The Drivers and Challenges of ESG for Private Equity

Environmental, social and governance (ESG) impact investing and socially responsible investing (SRI) continue to be hot topics for private equity, and the trends appear here to stay. However, while these initiatives are at the forefront of the industry, there are challenges to successfully planning, implementing and measuring the impact of ESG-related strategies for PE.

Foundations of the Movement

ESG concepts are not new. The foundation for the movement has been an element of worldwide initiatives for years. Beginning as early as 2000, the Global Reporting Initiative (GRI), an international association focused on helping organizations understand and report on their impact, developed and expanded on a sustainability reporting framework, and most recently introduced the GRI Standards in 2016.

The United Nations Principles for Responsible Investment (UNPRI) listed below were developed by an international group of the world’s largest institutional investors in 2005, and private equity groups have been signing on to commit to these principles ever since. They include:

1. Incorporating ESG issues into investment analyses and decision-making processes;
2. Being active owners and incorporating ESG issues into their own ownership policies and practices;
3. Seeking appropriate disclosures on ESG issues by the entities in which they invest;
4. Promoting acceptance and implementation of the Principles within the investment industry;
5. Working together to enhance their effectiveness in implementing the Principles;
6. Reporting on their activities and progress toward implementing the Principles.

In addition, the UN General Assembly set up the seventeen sustainable development goals (SDGs) in 2015, which include (as written) (1) No Poverty, (2) Zero Hunger, (3) Good Health and Well-Being, (4) Quality Education, (5) Gender Equality, (6) Clean Water and Sanitation, (7) Affordable and Clean Energy, (8) Decent Work and Economic Growth, (9) Industry, Innovation and Infrastructure, (10) Reducing Inequality, (11) Sustainable Cities and Communities, (12) Responsible Consumption and Production, (13) Climate Action, (14) Life Below Water, (15) Life On Land, (16) Peace, Justice, and Strong Institutions, and (17) Partnerships for the Goals. Realizing the breadth of these goals, the UN adopted a resolution two years later in 2017 to provide targets and indicators for each of the 17 goals.

These goals and principles, along with many others worldwide, are being referenced by private equity managers working to implement ESG strategies into their business and investment policies.

Similarly, ESG and impact investing funds are not new strategies. We had the opportunity to speak with Deborah La Franchi, the founder and CEO of Los Angeles-based impact investing firm SDS Capital – which she launched in 2001.

“When I launched SDS Capital, there wasn’t an industry focus or even an investor base for impact investing,” she said. “I found myself having to engage in a significant educational process to get investors on board.”

Challenges in ESG Adoption and Implementation

Until recently, even with a history of ESG-related initiatives, investment managers have faced challenges that have delayed the buy-in to ESG investing and implementation:

1. The misperception that focusing on these initiatives is at odds with an investment manager’s fiduciary duty to their investors. “Without financial performance there is no impact,” said La Franchi. “Our SDS Capital Group tagline is core to our true investment philosophy: We are ‘driven by impact and grounded in financial stewardship;’”;
2. The lack of a clear definition on what qualifies as an ESG strategy, and what makes something sustainable; and
   Differences in which ESG initiatives are considered material. Will a fund prioritize socially responsible investing, diversity, equity and inclusion, governance issues or environmental issues?
3. Varying approaches to ESG incorporation by investment management firms due to lack of guidance. There remains inconsistency in how private equity is using ESG in their investment decision-making and diligence, which creates difficulty when evaluating impact.
4. The risk that ESG measures taken by funds and their portfolio companies will be seen as superficial, in which case they risk “greenwashing,” or giving a false impression of the sustainability of investments within the portfolio. In more extreme cases, this could also result in non-compliance.

Key Drivers

While many of these challenges still remain, there are drivers pushing and supporting the movement in private equity.

“In the last 18 months, I have seen more change in the perception of ESG and impact investing than during the previous 18 years,” La Franchi said.

The Pandemic Has Led to Increased Momentum

Environmental issues have always been a main ESG focus, but the COVID-19 pandemic helped bring social considerations into the limelight as well. The pandemic disproportionately impacted poorer populations and minorities, further highlighting inequality. While many that remained employed were forced into a long-term work-from-home (WFH) situation, decreased morale and depression were on the rise. The lack of in-person schooling and child care created both learning challenges and balance struggles in the home. In the age of social media, company and fund responses to these issues was also on full display. As social pressure has increased, so have expectations.

