Private markets - a $10 trillion segment with growing appeal - are increasingly looking favourably at environmental, social and governance (ESG) investing. Private equity (PE) general partners (GPs) that are signatories to the Principles for Responsible Investment (PRI) have grown stupendously - from 155 in 2010 to 2,351 in 2023¹.  In the first half of 2022, assets under management (AUM) dedicated to ESG investments surpassed $100 billion for the first time.  And over the year, two-thirds of private capital raised was attributable to asset managers that incorporated ESG factors² in their investment decisions.
 

What gives?

Awareness of risks from unsustainable practices is rising, as is evidence on how robust ESG practices  drive financial performance, and enhanced risk management based on identified risks and opportunities. In short, asset managers are finding out that it pays to ‘do ESG’. This trend is only likely to accelerate, given sustained client demand, evolving regulations, and mounting evidence of ESG’s role in value creation.

ESG or nothing, say about three in four limited partners

According to a collaborative study last year by the Institutional Limited Partners Association (ILPA) and Bain³ , investment policies of ~70% of limited partners (LPs) include an ESG-based approach. Furthermore, a dramatic three-quarters of LPs said they would stop investing in products that do not align with ESG principles. Increasing awareness of sustainability and its long-term value, improved risk management practices, evolving regulatory requirements, and increasing stakeholder expectations, are all driving up their interest in ESG. 

Regulatory tide is turning 

Regulatory frameworks worldwide are continuously evolving standardised labels and taxonomies to promote sustainable investments. To tackle data-related challenges, there is growing emphasis on convergence of standards of the International Sustainability Standards Board (effective 2024) and disclosure regulations of EU Corporate Sustainability Reporting Directive (applicable from 2024) and the US Securities and Exchange Commission (expected to be introduced by the end of this year). This progressive approach will equip GPs with a more robust framework to identify sustainable investment opportunities, manage risks effectively, and facilitate easy comparison across portfolio companies. 

ESG emerging as a value enabler

ESG considerations have evolved from being mere checklist items. ESG considerations have evolved from being mere checklist items. According to the ILPA and Bain study, value creation now ranks among the top three drivers for LPs incorporating ESG in their investment policies, with a notable 50% of them acknowledging so. 

This marked shift in perspective has resulted from a deeper understanding of the materiality of ESG factors and realisation that responsible and sustainable practices can lead to long-term success in the investment landscape. McKinsey’s research  further validates this. It shows that ESG outperformers achieved an excess return of 200 basis points over entities that only outperformed financially. 

Moreover, the concept of an ‘ESG premium’ during exit is emerging as a prominent market trend. PE firms are now anticipating the ability to achieve higher returns on investments due to their focus on companies with strong ESG metrics, as the latter are believed to be better equipped to withstand market shocks and outperform their peers.

Factors holding back faster ESG integration

Inadequate data

Collecting data from private entities is proving tough. For instance, the ILPA and Bain study revealed that less than a quarter of GPs were able to provide data on scope emissions upon request. Furthermore, fewer than 30% were able to furnish data on all principal adverse indicators, indicating gaps in ESG data collection and reporting practices within private investments. The study also highlighted the absence of standardised reporting frameworks and difficulties in obtaining relevant data from portfolio companies.

ESG-blind portfolio companies

Lack of ESG practices within portfolio companies makes it difficult to compare and assess ESG performance across various investments. Asset managers encounter difficulties in systematically assessing companies that have yet to embark on their ESG journey. This calls for GPs to invest additional time and effort to educate them about ESG practices - a luxury smaller GPs can ill-afford.

Soup of ESG regulations

The increasing number of ESG regulations has led to ambiguity and uncertainty surrounding their applicability across different jurisdictions.  Specifically, GPs find the EU Sustainable Finance Disclosure Regulation difficult to implement, due to its intricate requirements and complexities in identifying relevant ESG data and determining appropriate fund categories.

But solutions are close at hand

Following an approach that incorporates sector-level nuances and addresses data gaps could help overcome some of these obstacles.    

Alternative data 

To address data gaps in ESG integration, asset managers could harness alternative data. They could identify ESG risks and opportunities by recognising relevant company-specific key performance indicators, set targets through peer benchmarking, and gather data from sector-specific (e.g.,  FDA database for healthcare) and issue-specific (e.g., Aqueduct Water Risk Atlas) sources. 

Tailored approach 

A detailed and customised due diligence approach that includes sector-specific materiality assessment, industry research, regional risks and controversy analysis can enable asset managers mitigate ESG risks and identify opportunities for value creation. 

Proactive portfolio evaluation 

Asset managers must proactively identify and analyse potential opportunities when evaluating the performance of portfolio companies. This would allow them gauge the value derived from effective ESG management practices and strong governance structures, resulting in enhanced financial performance, reduced risks, improved stakeholder relationships and sustainable long-term growth.

Active engagement with portfolio companies 

Investment firms need to play an active role in supporting their portfolio companies in ESG reporting. They could assist in identifying and managing material ESG issues, creating a robust governance framework, implementing diversity and inclusion efforts, measuring emissions, and developing decarbonisation plans. Such guidance and resources can empower portfolio companies integrate ESG considerations into their business strategies. Many investment firms are already using a foundational ‘101 policy playbook’ for their investee companies.

Effective communication with LPs 

Effective communication using recognised frameworks enables LPs to evaluate ESG practices of GPs, track their progress, and make informed investment decisions. GPs can achieve transparent communication with LPs by adopting ESG disclosures aligned with internationally recognised frameworks such as the Institutional Limited Partners Association template, International Capital Market Association impact reporting framework, Task Force on Climate-related Financial Disclosures recommendations, and other industry-specific guidelines (e.g., Sustainability Accounting Standards Board and Global Reporting Initiative). Moreover, GPs are proactively exploring the implementation of a responsible investment policy that adheres to the specific guidelines provided by LPs.

Conclusion

The pushback to ESG notwithstanding, it is finding growing appeal among private market investors at the moment. This is leading asset managers to increasingly weave ESG into their strategies. To overcome challenges in doing so, investment firms could leverage alternative data, customise due diligence to account for sectoral and regional nuances, and actively engage with portfolio companies to up their ESG quotient.  These initiatives will help asset managers make ESG work better for them, their investments and all stakeholders.

References 

¹PitchBook Research : Are “ESG Investors” Underperforming?
²McKinsey Global Private Markets Review 2023 : Private markets turn down the volume
³Report:Limited Partners and Private Equity Firms Embrace ESG
⁴Here, outperformers are defined as companies that have demonstrated improvement in their scores across a range of evaluated ESG metrics over a period (McKinsey Global Private Markets Review 2023).