How ESG shapes private equity

By: Kamran Anwar

Once considered a public relations ploy, adherence to an Environmental, Social, and Governance (ESG) agenda is now common practice in private equity.

In a recent Preqin survey1 , 86% of private equity investors say they intend to consider ESG policies when allocating capital. This shift is partly driven by end investors (e.g. public sector pension funds), who are not just content with private equity delivering generous returns, but require them to have a socially responsible operating model.

Governments are also encouraging an ESG agenda. For example:

  • The Paris Agreement commits governments to reduce global warming
  • The U.S. Department of Labor recently updated the Employee Retirement Income Security Act guidelines to acknowledge that ESG should be addressed in the investment process
  • Article 173 of France’s law on energy transition for green growth demands asset managers and other investors report on how ESG and climate change considerations are incorporated into investment policies
  • Pension funds in Sweden are seeking to decarbonise their portfolios by investing in passive fund structures tracking low carbon benchmarks

While there is uncertainty about the nature of deregulation in the U.S., more investors are making ESG a critical part of their portfolio selection. This is also driven by the outperformance of ESG-linked investments. Research by Cambridge Associates found the MSCI

Emerging Markets ESG Index outperformed the MSCI Emerging Markets Index by a cumulative 12% on a total return USD basis, of which 50% of the outperformance was attributed to ESG.

Private equity managers are ideally placed to incorporate ESG into their portfolios. They have a commitment to growing businesses and focus on long-term investment horizons, which must factor in ESG issues. However, the subjective nature of ESG brings challenges. For example, a distressed debt fund may seek to streamline inefficient companies through cost-cutting. While one investor may see mass job losses as contrary to its ESG principles, another may consider it necessary for sustainable growth.

The absence of standardized terminology also makes ESG tricky. Industry participants use several terms (e.g. Socially Responsible Investing, Sustainable Development, Impact Investing and Corporate Social Responsibility) which have different meanings for different stakeholders. Agreement on a universal definition of ESG would help mitigate this confusion, and interested parties are forming coalitions to help bring about greater alignment of expectations.

Due diligence professionals are increasingly including questions about ESG policy in manager reviews and verifying it during rigorous on-site visits. Private equity managers need to demonstrate that their ESG policy is more than just a tick-the-box mechanism. Investors will speak in depth with junior staff members to check whether a culture of ESG permeates throughout the business as opposed to being just a marketing buzzword.

The United Nations Principles for Responsible Investment (PRI) has created a due diligence questionnaire, and will publish guidance on how ESG provisions can be incorporated into LP agreements. The PRI will also develop best practice guidelines on how investors can monitor ESG adherence by general partners (GPs) during the fund lifecycle. Some GPs are signing the UN Global Compact, a voluntary platform that commits to ten ESG principles. However, signing up to the principles is not a precondition for capital allocation. Some lawyers caution firms against signing, as it can expose them to unforeseeable risks in emerging markets and where portfolio companies have highly complex supply chains. This could result in legal risk from aggrieved clients with ESG obligations.

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