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Annual ESG Review 2023

February 22, 2024

Fairlight’s primary objective is to deliver our investors superior long-term investment returns by owning a portfolio of high quality, value creating businesses. As a signatory to the UN PRI, we believe environmental, social and corporate governance (ESG) issues can directly impact company level performance and portfolio returns. Given our quality-focused investment philosophy, ESG analysis and risk management are inherently important to our investment process.

ESG issues are considered at each stage of Fairlight’s investment process, including screens, research reports, investment selection and portfolio management. We impose industry exclusion screens to account for the more obvious sources of ESG risk (e.g. tobacco, armaments and gambling).

All researched companies are individually scored across a standardised set of ESG metrics which generate a cost of capital charge which then affects their valuations. This proprietary process enables us to assess the relative attractiveness of our investments more accurately as it treats ESG risk in a systematic and objective way. We believe our strong quality focus and bottom-up investment process typically selects companies possessing relative ESG leadership, which in optimal cases can provide a valuable source of competitive advantage.

In addition to our internal ESG evaluation process, we also benchmark our portfolio using external sources, notably via third-party provider Sustainalytics. These providers have assessed our holdings to have relatively low ESG risk. For example, the Fairlight portfolio is 95% less carbon intensive (Scope 1 & 2) than its benchmark, the MSCI World SMID Cap index.

Fairlight considers active ownership a critical aspect of our fiduciary duty and we take this responsibility seriously. Not only do we vote judiciously at annual shareholder meetings, but we also actively engage with companies when we believe we can constructively influence relevant and positive change. In 2023, we increased the transparency of the Fairlight proxy voting guidelines and introduced external reporting to communicate voting outcomes. We have also improved the planning and structure of our engagement approach, including the development of a proprietary system to manage engagement processes. We are committed to continually improving our engagement process and transparently sharing the results of future activities.

Portfolio ESG Risk – external assessment

In assembling our portfolio, we avoid owning companies that exhibit high or severe ESG risks. In Figure 1 below, Sustainalytics classifies the Fairlight portfolio as holding a 1% exposure to high-risk categories via our small investment in Lifco, a European industrial holding-company, versus the 9% exposure of our benchmark.

While the result is pleasing, we believe the portfolio’s exposure to high-risk categories is even lower. In fact, Lifco is one of the most successful owners of industrial niche leaders in Europe, complies to the strictest environmental regulations in the world and has historically been shown to have a strong corporate governance system in place. This illustrates the limitation of broad algorithmic-based ESG evaluations and why Fairlight primarily conducts its own bottom-up analysis to assess risk.

Figure 1. Portfolio ESG Risk (Sustainalytics vs Internal)

Source: Sustainalytics

Portfolio Carbon Intensity – external assessment

A prominent ESG consideration in equity markets is the corporate contribution to greenhouse gas (GHG) emissions. The outcome of our research-driven approach to ESG, is a portfolio that in 2023, was 95% less carbon intensive than the benchmark. Specifically, regarding Scopes 1 & 2, the portfolio was 94.9% lower, and for Scopes 1, 2, and 3, the portfolio was 14.4% lower. The reason for the relative difference is due to our portfolio holding in Lennox International which has larger Scope 3 intensity.

Lennox, a US-based manufacturer of residential HVAC (heating, ventilation, and air conditioning) products, contributed 72.8% of Fairlight’s total portfolio emissions. However, we believe that taking a closer look at Lennox reveals positive rather than negative credentials given that its innovative products support the world’s future net zero ambitions.

Figure 2. Portfolio Carbon Intensity

Source: Sustainalytics

Proxy Voting and Engagement

Fairlight’s proxy voting guidelines are integral to our investment process. We firmly believe it is our responsibility to actively engage with management teams and/or board members regarding material issues and to cast votes that align with our clients’ long-term economic interest.

While proxy voting has always been integral to Fairlight, in 2023 we increased the level of transparency regarding our proxy voting guidelines and process. We have also introduced external reporting to communicate voting outcomes.

In 2023, Fairlight voted on 491 resolutions across 35 different meetings:

An important responsibility of the investment team is to actively engage with companies where we believe we have a responsibility to encourage positive change. Some examples of engagement with portfolio companies in 2023 include:

• Diploma: Following an equity raise that only involved large institutional investors in 2023, we engaged with the company to discuss optimal capital management with a view to ensuring that minority shareholders will be treated more fairly in any future capital raise.

• Bechtle: We expressed our dissatisfaction in relation to the issuance of dilutive convertible bonds at the end of 2023, at a time when the company was able to access finance from banks at an attractively low interest rate and was experiencing an improving cashflow conversion. We hope this will minimise the likelihood of similar issuances in the future.

The Fairlight View

Fairlight sees ESG analysis as a fundamental part of the research process needed to assess the quality of portfolio companies. We have found that, over the long term, there is a strong correlation between the quality of company ESG characteristics and their ability to sustain above-average returns on capital. As a result, ESG analysis will continue to feature as an important part of the research process. Fairlight also remains committed to investing additional resources to help improve the accuracy of our judgements and positively influence our investment companies, when necessary. For example, in 2023, we developed a proprietary system to manage our engagement processes. Fairlight looks forward to building upon this investment in 2024 and beyond.