Private equity cannot afford to leave out ESG

Green leaf

By Rodrigo Tavares, founder and president of the Granito Group – With fewer regulatory requirements compared with listed equity, the global USD4 trillion private equity market is lagging behind other asset classes when it comes to the adoption of ESG strategies. 

In recent years, the most noticeable movement towards ESG made by large private equity firms was related to the launch of new products, such as impact funds that select small and midcap companies according to specific environmental or social themes (e.g. education, healthcare, sustainable infrastructure) and align with the Sustainable Development Goals. TPG, KKR, Bain Capital, among others, have launched such funds. 

But the entrance hall cannot be mistaken as the ballroom. Notwithstanding the recent progress, private equity ESG implementation remains skin-deep and discretionary. Launching new products is a commendable step, but one that cannot grasp the full spectrum of opportunities unlocked by ESG. 

Investment firms should look at ESG policies, data, and practices as an aggregated layer of value that is embedded everywhere, from the company culture to the mathematical way money is allocated. 

The motivation to be ambitious is, in fact, related to the very nature of private equity. First, management firms are typically exposed to a considerable amount of risk, when compared to other asset classes, such as fixed income. In fact, in 1974 the US Congress restricted pension funds’ investment in private equity funds because they were too “risky”.

To cope with this, private equity firms should be highly equipped to not only identify all types of risk exposures but to convert them into performance boosting opportunities. And all companies are exposed to some degree of risks of an ESG nature, from mild to dangerously high. Neglecting them is akin to toying with recklessness. 

Second, the business of private equity – which can be traced back to 1901 when J.P. Morgan purchased Carnegie Steel Co – is about engaging with portfolio companies to enhance their performance. This cannot be done in a trade floor in a snap of fingers. It takes craftsmanship and time. So does ESG. Although the value of ESG can be identified in various timeframes, it is in the long-term that it generates superior long-term competitive financial returns. 

In essence, ESG focuses on process, not outcomes. It is more about the investment firm than about the products it manages. And it is a lot about leveraging ESG risks and opportunities to maximise value creation and long-term company performance. Unlike impact investing, in ESG integration there is no intentionality to positively impact society at large. It’s a welcoming side effect, but not the main agenda. Private equity with an ESG angle is oriented towards profit maximisation.

But how should private equity firms effectively integrate ESG practices? To begin with, they should focus on the firm itself. Company values and mission needs to be tweaked and ESG and impact targets that apply to all levels need to be set. Guidelines such as the UNDP’s SDG Impact Standards for private equity funds or the IFC’s Operating Principles for Impact Management are helpful in this regard.

Equally importantly, the company should adopt a Sustainable Finance Policy outlining commitment, practices, standards, and strategy towards ESG. With that in hands, ESG will branch out to various internal teams, such as legal/compliance and human resources. Some firms are starting to link ESG performance to compensation, for instance. And there needs to be some investment in the training of executives on ESG methods and concepts.

The second pillar is the integration of ESG in the investment cycle – sourcing, due diligence, investment, holding/engaging and exiting. ESG data needs to be integrated organically and be fully embedded in processes, operations and valuations.

For instance, ambitious private firms such as IG4 Capital are developing their proprietary valuation models (using DCF as a guideline) to quantify the value of ESG risk and opportunity for each company, at the entry and exit phases. Placing a monetary value on ESG relies heavily on data from the companies and it is not easy to achieve. But it becomes an indispensable tool once firms crack their way into determining the potential value that can be unlocked by doing ESG improvements at a company level.

Finally, private equity firms should develop outreach strategies which include participating in ESG-related associations (eg PRI or UKSIF), work to secure proper labelling and certification for their ESG activities and products, and annually report on their ESG activities (both at the portfolio and at the firm level) using standardised or proprietary reporting frameworks.

Private equity is very private. But firms may benefit if they disclose more, not less. For instance, as banks and credit ratings agencies move quickly to integrate ESG factors, private equity companies will access cheaper capital if they have an ESG track-record to boast.

Putting ESG criteria at the core of the investment strategy is meant to enhance, not constrain returns. With nearly USD2 trillion of dry-powder in 2020, this is something for private equity funds to bear in mind.

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