Progressing the ESG agenda through Reward in the Alternative Asset Management industry

‘ESG’ is a priority for the investment management industry, reflecting focus from an increasing stakeholder population including Limited Partners (LPs), employees and the general public. This pressure is shaped by different concerns. Some LPs are looking to enhance the impact of their investment, others looking to mitigate investment risk and many looking to ingrain responsible actions as part of their general purpose. Meanwhile investment firms themselves are keen to attract a talent base that is increasingly drawn to responsible business. As such ESG is likely to remain a priority for the foreseeable future and becoming part of ‘business as usual’. 

To reflect this significance and their commitment to embedding ESG into their business, investment firms are incorporating ESG metrics into their reward structures. Banks, asset and wealth managers have already begun to introduce ESG metrics into their annual bonus and Long-Term Incentive (LTI) plans for senior management, and are considering how these can be mapped across to the wider workforce.   

To date, there has been less integration in the Alternative Asset management space. However, as Alternatives move to embed ESG into their investment process, they are increasingly asking the question – where is there scope to include ESG in their reward mechanisms?

Where are we – ‘ESG’ in Financial Services

ESG in Banking / Asset Management vs. Alternatives [1]

[1] Data sourced from Deloitte’s analysis of publicly available information included in the relevant FTSE 100 company 2021 / 2022 annual report disclosures

How to reflect ESG in the reward framework for Alternative Asset Managers

Embedding ESG into the reward framework is not a simple task and existing incentive structures will need to be tailored to capture ESG performance measurement. The primary challenges are:

•     Bonuses are typically discretionary in nature; and

•     Carried Interest is directly linked to fund performance typically no individual performance underpin/overlay. 

Here we have set out a few approaches to integrating ESG performance measures into a reward framework:

ESG and annual bonus awards: Is it feasible to introduce ESG metrics within short term variable pay?

Within the Financial Services industry [banking and asset management industry], the most common approach is to introduce ESG metrics into the annual bonus calculations. In the UK, more than 75% of FTSE 100 companies, including asset and wealth managers, have adopted this approach. This is commonly part of an executive’s personal or strategic objectives, or as a standalone ESG scorecard. Distinct, achievable ESG goals are set up-front, and progress against these is measured at year end. 

Alternative Asset Management firms may struggle to replicate this model, particularly if they currently use a more discretionary approach in bonus determination. The first step would be to enhance transparency across their whole bonus structure to enable inclusion of distinct ESG metrics, perhaps introducing an overarching balanced scorecard which informs bonus determination (e.g. setting definitive financial and non-financial ESG criteria). This does not necessarily mean adopting a formulaic bonus but segmenting a portion of the bonus to ESG (and leaving the remainder as discretionary) or using ESG as an additional consideration within a discretionary structure.  

The relevant time horizons for each ESG goal should be considered. Some ESG ambitions may suit shorter performance assessment periods (e.g. ambitions related to immediate hiring plans, or other governance improvements). Others, particularly those relating to environmental changes (e.g. carbon emissions) are longer term aspirations more suited to long term assessment (three+ years). 

Firms should also consider the weighting on ESG vs other performance metrics. A limited focus on ESG performance might not prove sufficiently material to effect behavioural change (for example, where used, ESG related metrics make up to 20% of scorecards within banking). Equally, while adding ESG into the bonus may be beneficial in signalling to the workforce the increasing focus on ESG, will it be enough to change behaviours when reward is so heavily orientated towards Carry?

ESG and Carry: Could Carry distributions incorporate an element of ESG?

Given the time horizons of measurement and how meaningful Carry is in the reward offering, the most effective way to link ESG related metrics may be through Carried Interest. Whilst this sounds the most effective way it will require careful consideration and represents a departure from the single financial performance metric that applies to the very vast majority of current Carried Interest plans. 

Some potential ways in which ESG could be incorporated into Carried Interest include holding a portion of an individual’s points entitlement in escrow and reducing them if pre-agreed ESG targets / underpins are not met. Alternatively, a portion of warehoused points could be held back and released subject to ESG conditions. 

Given the complexity of Carry there are several operational factors which should be considered:

•     Unpredictability on the timing of Carry distributions 

•     Erosion of alignment between participants and LPs

•     Potential negative tax consequences. 

•     Treatment of undistributed profits

•     Data integrity – is there sufficient robust, quantitative data held at House level to enable meaningful measurement?

As the significance of ESG grows, it will be important to test whether the historic position that Carried Interest should only be based on financial returns holds true and if incorporating ESG related metrics brings a subtle but important difference in investment approach.

ESG and portfolio company reward: Is a ‘ground-up’ approach a more effective and practical approach?

ESG metrics could be considered within reward structures at the Portfolio company level. This could be in addition to introduction at the House level, or it may be that reflecting at the Portfolio company level only is more suitable. 

This approach has the advantage of allowing ESG to be assessed in a targeted manner suited to each underlying investment. Suitable ESG metrics will highly depend on the industry and operations of each company. 

Or, ESG could be reflected in different parts of the Portfolio company reward frameworks. Adding the requirement into any bonus scheme might suit some ESG metrics. Other metrics might better fit into longer terms plans. In the FTSE 100, 45% of LTIPs now include an ESG metric. Other markets are also seeing increasing adoption across the framework.

Adoption of ESG metrics in incentive plans [2]

[2] Data sourced from Deloitte’s analysis of publicly available information included in the relevant FTSE 100 company 2021 / 2022 annual report disclosures

Most Portfolio companies backed by Private Equity operate Management Incentive Plans (MIP). Incorporating ESG metrics within Management Incentive Plans (MIP)s will likely result in similar complications to Carry schemes, as set out above. Much like Carried Interest, such structures could be challenged to consider whether alternative metrics could be employed which focus MIPs on financial returns but have the ability to be modified to reflect wider ESG metrics.

In Summary

The investment industry is aware that embedding ESG metrics within their reward structure bring new responsibilities and opportunities. 

Strengthening the link between reward and ESG can enable Alternative Asset Managers to incentivise their people to meet these opportunities and drive a positive reputation amid the ever-growing global discourse on ESG issues. 

The right approach to measuring ESG progress will ultimately depend on the firm, the reward structures already in place and the investment strategy. We expect the most effective approach will likely involve a combination of short, medium, and long-term reward structures that focus on material, measurable and quantifiable performance metrics. 

There are three main factors that Firms should consider when looking to adopt ESG metrics;

o      Which ESG metrics are the most appropriate – this should align with the specific ESG ambitions of the Firm. 

o      The availability and quality of ESG data when setting targets.

o      Balancing ESG objectives (and performance testing) at the House and asset level.