ESG has been a trending topic for years, as public concern over climate change, social inequities and corporate accountability mount in countries around the world. Consumers and investors in virtually every industry, including private equity, are increasingly demanding that their vendors meet ESG criteria. New regulations, such as the EU’s Sustainable Finance Disclosure Regulation (SFDR), have only increased the commercial importance of ESG.
Standardised ESG reporting requirements are not yet widespread or binding, but many PE firms and companies are developing ESG strategies, policies and practices — including ESG reporting frameworks — while reporting is still voluntary. It can be difficult for PE firms to streamline reporting across multiple investments and jurisdictions. Taking a proactive approach to ESG will put PE firms in a position to maximise efficiencies and minimise risk when reporting does become mandatory. It will also position them in the market as forward-thinking on ESG matters.
The ABCs of ESG for private equity firms
ESG was first coined in 2005 in a study examining the role of environmental, social and governance value drivers in asset management and in the financial industry as a whole. The report, titled “Who Cares Wins,” made the case that incorporating ESG into financial strategies led to higher-yield investments, more sustainable markets and overall better societal outcomes.
While ESG may have once felt like a nice-to-have checkbox for socially-focused organisations, the tide has been turning — particularly in the private equity sphere. Firms are quickly realising that integrating ESG into their organisation and investment strategies is simply good business. Not only can an ESG-led investment strategy result in better risk-adjusted returns and a competitive edge, but it can also satisfy investors needing to justify investment or looking for funds with ESG reporting alongside revenues. Rather than viewing ESG simply as an expense, it is now seen as an intelligent investment as well as an opportunity to prepare for compliance obligations down the road.
While ESG criteria vary by industry and areas of specialty, some common areas of evaluation are:
- Environmental: Carbon or greenhouse gas emissions, electricity consumption, waste management, water management and natural resource management.
- Social: Health and welfare of employees and employment practices that centre diversity, equity and inclusion, which may include equitable hiring practices, pay scales and training opportunities.
- Governance: Management practices that underpin the “E” and “S” criteria of ESG. This may include corporate management structure, anticorruption practices and financial transparency.
ESG is on the cusp of mainstream global adoption by private equity firms. According to the 2020 Edelman Trust Barometer Special Report: Institutional Investors, 88 percent of limited partners use ESG performance indicators when making investment decisions. Signatories to the United Nations’ Principles for Responsible Investment (PRI) increased 42 percent in the last year, numbering nearly 4,000 institutional investors and PE firms representing over US$110 trillion in assets. Just recently, a number of private equity investors, collectively representing US$4 trillion in assets under management, agreed on what they believe will be the first standardised set of ESG reporting metrics for the PE industry. This “ESG Data Convergence Project” will create annual reports on metrics such as greenhouse gas emissions, renewable energy, board diversity and work-related injuries.
Clearly, now is the time for private equity firms to consider their ESG strategies. Adopting an early approach to managing ESG factors will ensure that firms stay ahead of the curve and are better prepared for the compliance obligations that will almost certainly soon follow.
Considerations for private equity firms developing an ESG strategy
If your PE firm is examining how to approach ESG, here are some best practices to keep in mind.
Evaluate your firm – and your investments – with an unbiased framework
The first step when developing an ESG strategy is to clearly define what ESG means to your firm. Using an external framework (which typically sets forth recommendation and evaluation methodologies) not only helps to take the guesswork out of ESG, but may provide clear justification to internal and external stakeholders. In the absence of a unified global ESG framework, many private equity firms select one that tracks best to their corporate goals and values. In addition to the UN’s PRI, other popular ESG frameworks come from the Task Force on Climate-related Financial Disclosures (TCFD) and Sustainability Accounting Standards Board (SASB). These frameworks can identify areas of opportunity for stewardship and improvement for your own firm, current investments and prospective portfolio companies.
Prioritise high-impact opportunities
As with any investment, identifying a few strategic areas for growth is often more successful than spreading efforts thinly across the board. After evaluating your firm and portfolio against a framework, it’s best to pick a few areas where you can really move the needle. If your portfolio companies are largely in energy, for example, you might want to concentrate on lowering your own firm’s carbon footprint and investing in companies with similar environmental practices. Investments in real estate might merit a higher focus on energy consumption and water management. Understanding what areas are top of mind for limited partners can help inform your prioritisation. Develop clear rationale around why you have identified certain areas as higher priority than others.
Set targets and develop a measurement plan
ESG criteria and related targets will evolve, so understanding how to effectively measure progress is an important step when implementing a strategy. Establishing clear performance indicators and baselines will allow year-over-year comparisons and lay the foundation for an effective reporting structure. A strong measurement plan can also benefit fund managers who often need to demonstrate a credible transition story when their ratings move upwards.
Establish regular reporting standards
While some ESG reporting requirements (such as SFDR) are in effect, ESG reporting for PE firms remains largely voluntary. However, reporting obligations are likely to increase as standardised approaches are rolled out. Firms must be vigilant about monitoring ESG regulatory changes so they are aware of reporting requirements across the globe and can balance these needs with reporting priorities from investors.
Organisations like SASB and the International Financial Reporting Standards (IFRS) Foundation are working to develop industry-wide ESG reporting standards. For PE firms, one of the biggest challenges in the current ESG landscape is developing a consistent reporting structure across all portfolio companies. It’s important to have high-quality data to help manage the complexity of collating information across multiple markets. Having a pulse on progress across all investments is an important part of preparing for future compliance requirements.
Integrate ESG into existing risk mitigation strategies
As we’ve seen, ESG is an important element of risk management for many firms, and that trend is likely to continue. In a recent study of PE firms, 72 percent of respondents reported that they always screen target companies for ESG risks and opportunities at the pre-acquisition stage. More than half of respondents have turned down a potential investment on ESG grounds.
Beyond risk, ESG can be a valuable metric for performance. One study showed that strong sustainability practices have a positive influence on investment performance. For that reason, many PE firms are using ESG as a litmus test to filter through potential investments and identify companies with a higher likelihood of success.
The private equity landscape is rapidly evolving, particularly when it comes to ESG. Firms that choose to develop and implement sound ESG strategies and practices now, rather than waiting for reporting requirements to be implemented later, will be in a far better position down the line to effectively manage risk.
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