ESG in private equity: From why to why not?

The Principles for Responsible Investment (PRI) initiative to promote responsible investment across several asset classes, including private markets, now has over 500 private equity funds as signatories. Indeed, the dichotomy between private equity and ESG is a false one: in many cases ESG is synonymous with operational best practice, something which private equity strives to implement during the period of time they hold a portfolio company.

Many have been critical of private equity’s lack of engagement with ESG monitoring and reporting (beyond a small group of ‘impact’ or ‘exclusion strategy’ funds) with the task of capturing ESG data from private portfolio companies simply falling under the heading of ‘too difficult’.

One of the key challenges for private equity is the inconsistency in how ESG is reflected in investment choices, and the absence of an accepted standard on data formats. We must take into account that the listed space has a multitude of data collection solutions, providers and indices, there are few reputable independent, global ESG providers for the private markets.

The market remains extremely hungry for a quality, independent ESG offering, in order to pre-screen and assess current portfolios. We have been pleasantly surprised by the number of funds, both large and small willing to engage with the ESG conversation and are excited by the proposition of solutions to enable the collection and analysis of data.

With appetite, and pressure to meaningfully engage with ESG, there remain four primary questions facing private equity: What reputable methodology to use, and data to capture to avoid accusations of ‘greenwashing’? How to source the data in a time efficient, logical and accurate manner? Who to then measure performance against including international standards and sector peers?

An independent, end-to-end, high class offering has long been needed, not only to drive relevance, consistency and longevity surrounding ESG, but also to create better, more risk resilient, more profitable and valuable companies, across all facets of the investment cycle.

Demand for non-financial, ESG reporting is rising from a range of stakeholders and there are four key drivers of ESG disclosure. Firstly, LPs are now considering the ESG criteria of the funds they invest in more closely than ever and the demands being made on private equity managers are ultimately no different from those made on public companies by institutional investors and pension funds.

As in the public markets, ESG is no longer a ‘nice to do’ but has become an essential part of their due diligence. We anticipate that soon GPs will be required to pass an ESG screening as part of their vetting process as LPs demand more transparency into ESG policies, procedures and performance of portfolio assets.

However, greenwashing remains an ongoing LP concern and to demonstrate credibility, managers are going to need to make a concerted push to incorporate ESG metrics into their investment methodologies and show the financial value that comes from this approach.

National and supranational governments and economic unions are regulating across the ESG universe. Both LPs and GPs want to show market leading credentials and compliance voluntarily before they are forced to change by the implementation of regulation.

With less than six months until the introduction of the EU Sustainable Finance Disclosure Regulation in March 2021, the regulatory imperative for funds to better understand the ESG status of their portfolio investments is looming large.

The EU Sustainable Finance Disclosure Regulation will require asset managers to report on the sustainability characteristics of their investments.

And finally, an often overlooked driver is that private equity funds are facing employee pressure at all levels, seeking action from the inside out to make change.

As we know from our own experiences, especially during the Covid-19 pandemic, people want to work for purpose-driven organisations, that stand for more than only making money.

Being able to demonstrate this is key for recruitment, retention and motivation of the industry’s top talent, especially for the generations who grew up during the global financial crisis. Some theorised that the coronavirus outbreak and the focus on value preservation would dampen private equity’s commitment to ESG, but we are yet to see any signs that this is the case.

From a practical perspective, private equity firms have a duty to live up to the ESG commitments they made to their investors when raising their funds and must avoid the reputational damage that might be done by cutting corners.

From what we have seen so far, there will be increased pressure from the LPs to ensure that non-financial risk mitigation plans are developed and implemented and a rigorous ESG analysis of their portfolio companies will be an obvious starting point.

As the pandemic begins to abate, private equity investors and their portfolio companies are in a unique position to act as change agents to build back better, and ESG must play an integral part in this.

Source: Private Equity News