The rise of integrated reporting
Over the past three years, Baxon has seen how its clients, the majority of whom are fund managers, have sought to take a more holistic approach to measurement. We have seen a seismic move toward ‘integrated reporting’, which considers financial and operational information alongside responsible investment (RI) and ESG factors.
Originally, ESG compliance appeared to be more a matter of GPs reacting to LP’s requests, rather than a real and proactive commitment. However, as the market evolved the measure of RI factors was seen as increasingly important to real performance. ESG aspects therefore became relevant, not only from a regulatory and compliance angle, but from a competitive perspective. ESG is no longer perceived solely as a risk management tool, but also as a way to add value to investments in the long term, increasing the pressure on companies and funds to track and report on ESG aspects.
As ESG factors become increasingly vital to a company’s strategy and decision-making process, the need has emerged to enhance the reporting capacity to cover these aspects in a lean and scalable way. Having a dedicated in-house RI team, or hiring external ESG consultants is an important step, but can also be costly, and alone may not be enough to provide a long-term solution for ESG integration. There is a need to go beyond this to achieve the synergy and benefits of ‘integrated reporting’.
Digital solutions to streamline reporting
Digital reporting systems have the ability to enhance the way the field defines, measures and drives performance, providing the opportunity for greater efficiency and effectiveness of measurement.
Since 2005, Baxon has developed cutting-edge systems to streamline the entire portfolio reporting process for private equity.
Both from our position in the market, as a service provider, with a deep and well developed understanding of the demands and needs of our clients in terms of financial and ESG information and reporting requirements; and from our practical involvement in this transition moving from the prevailing two dimensions of risk and return, to multi-dimensional considerations of risk, return and impact, we see the way forward as the integration of standard financial and ESG reporting, and not the generation of two sets of reports with ESG being an add-on to the traditional financial and accounting reporting.
As such, our platform can bring to life an integrated reporting view that can also be used across the full investment life cycle. For example, monthly financials and operational figures from portfolio companies are already collected in Baxon platform, which makes it easy to add ESG indicators and form an integrated view. This helps save time, work and consequently money for the portfolio company and the GP.
The way in which data is captured, kept, analysed and especially made available is also critical to success. In many cases, investors have turned down deals with companies that do not disclose ESG aspects well enough or do not disclose at all. We use a variety of easy-to-understand interactive dashboards; ‘traffic lights’ alerts on deviations and consequently risks, to ensure a holistic and rigorous approach.
Since inception, we have focused on working with the industry to ensure we are constantly learning and developing the best tools for the job. Based on feedback from our clientele, we have identified a systematic approach to analyse qualitative information in a user friendly way which also includes the measurement of soft variables.
Accordingly, this gives the manager the opportunity to easily merge traditional financial and operational data with ESG metrics directly from the portfolio company, allowing them to find correlations between non-financial information and value creation. Once a correlation is found, it can be analysed and eventually extrapolated to the rest of the portfolio to find opportunities for value creation and risk reduction.
What’s most important to stakeholders?
ESG is broad and action is generally narrowed down according to what is most important to stakeholders. As ESG has gained increasing relevance for LP-GPs across the investment life cycle, activity starts to go beyond the initial screening and due diligence. Working with Acrux Partners, a specialist ESG and Impact Investment advisory firm, we have identified key processes and steps where ESG must be better integrated to enhance the benefits of integrated reporting. These are set out in Table 1.1.
Table 1.1: Critical processes for integrating ESG to enhance the benefits of integrated reporting
These rules of thumb are reflected clearly in Figures 1.1 and 1.2 below. Taken from two different surveys by the PRI, these show how investors value the integration of RI practices and ESG issues during their investment selection.
Figure 1.1: RI practices most valued by LPs in fund manager selection
Real ESG management, i.e. being able to capture and disclose the data-source from the portfolio company, allows both private equity funds and portfolio companies to more effectively respond to challenges and achieve better and more sustainable returns throughout the life of the investment. As shown in table 1.1, from a GP perspective monitoring the improvements and impact generated by these factors, the company can improve efficiency, value creation and reduce potential risks.
In this process, the GP is vital given its influence on the direction of the portfolio company’s management, especially when the GP has a majority stake. By insisting on the inclusion of ESG policies with a comprehensive set of metrics, the GP can lower risk and add value, making companies more financially attractive for exit.
RI adoption and progress globally
We have found that progress toward responsible investment (RI differs by geography. Clearly, adoption levels will in turn, have an impact on integrated reporting practices. Essentially, motivation for adopting RI practices and regulations varies from country to country.
Regulation is a key factor.
Regulation is one of the key drivers of the development of responsible investment (RI) in different geographies.
As M.L.Tinelli explains, in countries without a long tradition of ethical or socially responsible investment, regulation has been a key driver in the uptake of RI practices and the incorporation of ESG issues. Regulation can take the shape of an explicit requirement for pension funds to include ESG issues as part of their fiduciary duty (as is the case of South Africa). It can also take the form of guidelines issued by the central bank that are applicable to all investors (as is the case of Brazil); stewardship codes (in the UK, Japan, and soon to be in Malaysia). There can also be stock exchange requirements or different versions of the ‘comply or explain’ approach present in various countries.
