Private equity (PE) firms are being held to much higher fiduciary standards than ever before. Long gone are the days where PE fund sponsors could downplay their contractual obligation to limited partner investors to the sole objective of maximizing returns. In the past decade, there has been a significant cultural shift through which PE firms are now expected to serve a greater social purpose and deliver a positive contribution to society while also maximizing financial returns.
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It has taken some time for PE firms to catch up with the environmental, social and governance (ESG) policies and procedures expected of them today, according to Mark Reilly, SVP and head of Ironshore’s financial institutions group. He commented: “Ten years ago, a PE Sponsor’s primary focus was maximizing investment returns, with very few questioning their methods or impact. Today, they are held accountable for the due diligence and acceptance of limited partners, where and with whom they invest, and how they manage that capital to realization.”
“PE firms are now being held to a much higher standard, and if they fail to meet that standard, there are risks ranging from reputational to legal and regulatory that can go far beyond a surface wound. For example, if a large public pension plan or an endowment takes a stance on a social or environmental issue, only to find that their PE fund sponsor is making investments that contradict this position, that pension fund could take action ranging from pulling their capital commitment to bringing a suit alleging a misrepresentation of investment strategy.”
A prime example of a PE firm taking a strong stance on ESG issues is global investment management corporation BlackRock. In January 2020, BlackRock CEO Larry Fink announced via his annual letter that environmental sustainability will now be a cornerstone of its investment approach moving forward. He wrote: “Our investment conviction is that sustainability- and climate-integrated portfolios can provide better risk-adjusted returns to investors. And with the impact of sustainability on investment returns increasing, we believe that sustainable investing is the strongest foundation for client portfolios going forward.”
It’s not just ESG issues that PE firms are obliged to tackle as fiduciaries today. They’re also under pressure, like many of their counterparts in financial services, to improve diversity and inclusion (D&I) within their organizations and in the industry as a whole. Reilly noted: “D&I is a huge issue at the PE fund level. While these firms and funds have made strides in the area of diversity and inclusion, most acknowledge they have a long way to go. We’ve had a lot of discussions with PE firms about their plans and ideas for addressing those issues. It’s a very real and current challenge in the PE space.
It’s more important than ever for risk managers at PE firms to consider issues like ESG and D&I when preparing their overall risk strategy. Any promises, disclosures or commitments they make, whether it’s to their employees and investors, or to the minority shareholders, employees and constituents at the portfolio company level, they will be held accountable for. Any slip up could result in a claim, whether it’s a limited partnership (LP) liability claim or a breach of fiduciary duty suit, both of which are undesirable in a hardening insurance market where the general partnership liability lines (directors & officers, errors & omissions, and employment practices liability for the fund sponsors) have all become quite challenging.
“From the general partnership liability perspective, the frequency of claims remains high, in addition to an increase in severity… driven by defense costs in these matters,” Reilly told Insurance Business. “Typically, a PE firm’s largest, direct constituents are the limited partner investors - they’re the ones with the most skin in the game from a capital perspective, akin to public company shareholders. When a portfolio company fails, or a fund does not achieve its desired returns, or the sponsor fails to properly disclose in a proper or timely fashion, Limited Partners can become disgruntled, resulting in more questions and potential claims. LP claims exist – they’re alive and well in the market today.”
Another trend that has become a real defensible concern for general partnership liability insurers is the overflow of issues, including those surrounding ESG and D&I, from the portfolio level to the fund sponsor. PE firms have to answer now for the decisions that have been made at a portfolio company level.
Reilly commented: “It’s well recognized today that even though PE fund sponsors tend to stay away from the day-to-day management and decision making at the portfolio company level, as the majority owner or largest shareholder, in essence […] they have re-created the portfolio company’s operating strategy. The PE firms are going in and executing the financial restructuring, a new capital and potentially new operating plan at the portfolio company. These actions are taken to help the portfolio company operate more efficiently, put the right people in place, and turn it into a winner for all concerned down the road.”
“So, when something goes wrong at the portfolio company level, now those employees, minority shareholders, and creditors at the portfolio company level could come back and sue the private equity fund sponsor directly, saying: ‘You’re ultimately the one responsible for this, although you’re not the CEO or CFO or general counsel. You’re the one who’s executing a plan.’ This is a newer phenomenon that’s been driven by an expansion in general partnership liability coverage over the past 10-years.”
What is clear is that it’s not just PE firms that are being held to higher standards by society today; every business is impacted by these trends. PE fund sponsors just have a lot more financial skin in the game than most.