A lack of regulatory alignment on ESG disclosure has created a noisy backdrop of third-party standards and metrics so private equity funds are attempting to lead the way instead…
For much of the past 10 years, private equity firms have been swimming in an alphabet soup of ESG standards.
Recent estimates put the figure at around 200 standards globally, for reporting and assessing sustainability risks across fund portfolios. Many have little coordination between regulators, investors or across different jurisdictions.
A lack of standardisation can make it difficult to outwardly assess the impact of ESG progress on financial results and has left many GPs overwhelmed with data requests from LPs.
“We need to end this war of standards. We need to agree on a common methodology,” says Sophie Flak, head of ESG at French private equity firm Eurazeo. “What I’m telling my LPs, and what I discuss a lot with my fellow competitors is, could we please stop being creative about the methodologies we use? Could we please agree on what’s important?”
Agreement may be near, say ESG experts. Cross-industry collaboration between GPs and LPs, the development of bespoke in-house metrics and technology, and wider regulation are all accelerating the focus on a tighter set of agreed standards.
At COP26 in Glasgow towards the end of last year, the IFRS Foundation announced the formation of the International Sustainability Standards Board (ISSB) to develop a global baseline of sustainability disclosures for financial markets.
In January, the ESG Data Convergence Project announced a milestone commitment of over 100 GPs and LPs to a process which will standardise ESG metrics and “streamline the industry’s historically fragmented approach to collecting and reporting ESG data”, according to a statement from the group.
Data will be collected in April for the first year across six categories: greenhouse gas emissions; renewable energy; board diversity; work-related injuries; net new hires; and employee engagement.
GPs in the project’s steering committee have provided historical data from 2018-2020 from around 100 portfolio companies to establish a pilot data set.
“I would be surprised if what regulators come up with is remarkably different,” says Lorenna Buck, senior adviser at Boston Consulting Group, which is currently aggregating the data.
Early signs are positive: in 2018, only 1 per cent of the portfolio companies in the project’s pilot data set reported on their Scope 1 and Scope 2 emissions. In 2020, that number increased to 61 per cent.
Aligning such key performance indicators has been the greatest challenge among the many different benchmarks and providers to date, says Julien Krantz, research director at private equity association Invest Europe, which is separately working with the private equity industry on 10 ESG metrics of its own.
Sharing data
Krantz sees a clear shift away from commercial providers and more willingness among GPs to share their ESG performance data.
“It’s a learning curve [for them]. Commercial benchmarks and providers are no longer the leaders on this, and it is becoming more of an industry-led and owned initiative,” he says. “This shows that GPs are taking responsibility and it’s less of a box-ticking exercise.”
In May last year, EY found that only 34 per cent of firms it surveyed with more than USD15 billion in assets had a head of ESG, which fell to 12 per cent for firms with between USD2.5 billion and USD15 billion and to 2 per cent for firms with under USD2.5 billion in assets.
But as each month goes by, heads of ESG and chief sustainability officers are increasingly visible at large and medium-sized buyout groups, and pay is being tied to financial performance.
In a sign of how the industry is bringing ESG expertise in-house, Blackstone in November appointed the founder and former CEO of the Sustainability Accounting Standards Board (SASB) Jean Rogers as its new head of ESG, following 12 separate ESG hires across different asset classes during the year.
“The engagement that we already have with our assets in private equity means we can get the information that we need without necessarily spending years coming up with the standard,” she says in an exclusive interview with Private Equity Wire. “Private equity just moves a lot faster. There are some universal issues – decarbonisation and diversity – that’s what the Convergence Project is focused on, but beyond that it really comes down to what strategy you are driving and the data, is it specific? We can’t always wait five years for a framework.”
Other large PE houses have acquired environmental consultancies outright.
The development of in-house ESG capabilities and greater measurement makes GPs better able to engage with their LPs, move the needle on value creation in their existing portfolio and also screen new investments for ESG risks.
“LPs know that they want good ESG but what they really want is to be able to trust the manager to do a good job managing ESG issues – that we know how to identify and manage the correct issues,” says Colin Etnire, head of ESG at BC Partners. “What LPs are really investing in when they’re investing in the GP is the ESG team’s approach, so we provide data to justify it and validate their faith in us.”
Winners and losers
“Enacting fiscal policy is not just to inform investors, but to actively drive capital into certain sectors to create winners and losers,” says Rogers. “That is the opportunity companies should look to seize. If we all are too focused on disclosure and metrics, we are really going to miss what’s happening in the market.”
Those involved in ESG reporting for private equity firms believe there will ultimately be a wave of consolidation among commercial, third-party data platforms as industry alignment accelerates, leaving some space for the provision of industry-specific and portfolio company data, which can be more complex, particularly for smaller managers.
In a similar way to the measurement of financial performance and return benchmarks, experts expect around five or six ESG standards to emerge as reference points for private equity GPs and LPs globally, with some ability to customise metrics for regional differences, for example around diversity requirements or health and safety legislation.
“We align our approach with respect to what is happening in the regulatory space, but we see it as very important to stay flexible as regulation is only one part of what is driving the market,” says Moritz Haarmann, head of product development at asset service provider AssetMetrix. “GPs have different strategies and different metrics, and approaches will make more or less sense. One thing they all have in common though are their investors who will require more ESG transparency and regulatory compliance in the coming years.”
Moritz says there is appetite from some GPs for a more standardised reporting platform and for a data exchange capability with their LPs.
Forthcoming regulation moves, particularly in the US, will determine how truly global industry-led benchmarks can become. Regulatory momentum around ESG disclosure is currently with Europe, following the introduction of the SFDR last year, but expectations are growing that other jurisdictions will follow suit.
“Although GPs might at this point still be a bit divergent in terms of how they’re approaching the topics, with regulation as well as pressure from investors, it is in GPs and LPs interest that ESG disclosure and reporting becomes more aligned,” says Hanne Dybesland, product development, AssetMetrix. “The regulatory requirements are still in development and so are industry initiatives, meaning that it will still take some time before a clear and useful alignment comes into place.”
New world order
Indeed, the ESG Data Convergence Project may eventually incorporate some parts of this and the SFDR in Europe, says Buck at BCG.
“We know that not every part of SFDR is necessarily relevant to a global audience, but the goal right now is to do something that’s going to be relevant to a global audience,” she says.
“The prevailing thinking is that regulatory requirements will also come to North America,” says Yett at Hamilton Lane, “it’ll come to Australia, it will be prevalent in other parts of the globe, in very short order. So a lot of people are focusing on getting their house in order so to speak, and I think SFDR helps drive that.”
What will come from the US is still an open question, but more clarity is expected by the end of 2022 (see box). Whether it moves in line with the EU’s SFDR and the global industry’s own collaborative efforts to measure ESG will be watched closely by all concerned.
“I think the US will continue to be more hesitant to mandate particular types of outcomes,” says Etnire at BC Partners. “And I think this probably just reflects the American regulatory culture more generally. So as an industry we want to kind of define the standards on terms that we’re comfortable with. And then hopefully, the regulator’s jump on that or are comfortable with that rather than the other way around.”
Read the rest of the Private Equity Wire Insight Report: Creating Values: Behind the ESG Revolution in Private Equity
