By Atul Mehta, IFC Director of TMT, Venture Capital and Funds Department, and Morgan Landy, IFC Director of Environmental, Social and Governance Department
There is increasing evidence that companies with strong environmental and social practices perform better financially. Cambridge Associates found that sustainability makes an even stronger contribution to the performance and competitiveness of companies in emerging markets than those in developed markets. This is likely due to weaker regulation in emerging markets: companies that do more than what is required by law set themselves apart from the competition.
We’ve seen it in IFC’s own portfolio. Companies with strong environmental, social and governance (ESG) scores tend to outperform other client companies on return on equity and return on assets. IFC clients with high ESG scores outperformed the MSCI Emerging Market Index, whereas a deterioration in ESG performance resulted in worse financial performance in the range of three to eight per cent. The same holds true for IFC’s investments in private equity funds.
IFC is sharing these data and experience to help our clients develop and implement high standards that can benefit their business.
In early October, IFC’s CEO, Philippe Le Houerou, wrote about IFC’s work with financial institutions and the evolution of our approach, as we seek to create a more responsible banking system and boost financial inclusion globally. IFC has also enhanced its approach to working with private equity funds.
The key components of our approach include dividing private equity funds into categories based on risk and implementing appropriate risk management; reducing our investments in high risk funds; and increasing disclosure of projects our client funds invest in.
We divide private equity funds into three categories — high, medium, and low-risk — based on their prospective investee companies’ activities. We then work with fund managers to implement tools that assess and manage these risks throughout the investment’s lifecycle.
Most funds invest in companies and sectors that expose them to limited risks (mainly labor), but a few face considerably higher risk. We ensure that our clients are aware of the risks they will likely face and that they either build necessary expertise in-house to manage it or that they know where to find the expertise to help them appraise higher-risk projects ahead of an investment.
IFC also provides this type of support to our clients and, on occasion, we co-invest and directly assess risks and ensure appropriate safeguards.
For high-risk funds, such as those investing in infrastructure or agribusiness, we take a highly selective and individualized approach to design tailor-made E&S risk management.
For medium-risk funds, such as generalist growth equity funds, we require fund managers to have a functioning E&S Management System and in-house capacity to assess the E&S risks of investee companies and address any identified gaps. IFC reviews the E&S due diligence conducted by the fund for the initial investments to verify in-house risk management capacity. IFC also reviews all high-risk (i.e. Category A) investments in the pool.
For low-risk funds, such as Venture Capital funds, we have developed a sample screening process to check the funds’ investments against relevant national laws and requirements, and key risks — typically those related to labour and working conditions
Supervision of our investments in funds is a critical component of our continued engagement. IFC’s E&S specialists conduct regular supervision visits of a sample of fund portfolio companies to assess E&S risks and provide support to fund managers. We focus more of our attention on high and medium risk funds.
IFC also offers regular E&S risk management training around the world. Over the past two years, IFC has provided advanced E&S training to over 100 fund managers in Asia, the Middle East, Africa and Latin America. This has resulted in better understanding and implementation of IFC’s E&S requirements by our fund managers.
In addition to these initiatives, IFC has strengthened its reporting. We publish the name, sector and location of every investment of our funds’ portfolio companies. In 2017, IFC fulfilled 100 percent of this requirement for the 63 fund investments initiated since 2012, and published information on more than 387 funds’ portfolio companies.
The process, while robust, does not mean that we and/or our clients will never face challenges with our investments in this space. But it does mean that we significantly reduce the risk of such incidents and that we are better prepared to deal with them when they arise.
It is challenging work. We believe that our new approach helps IFC and our clients identify and reduce risks early in the investment process and better prepares us to address new risks that may arise throughout the investment lifecycle.