Countries with some form of regulation or guidelines in terms of RI and ESG incorporation will tend to be most advanced in their RI practices. Some of these countries also have the highest uptake of different RI-related bodies or organisations, such as Social Investment Forums, the PRI, the Global Reporting Initiative, the UN Global Compact, and Sustainable Stock Exchanges, among others.
Multilateral bodies and regional economic areas also play a key role in the regulation and promotion of responsible investment. As an example, the European Union advocated for the importance of standardised reporting through the creation of the European Transparency Code in 2004 to harmonise the disclosure of extra financial data across Europe and to improve clarity on principles and processes of SRI mutual funds.
Whistle-stop tour of the pioneers
Within Continental and Eastern Europe, we see a clear distinction between the leaders and those taking their first steps. The UK, with its enforcement of the Pensions Act in 2000, requires reporting from its pension funds on ESG issues, while the issue of fiduciary duty lies at the centre of the debate.
The Scandinavian countries were also early adopters, and some of the first to introduce regulatory frameworks and standards promoting ESG activities in financial management. The frameworks of Norway, Sweden and Denmark provide a good example of this approach.
In emerging markets, countries like Peru, Chile, Namibia, Botswana and Zambia, among others, are replicating what they find useful from leading countries in the field and adapting it to local regulation.
South Africa has the most developed regulatory framework for institutional investors on RI. Responsible investment is top of mind in the South African retirement fund industry, following the amendment of Regulation 28 of the Pension Funds Act and the development of the Codes for Responsible Investing in South Africa (CRISA) in 2011. Neighbouring countries are looking to South Africa for inspiration. Namibia, Botswana, Zambia and Swaziland have been referring to South Africa’s Regulation 28 in the process of updating their own pension regulations.
Brazil is another pioneer, leading the way in responsible investment in South America. As Yamahaki and Gaban explain, in 2009 the Brazilian National Monetary Council issued a resolution “requiring all Brazilian pension funds to state in their investment policy whether they consider social and environmental issues in their investment decisions (BCB, 2009). Although integrating ESG issues was not made mandatory, this piece of legislation brought the topics of responsible investment and sustainability to the forefront of the discussion in the pension fund industry.” In 2014, Resolution 4327 from the Central Bank established guidelines for financial institutions for the creation and implementation of social and environmental responsibility policies, and Resolution 3792 demands that pension funds explain and report on whether they observe ESG issues in their investment policies and practice.
LeapFrog Investments, the specialist emerging markets investor, is demonstrating how investors can achieve top-tier commercial returns alongside transformative social impact. Guided by a profit-with-purpose approach, LeapFrog invests in high-growth companies across Africa and Asia, serving a market of close to two-billion low-income or excluded emerging consumers with critical financial services and healthcare. At the time of writing, LeapFrog portfolio companies were demonstrating annual revenue growth of 43.2% between 2013-15 while reaching a total of 84.8 million people, including 67.7 million people who are underserved or excluded.
LeapFrog has an intentional focus on integrated reporting, and importantly uses it as a material way to enhance and drive performance. LeapFrog views integrated measurement as a key enabler to achieving top-tier financial and social returns, and its approach focuses on ‘ESG++’ – the notion of using measurement to go beyond reporting, and to also help define and drive performance. To operationalise this concept, LeapFrog developed FIIRM, a field-leading Profit with Purpose measurement framework tailored to financial services and healthcare. LeapFrog uses Baxon to collect, store, and report on FIIRM data. FIIRM stands for Financial, Impact, Innovation, Risk Management and consists of a set of financial, non-financial and ‘extra-financial’ or qualitative KPIs that give a holistic view of Profit and Purpose, and are used by the firm to drive results. LeapFrog tracks company and fund performance, from due diligence through to exit, and has developed a set of integrated dashboards for internal and external performance reporting. Baxon has supported LeapFrog on this journey, providing the investor with the functionality to report on non-financial and qualitative data and build customised dashboards. LeapFrog says: “Baxon combines the rigor of a standardised platform with the ability to customise and innovate in integrated reporting. In our view this is a key differentiator of the platform. It’s Baxon’s forward-looking view and commitment to integrated reporting that makes our task much easier.”
FIIRM has enabled LeapFrog to demonstrate tremendous Profit with Purpose results. The framework has also informed broader industry developments; FIIRM KPIs were used as the foundation for the globally accepted Impact Reporting and Investment Standards (IRIS) for insurance, for example, and LeapFrog contributes actively to other standards at UN PRI and B Lab, such as GIIRS.
 Maria Laura Tinelli, ’Responsible investment around the world’ in The Routledge Handbook of Responsible Investment (2015), edited by Tessa Hebb, James P. Hawley, Andreas G.F. Hoepner, Agnes L. Neher, David Wood.
 David Wood, ‘RI in South America’ in The Routledge Handbook of Responsible Investment, (2015), edited by Tessa Hebb, James P. Hawley, Andreas G.F. Hoepner, Agnes L. Neher.
This article was first published in PEI’s Value Creation Through Responsible Investment.