Structuring Considerations for ESG-Centered LP Investments

Introduction

Since the launch of the United Nations Principles for Responsible Investment (UNPRI) back in 2006, institutional investors of private equity and venture capital funds have employed various governance and economic options to promote their particular environmental, social and governance (ESG) goals. Over the years, and as more investors have signed onto UNPRI, we have observed an evolution in how institutional LPs (limited partners) have approached the implementation of these goals. This article explores a number of these approaches and delves into particular structuring considerations under the standard general partner-limited partner (GP-LP) framework that is common for private equity and venture capital funds.

Overview of Structuring Options

The GP-LP model

For an LP following the traditional GP-LP model, selection of fund managers and fund themes is central to the promotion of such LP’s own ESG initiatives and investment goals. This is typically done via pre-investment due diligence, with an in-depth analysis of the relevant fund managers’ profiles, track records and levels of commitment to the relevant ESG initiatives.

The traditional approach for ESG investing pioneered by international development institutions typically offers guidance to GPs (general partners) by providing data and know-how on best practices to achieve certain ESG and sustainability goals. In addition, these institutions provide financial support to hire technical experts to overcome financial, operational and other challenges for emerging managers as a condition for their LP investments.

More recently, we also have seen other new multilateral development banks structure their private fund investments by creating economic incentives for the fund managers to achieve impact targets, such as ethical supply chains and sustainability. These economic incentives include favorable carried interest arrangements to fund managers that score high on certain impact metrics.

Both approaches are intended as a way to transform an LP’s traditional role as a passive investor in the fund vehicle and promote the effectiveness of post-closing monitoring of the fund manager’s ESG- related performance.

The co-GP model

Other institutional LPs with adequate internal resources and a fund manager’s skill set have not limited themselves to the role of passive investors – instead, such LPs may have the willingness and capability to co-sponsor a fund vehicle. We find this pattern particularly suitable for a large business conglomerate with an established asset management function. By being a stakeholder in the fund’s GP and/or investment manager entity, LPs adopting the co-GP model run their

ESG-centered fund investment program in a manner that is analogous to a joint venture (JV) formed with the relevant fund manager. In the event that such LP is a minority shareholder in the JV, getting veto rights on material business issues – such as the expansion or alteration of the fund’s investment scope – is an effective tool for the investor to exert their influence over the fund’s directions.

Strategic partnerships

Considering the traditional GP-LP model and the co-GP model as two ends of one spectrum measured by the degree of LP involvement, we also have encountered an increasing number of strategic partnerships that are somewhere in between – i.e., while the investor is not part of the fund manager’s organizational structure chart, it has the right to directly influence the fund’s post- closing investment directions through contractual arrangements, which is one degree less than a JV.

ESG-Focused Strategic Partnerships: A Closer Look

Some distinctive legal features of strategic partnerships include:

1. Exclusive investor base. Strategic partnerships are essentially closed- door alliances, as access is limited to investors with the “right” profile – g., when a leading energy industry association sponsors a private equity fund targeting investments in technologies that enable low-carbon chemicals and fuels, the existing members of such organization naturally become investors in the fund. For these sector-focused funds, the admission of any additional “nonaligned” LP will require the consent of the current members. Such entry barrier may limit the sources of financing for the fund, but the logic of this exclusivity is that all members of the industry association share one common initiative, which is to accelerate the reduction of greenhouse gas emissions globally, thereby solidifying the foundation for ESG-driven collaboration.

2. LP transfer restrictions. Strategic partnerships usually also come with investor transfer and assignment restrictions – g., an LP’s right to transfer its partnership interest or to assign rights thereunder to a third party is subject to a right of first refusal by existing investors in the fund. The suitability of a transferee or a substituted LP is not determined by the GP alone but instead requires approval by all other LPs. While such types of restrictions are uncommon in regular blind pool fund offerings, this is consistent with the quasi-JV nature of the strategic partnership, which effectively limits investor mobility and is aligned with the idea of maintaining an LP base that is focused on the ESG goals at hand.

Even though the liquidity of the investment may not be a priority concern for LPs participating in an ESG-oriented fund, when designing the fund structure or engaging in negotiations for an LP investment in such a strategic partnership, it is worthwhile to consider whether there should be some mechanism to facilitate reasonable future adjustments to the LP base. Given that those investments are typically 10- year, 15-year or longer commitments, technology developments, market shifts, geopolitics and other unforeseen factors may lead to an initial LP no longer being suitable. Moreover, adding new industry players to the fund as investors would significantly promote efficiency. One illustrative example is that of a major airline company. While not a member of the energy industry-led association sponsoring a decarbonization fund, it is, in fact, a powerful addition to the existing LP composition of oil and gas giants, given such airline’s deep experience in the field of sustainable aviation fuels, which falls squarely within the fund’s investment targets.

3. Tailor-made governance In a strategic partnership where each investor brings its industry experience and connections to the fund on top of capital injections, proper design of fund governance is critical to value maximization. For example, allowing a majority of the LPs to approve the admission of a new investor could provide more flexibility and strategic advantage to a fund than a unanimous consent mechanism, where one single investor may be able to block a deal. In addition, conflicts of interest and competition dynamics need to be appropriately addressed, particularly when the investors are corporate venture capital LPs.

Depending on the fund’s investment theme and the nature of its LP mix, sometimes an anchor investor gains influence by sitting as a voting member on the fund’s and/ or the fund manager’s investment committee (IC), while other investors may serve as IC observers. Or, if there are a number of equally (or similarly) situated “founding” LPs, an investor advisory board may be formed at the fund level, consisting of representatives appointed by each such investor. In many instances, such board’s power is significantly more extensive than a regular LP advisory committee (commonly referred to as an LPAC). For example, such board of investors may be able to veto the fund’s target portfolio investments or deny the GP’s proposed budget for fund expenses.

When reviewing this kind of IC or board arrangement, one needs to be mindful of whether there is any tie-breaking mechanism in voting to avoid deadlock situations. An additional critical legal question to ask is whether the level of involvement in deal sourcing, due diligence, investment decision-making and other investor management activities by a non-GP investor may lead to it being denied the protection of limited liability as an LP under the laws of the applicable jurisdiction. While we have seen a growing number of these types of transactions taking place in the global market, given the bespoke design of each strategic partnership, the level of risk exposure borne by an ESG-oriented LP could vary from deal to deal and requires close examination each time.

Conclusion

As different ESG priorities emerge, institutional LPs have a range of governance and structuring options that they can deploy to implement their specific goals. Depending on the capabilities and resources of the institutional LPs, ESG structuring solutions need to be highly tailored to promote effectiveness and alignment. As the market for ESG investment evolves, it will be interesting to see how those priorities will impact fund terms. 

This article first appeared in the June 2025 issue of Hong Kong Lawyer – the official monthly publication of The Law Society of Hong Kong.

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