Legal briefing | 09 Feb 2024 |

Travers Smith's Sustainability Insights: Getting governance right

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A regular briefing for the alternative asset management industry.

Many alternative asset managers and their large portfolio companies are already engaging with the EU's Corporate Sustainability Reporting Directive, or CSRD. For good reason: the CSRD will herald a revolution in non-financial reporting. It will require extensive and audited public disclosure of a wide range of environmental and social impacts, risks and opportunities. A company needs to report on its own operations and, to some extent, its "value chain" – a wide-ranging concept that includes (for example) suppliers, customers and investee companies.

Understanding whether and when these disclosures are required will be a priority this year.

But, of course, non-financial reporting is not new. A portfolio company's annual report is already a significant source of information for stakeholders, and can come under scrutiny when a business hits the headlines. At this time of year, the UK private equity community receives an important reminder of that scrutiny, when PERG – the Private Equity Reporting Group – issues its annual report, accompanied by the PwC analysis of good practice.

The PERG report covers the largest UK portfolio companies of private equity (and "private equity-like") firms – those covered by the Walker Guidelines. The catalyst for those Guidelines, commissioned by the BVCA and written by Sir David Walker in 2007, was a sudden public focus on private equity. Politicians were concerned that private equity-backed companies were not as open and transparent as their publicly listed counterparts. The Guidelines were an important milestone for the industry: they signalled a recognition that stakeholders have a legitimate interest in a large company's impact, and are entitled to reliable information.

In fact, since 2007, regulators have increasingly imposed non-financial reporting requirements on large private companies and well as their public counterparts. The EU's CSRD may be the most significant change to reporting for private companies, but UK corporate disclosure rules – including the requirement to report on climate-related risks and opportunities using the TCFD framework – now routinely include economically significant private companies. (In fact, the UK government has been flip-flopping on this recently, with further reforms announced and then ditched, following a call for evidence to gather ideas for simplifying the rules.)

Despite these recent changes, the Walker Guidelines still raise the bar beyond the legal minimum, requiring extra information on (for example) human rights, gender diversity and employee engagement.

This year's PERG report – its sixteenth – covers 81 UK companies, including many that have regularly been in the news: The AA, ASDA and Morrisons, for example. The 71 firms that back these companies include international household name sponsors, as well as sovereign wealth funds and non-UK pension funds. Eleven companies did not prepare an annual report that complied with the Guidelines' enhanced requirements, although PERG notes that none of these was backed by a BVCA member firm. The remaining companies did conform to the Guidelines, although in some cases only by issuing an addendum after PERG's review, and 60% were judged to have produced disclosures that were "good" – roughly the same standard as that achieved by public companies in the FTSE 250. One company was given an "excellent" rating.

As strategic buyers and the public markets increasingly pay a premium for companies that can demonstrate good ESG performance, a focus on good governance practices may pay dividends …

The PwC report, issued at the same time as PERG's review, identifies specific examples of good and best practice, and is a very useful point of reference for those preparing or reviewing portfolio company reports.

The PERG review and PwC guidance are not the only show in town. Last week, the UK's Financial Reporting Council – the accounting watchdog – issued its own review of reporting by the UK's largest private companies. The unsurprising headline was that variability is high, but the focus for this review was on financial reporting. In fact, the FRC's Guidance on the Strategic Report and Thematic review of climate-related metrics and targets offer a more helpful steer on non-financial reporting requirements and best practices. Other useful sources include the Wates Corporate Governance Principles for Large Private Companies, the UK Corporate Governance Code itself (amended this year, and with updated guidance) and the CGI model terms of reference for an ESG Committee.

The UK's requirement for a so-called "Section 172" statement in the strategic report of all large companies can provide a helpful focus for thinking about how the company interacts with its stakeholders. Section 172 of the Companies Act requires directors to promote the long-term success of the company, for the benefit of the company's shareholders – usually taken to mean that the board's obligation is to maximise long term share value. However, in doing that, the law requires directors to have regard to the interests of a range of stakeholder interests, including employees, customers, and "the community and the environment". A good Section 172 statement will include details of how the directors of the company ensure that they are properly informed about these matters, and give examples of decisions taken by the board that were influenced by these factors.

A good Section 172 statement, and a well-written strategic report, is not only evidence of good governance, but will also focus management minds on how non-financial issues affect long term performance and feed into strategy. As strategic buyers and the public markets increasingly pay a premium for companies that can demonstrate good ESG performance, a focus on good governance practices may pay dividends – as well as ticking some regulatory boxes.