Responsible investing – the PE approach

October 2022  |  FEATURE | PRIVATE EQUITY

Financier Worldwide Magazine

October 2022 Issue

Influential private equity (PE) houses are increasingly showing signs of embracing environmental, social and governance (ESG) within their investment practices.

Not so long ago, sustainable investment was confined to a small, dedicated corner of the PE market. But over the past few years, a combination of factors has seen sustainability permeate almost every aspect of private markets. Across the PE space, ESG is increasingly recognised as a driver of value creation, rather than just a compliance or reporting topic.

In a survey of general partners (GPs) focused on assessing ESG credentials, Ardian found that 30 percent of firms have at least one full-time corporate social responsibility officer, up from 14 percent in 2019.

Against a backdrop of recent geopolitical, economic and health crises, responsible and sustainable investing has ascended. The legacy of the coronavirus (COVID-19) pandemic, the ongoing climate crisis and demands for a fairer and more equitable society are issues that PE firms are taking into consideration while still generating growth. Going forward, demands to create more sustainable economies and systems will intensify.

Pressure to consider ESG in PE investing is coming from a number of different sources, but principally from regulators and investors.

Regulatory bodies are adopting ESG mandates for company and investor actions. The EU Sustainable Finance Disclosure Regulation, for example, requires fund managers to disclose how sustainability risks are integrated into investment decisions and to ensure remuneration policies are consistent with the integration of sustainability risks. According to Bain’s 2021 PE report, the EU taxonomy would “force asset managers in the EU to disclose their share of taxonomy-aligned assets under management, inevitably creating an incentive to raise that share to remain competitive.”

Many GPs are also developing standards around sustainability and responsible investing, and have signed up to the UN Principles for Responsible Investment, which commits them to include ESG as part of investment decisions and reporting, and Initiative Climate International, which includes 90 GPs managing $700bn in assets.

As for investors, figures trace the rise of ESG issues among US investors, with 72 percent of respondents to one Morningstar survey expressing at least some attraction to sustainable investing. The most noticeable shift has been among younger generations.

Gen Z and millennials show the keenest interest in sustainable investing, according to a 2021 CNBC poll, with a third of millennials and 19 percent of Gen Z investors factoring ESG into their investment decisions, while 16 percent of Gen X and only 2 percent of baby boomers say the same. A 2021 Pathstone report suggests that millennial investors are more than twice as likely as older generations to be interested in making an impact with their investment decisions.

Gen Z and millennials have largely common views on key social and policy issues. Both groups tend to adopt more socially progressive standpoints than older investors, and these perspectives are likely to be reflected in purchasing or investment decisions. According to a 2018 Spectrem report, 52 percent of millennial investors see ESG as important investment criteria compared with less than 30 percent of baby boomers and 42 percent of Gen X investors.

Compounding this trend, millennials are set to inherit significant sums of money over the next decade. According to a report from the Coldwell Banker Global Luxury programme and WealthEngine, by 2030 millennials will hold five times as much wealth as they have today. This group is anticipated to inherit over $68 trillion from their baby boomer parents by 2030, one of the greatest wealth transfers in modern times.

With this impending shift in attitudes, there will be opportunities. More PE firms are focused on using ESG as a value driver. As such, many are no longer branding dedicated funds as ESG or sustainability funds, but are instead incorporating sustainability into all their investment activities.

Part of this includes greater scrutiny of potential greenwashing – where companies market themselves as ESG-friendly but do not provide the transparency and data to support such claims – during PE firms’ transactional due diligence. An eye on how to exit the investment is always on GPs’ minds, and unsubstantiated greenwashing claims may negatively impact future returns. It will be important to rigorously verify the target’s policies and practices relating to ESG, to identify issues that may need further investigation or clarification before the deal is closed.

PE stakeholders will ensure the importance of ESG considerations continues to grow. ESG issues –  including climate-related risks and the transition to a low-carbon economy – will dictate the direction of travel in the global economy for years to come, and the PE space will be no different.

As ESG impacts investment portfolios, it is vital that PE firms incorporate responsible investing into their general business strategy. It can no longer be considered a side issue, particularly amid burgeoning interest from investors and regulators alike.

© Financier Worldwide

BY

Richard Summerfield