From nice to have to mainstream: ESG in private equity

February 2021  |  FEATURE  |  PRIVATE EQUITY

Financier Worldwide Magazine

February 2021 Issue

From a state of broad awareness but uneven adoption only a few years ago, asset managers have generally come to accept environmental, social and governance (ESG) integration as a standard part of doing business in recent years. Across the private equity (PE) industry, the importance of ESG initiatives is becoming clearer. Not only do ESG policies make a positive contribution to the environment and society, they are also seen as vital to the development of a resilient and successful modern business, amid ever-expanding competition.

According to BDO, almost two thirds (63 percent) of UK PE firms now take ESG principles into account when making investments. Furthermore, 48 percent of PE firms in the UK report in detail on the ESG impact of their investments, while 25 percent have a dedicated individual or team responsible for embedding ESG into the investment process.

Of course, while PE is particularly suited to responsible investment through its long-term investment horizon and stewardship-based style, the PE space is not alone in its increased focus on ESG. The issue has begun to dominate discourse and moved up the boardroom agenda – but what has driven this increased focus?

From a PE perspective, ESG has become increasingly important for a number of reasons, not least because investors are demanding greater ESG integration and transparency from fund sponsors. There is also increasing regulatory fluidity and enhanced global regulatory focus around ESG, and shifting ‘market norms’ on ESG within private equity itself.

According to a 2020 survey from Intertrust, 88 percent of PE investors plan to increase their efforts to manage and measure ESG performance in their portfolio companies over the next two years. “As a result of investor demand, firms have increasingly been taking back the initiative and really investing time and resources on their ESG policies and focus,” says John Verwey, a partner at Proskauer Rose LLP.

There is a growing demand among prospective limited partners (LPs) for PE firms to demonstrate their comprehensive approach to ESG. Increasingly, PE firms must be able to prove that their policies at least match the minimum ESG criteria set out by LPs.

But there are other drivers too, according to Nadia Murad, a partner at Kirkland & Ellis LLP. “While investors are increasingly focused on ESG policies and procedures as part of their investment decisions, fund sponsors are also increasingly viewing ESG as an opportunity to not only satisfy investor demands, but also to mitigate risks, create long-term sustainable value in their investments and enhance returns for their investors,” she explains. “Societal and cultural shifts are also driving ESG considerations, reflecting expanding views of corporate purpose. For example, today we see investors and sponsors increasingly focused on diversity policies and commitments to climate change initiatives.”

Regulatory imperatives are further advancing ESG initiatives. In Europe, for example, the new Disclosure Regulation sets out detailed rules that will require firms, including most PE fund managers, to disclose how ESG considerations form part of their investment decision-making process and how their investment decisions impact sustainability factors. The regulation applies to fund managers, financial advisers and many other EU-regulated firms, as well as non-EU fund managers marketing their funds in the EU. “The focus on ESG in PE will only be increased with the new EU regulations which will start coming into force from March 2021,” says Mr Verwey.

To comply with the Disclosure Regulation, many PE firms will need to make changes to their reporting models and introduce processes to gather relevant ESG data, which can be quite complex. This will need to be done in a constrained time period, while juggling myriad other challenges related to the COVID-19 crisis which has already added significant pressure.

In addition to investor and regulator expectations, PE funds are also under increasing pressure from other stakeholders to improve their ESG credentials. Employees, particularly millennials, are keen to work for purpose-driven, socially and environmentally conscious organisations that embrace ESG principles. From a recruitment, retention and motivation perspective, PE firms will need to demonstrate their ESG commitment to current and prospective employees.

One way firms can signal their commitment to ESG is to link employee evaluation to the specific ESG-related performance of the fund and its portfolio companies. For example, a GP could have a reporting structure which links relevant indicators for the fund or portfolio company to the GP’s ESG objectives and targets.

Choppy waters

But the transition to ESG integration and reporting is not likely to be smooth sailing. Not only is there no ‘one size fits all’ approach to ESG integration, currently there is no set industry standard for quantifying or reporting on ESG, which creates its own challenges. “While there are numerous frameworks that have gained market traction and influenced ESG investing considerations – such as the UN Sustainable Development Goals, the UN PRI and, with respect to impact investing, the IFC Operating Principles for Impact Management – PE portfolios cover a wide range of industries and there is really no ‘one size fits all’ approach to ESG,” explains Ms Murad. “However, the lack of standardised metrics also provides PE firms with an opportunity to customise ESG policies, procedures and metrics that are tailored to their portfolios.”

