficult if there is an insufficient level of verifiability and comparability in the information provided. For example, what does the output of their ESG performance data look like and how do they present this to investors? Have they signed up to the Principles for Responsible Investment and included these in an assessment report? Equally, how do they themselves get comfort over the validity of data reported by the investments they hold? External assurance over both processes in place as well as metrics reported is a solution which can provide confidence over the reliability of reported information, helping to address the problem of greenwashing and identify the difference between true ESG principles and shallow marketing.

The ’G’ in ‘ESG’

Finally, what does governance, a key component of ESG, look like at the external manager? The questions posed throughout this blog are rooted in the governance practices both within the external manager and its investee companies and a lack of tone from the top can be a red flag for investors. For example, have they signed up to the UK Stewardship Code 2020 or any other ESG organisations? What is the process for investment decision-making and is there a dedicated ESG committee in place? Due diligence over sustainability practices should include analysis over the funds, the managers and the firm itself. It is arguably as important for the family office to have sufficient oversight over the external managers used, as for the manager to have oversight over its underlying investments.

Red flags

In summary, family offices should be vigilant in respect of the following red flags when performing due diligence over external managers:

• Complicated jargon used in communicating ESG goals without numerical quantification;
• Claims of engagement without evidence of the impact or not publishing a voting track record;
• ESG performance data is not verified or reported by the manager; and
• A lack of tone from the top and evidence of commitment to governance within the manager.

Through adopting this approach to ESG investment due diligence, the family office will be moving in the right direction towards being aligned with best practice throughout the investment cycle and avoiding potentially costly mistakes or contradiction with their investment philosophy.

For further reading on the emergence of greenwashing, refer to this Deloitte blog on the topic.