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ESG in the U.S.: demonstrating value is key in an increasingly complex regulatory landscape

In this Preqin article, partners Jennie Morawetz and Mackenzie Drutowski discuss navigating the diverse ESG landscape in the United States. To read the original blog post, visit here

Environmental, social, and governance (ESG) strategies are under increased scrutiny from politicians, regulators, and stakeholders. Businesses must navigate a rapidly evolving web of complex rules and standards, which vary widely across jurisdictions. None more evident than in the US, where the anti-ESG movement is gaining traction. Jennie Morawetz and Mackenzie Drutowski, Partners in Kirkland’s ESG & Impact practice, spoke with Jayda Etienne, Assistant Editor, Preqin First Close, about the impact of the ESG backlash for investors and fund managers. 

What does ESG mean to Kirkland?

Jennie: ESG is very important to us and our clients. We represent the world’s most sophisticated alternative asset managers, financial institutions, and corporates at a moment in time where, regardless of political or personal beliefs, there are some big global challenges that businesses must confront. For us, ESG is a way of thinking about the role of business and investors amid these macro-challenges. 

What does the day-to-day look like?

Mackenzie: We advise GPs, public and private companies, and portfolio companies on ESG strategy and disclosures. Much of the work we do for GPs is at three levels; firm level, establishing the ESG program and reporting; fund level, fund and marketing documents, LP negotiations, and side letters; and the portfolio company level, making sure they’ve done their due diligence.

How are you advising clients when it comes to integrating ESG into their investment processes?

Mackenzie: First, define what ESG means for your business. This is key to understanding how you’re going to set up your program and consistently message it to different stakeholders, across different jurisdictions, who may want to hear about different elements of a strategy. Second, establish strong supporting policies and procedures, something that the US Securities and Exchange Commission (SEC) has been focusing on. Third, identify and communicate what the value-add will be to investors through data. 

How are your clients approaching the complex ESG environment in the US?

Mackenzie: This increasingly complex landscape is challenging our clients to be clearer about the essential tie between what they’re doing, and the value for their investors. For a while there was often this general messaging surrounding ESG that ‘we’re doing this to save the planet’ when for most of our clients, the primary driver is to support strong returns.

Jennie: In the early stages of ESG in the US, some clients were very reactive in creating their ESG programs. Lots of new voluntary frameworks and regulations were being introduced at once, and many of our clients felt like they were struggling to keep up. Now we’re in this period where there’s a bit of a backlash. It’s a good time for businesses to take a step back and reclarify what ESG means for them.

Are Republican or Democratic states affecting whether you label a fund SFDR Article 8 or 9?

Mackenzie: Not particularly. If a fund is disclosing under Article 9, then the relevant objective is usually fundamental to their strategy. Whenever a firm is looking at SFDR or any other ESG disclosure regime, we encourage them to think about who their LPs will be and their expectations, as well as the regulatory requirements they will be subject to. 

Jennie: Article 8 has become an allocation factor for some European LPs, at least for some strategies, asset classes, and products. So even if the client is US-based, when marketing in Europe, they may choose to pursue an ESG strategy that is suitable for disclosure under Article 8 over Article 6. In all cases, it’s helpful to consider the entire LP's base when defining the fund’s ESG strategy, to help ensure it makes sense in light of who the client wants to raise money from, be it European investors, Democratic states, Republican states, or beyond. 

How are the conflicting ESG regimes in the US challenging for fundraising?

Mackenzie: Navigating fundraising in this environment comes up a lot in discussions with investors, side letter negotiations, and requests for certifications for investors who are subject to pro- or anti-ESG laws or have certain ESG-related preferences or commitments. But we haven’t seen a huge impact on the flow of capital. 

Jennie: It’s important to keep in mind that the anti-ESG movement in the US isn’t driven by LPs, it’s driven by political actors. LPs must comply with state law. The challenge for GPs is figuring out how to minimize legal risk when they have a diverse LP base with different, and sometimes conflicting, preferences and regulatory obligations. 

Do your clients approach ESG from more of a risk mitigation or opportunistic perspective?

Jennie: There’s a little bit of divergence here between the US and Europe. Over the last few years, US investors have tended to talk about ESG in risk-based language. Whereas in Europe, there’s always been more of a focus on impact, with the view that investors have a role to play in driving capital toward more sustainable business activities. But that’s a huge generalization and of course there are many exceptions. GPs, regardless of location, must demonstrate the business case for ESG, and we are seeing an increased focus on enhancing the data to do so. As data becomes more sophisticated, the narrative might further evolve. 

What do ESG opportunities look like for LPs and GPs? 

Mackenzie: Our clients are already implementing many ESG opportunities, but not all are framing them through an ESG lens. For example, bringing energy costs down or making their company attractive to a broader range of employees. We also have clients that are focused on the market opportunities coming out of the ESG movement, such as investing in technology and infrastructure to support the energy transition. 

What emerging ESG regulatory risks should investors and fund managers be looking out for?

Mackenzie: It’s an interesting time for regulatory risks. New laws are coming into effect, and certain ESG-related disclosures are moving from voluntary to mandatory. California recently passed three ground-breaking climate bills. Hopefully we’ll get a final copy of the SEC climate rule soon, as well as the SEC’s rule for private fund advisors on ESG disclosures. Awareness of these upcoming regulations is key, also building your response plan and understanding what applies to you and your portfolio.

Reprinted with permission from the January 29, 2024 edition of Preqin. Further duplication without permission is prohibited.