According to Kirsten Lapham, a partner at Proskauer Rose LLP, EU regulations in this area are well intentioned and aim to harmonise the way products are labelled, to design a common language. “Metrics will be helpful to some extent,” she says, “but the challenge will be for global managers to be able to meet the expectations of both investors and regulators globally to reflect ESG considerations in their investments.”

Despite some reluctance to accept the benefits of ESG, particularly in terms of delivering ESG metrics without negatively impacting investor returns, the issue cannot be ignored. “ESG has and will continue to be a key focus of PE firms, with the principal drivers being investor demand, regulatory requirements and firms themselves increasingly seeking to bring ESG considerations into their decision making,” suggests Mr Verwey.

Recently, there have been fears that the COVID-19 crisis would dilute or distract PE firms’ commitment to ESG, but in fact the opposite may prove true, with the pandemic serving as a catalyst for raising awareness. In a J.P. Morgan poll of investors from 50 global institutions with a total of $12.9 trillion in assets under management, 71 percent of respondents noted that it was ‘rather likely’, ‘likely’ or ‘very likely’ that the occurrence of a low probability/high impact risk, such as COVID-19, would increase awareness and actions globally to tackle high impact/high probability risks, such as those related to climate change and biodiversity losses. For governments, regulators and investors alike, the COVID-19 crisis may change opinions around the need for a different approach to investing in the years ahead.

Reaping the benefits

On an organisational level, PE firms will need to take steps to give ESG issues the consideration they require. Those that try to cut corners may regret it. For example, the potential backlash against greenwashing – putting out misleading or unsubstantiated claims about their ESG profile to capitalise on the sustainability trend – can be severe if exposed.

“Firms must do what they say, and say what they do,” advises Ms Murad. “While best practices are still evolving, firms should consider a few things. First, formalise an ESG policy. Make sure that policy accurately reflects a firm’s operations and procedures. For example, how is ESG integrated into investment decisions, monitored over the course of an investment and reported on? With the SEC’s focus on ESG, it is important that any disclosures accurately and adequately describe a firm’s ESG policies and procedures. Second, ensure commitment from the top down. Most firms that integrate ESG successfully believe it is an important part of value creation and good investing. And while it is core responsibility of ESG personnel within firms, those companies that do not have dedicated ESG personnel would need to work with outside experts, attorneys and consultants to stay abreast of industry and regulatory developments and best practices.

“With ESG expanding to cover everything from diversity to climate change, growing investor demand and an increasingly complex global regulatory framework, outside experts can help firms stay up to date,” she adds.

According to Ms Lapham, while it may be too early to say that something is a ‘best practice’ when it comes to ESG in PE, firms that have taken the initiative and lead in this space will have the advantage of being ahead of the curve. They will lead the industry because they already have ESG policies that are comprehensive, they are signatories to the UN Principles for Responsible Investment or similar standards, and they have engaged with experts in this area. Integration of these concepts from a regulatory compliance perspective will, therefore, be an easier process for these firms.

“Fostering relationships at company level and ensuring diversity metrics are upheld can only lead to employee satisfaction, better reputation over time and less staff turnover,” points out Ms Lapham. “Reducing waste at the portfolio company level and in your investments will lead to lower costs over time through reduced waste.

“Having a strong ESG proposition will create value over time,” she continues. “Firms will be more prepared and have minimal disruption from regulatory change in this area. Value will be created through top-line growth by attracting investors that are increasingly focused on these issues. In addition, ESG will create value in the long term just by ensuring you do not fall behind competitors that have diversified and are enhancing investment returns by allocating capital where they are likely have longer term ESG outcomes,” she adds.

Even prior to the COVID-19 crisis, issues such as climate change and social inequality were featuring more prominently on the agenda – and they will be there long after the COVID-19 crisis has passed. Once the dust has settled and life returns to ‘normal’, ESG will occupy a key strategic position in business thinking, particularly as investor demand for sustainable investing continues to grow. This interest echoes societal and cultural shifts over the last few years, which are reflected in ESG and impact investing opportunities.

“The COVID-19 pandemic put a spotlight on the private sector’s role in solving the world’s biggest challenges and has increased interest and urgency in sustainable investing for both risk mitigation and long-term viability, reputation and profitability,” says Ms Murad. “We expect that these shifts, together with investor demand, will continue to put ESG and sustainable investing at the forefront for the private sector in the coming years.”

In the post-COVID-19 economy, PE firms will be expected to weigh up the balance between generating returns and ‘doing good’, and to find creative ways to achieve both. Of course, to maximise the PE dynamic, GP and LP interests should be aligned. In the end, what may be best for society and the environment may well be what is best for investors.

© Financier Worldwide

BY

Richard Summerfield