ESG is a Focus for Stakeholders

Limited partner behavior has been a key force driving ESG in private equity, as many investors have begun to include ESG considerations in their allocation decisions. Data has suggested that ESG funds have been outperforming, and the perception of ESG has shifted from “the right thing to do” to an opportunity for value creation. This is changing the landscape of investors that are allocating to ESG.

“Our investor base has evolved more over the past 24 months than during the preceding 18 years,” La Franchi said. “SDS Capital Group started raising funds in 2001. 95% of the capital in the impact funds we helped develop came from banks with the remaining 5% from foundation endowments aligned with our mission. The investor base has expanded significantly over the past two years. A wider range of corporate and public-sector investors are now entering or starting to consider impact investing. Even public pension funds are now willing to consider investing in impact funds -- as long as the strategy adheres to a risk-adjusted rate of return that is competitive with similar non-impact strategies. I’m thrilled to see these big changes over just the past 24 months!”

Diligence and expectations from limited partners have also changed. Investors are not only prioritizing how a private equity group or business may be implementing ESG, they are also looking to allocate to minority or women-owned funds and businesses. ESG is also becoming an increasingly important factor in attracting and retaining talent. There are now reputational risks as well as fundraising challenges facing managers that fail to include ESG in their business and investment decisions.

Regulations are Forthcoming

Domestically, President Biden has made it clear that ESG is a priority for his agenda, which is expected to translate to increased regulation. The SEC is focused on ESG disclosures, further fueled by the European Union’s Sustainable Finance Disclosure Regulation (SFDR), which went into effect in March 2021. The SFDR imposes stricter rules and requirements on financial market participants such as investment firms with regards to their sustainability practices and disclosures. Even if not impacted by the SFDR directly, private equity firms will need to begin to think about how these regulations could be adapted to them in the future.

Data and Technology Are Creating Opportunities for ESG

Tools have been surfacing to monitor ESG performance, such as Preqin ESG Indicators providing ESG scoring for a portfolio, or the Global Impact Investing Network’s (GIIN) IRIS+ system for measuring, managing, and optimizing impact. In 2020, Apex Group also launched an ESG ratings and advisory platform specifically for private markets. Further, companies are offering ESG materiality assessments for private equity. As technology advances, so will the availability of data and statistics to measure impact, breaking down some of the challenges to successful implementation and creating better transparency for investors.

The Evolution of Accepted Metrics and Guidelines Can Lead to Greater Consistency

There has been an increased push to provide the market with guidelines and metrics related to ESG. In mid-2019, the Institutional Limited Partners’ Association (ILPA), a global community of private equity investors, released their ILPA Principles 3.0, which included a section dedicated to ESG policies and reporting. The group also developed an ESG Roadmap for its members to guide them in best practices for implementing an ESG strategy. In 2020, the World Economic Forum introduced the “Stakeholder Capitalism Metrics” to guide companies in how to align reporting with ESG indicators. In 2021, the Value Reporting Foundation was formed through the merger of the Sustainability Accounting Standards Board and the International Integrated Reporting Council, with the goal of unifying to provide integrated reporting frameworks and standards. Most recently, the SEC’s Asset Management Advisory Committee discussed forming a subcommittee for recommendations on ESG related disclosure. As frameworks and standards become more widely accepted, they will provide clarity when defining and disclosing an ESG strategy.

Conclusion

The bottom line is that many of the difficulties in ESG adoption and implementation are currently being addressed, and with this comes both risk and opportunity for the private markets. Private equity funds should expect to receive increased questions during diligence from their limited partners on how they think about ESG in both their organization and their portfolio companies, as well as more questions from their own staff on how ESG is viewed and practiced at the fund. Funds that have already employed a thoughtful strategy with assistance from stakeholders and consultants may have a competitive advantage. With private equity stakeholders and regulators making this a priority, funds should take a proactive approach to evaluating and implementing ESG initiatives to minimize the risk of inaction.

“For a company or organization to create an ESG or impact investing strategy, there must be strong internal advocacy,” La Franchi said. “It takes intentionality and focus to create this approach. A good first step is to create goals within your existing investment strategies or portfolio. Holding impact managers to the high standards you apply to all your investment managers is critical to success when underwriting their products and conducting your due diligence. Impact should not trump financial performance.”

Our Current Issue: Q3 2021

• Checklist for SPAC Investors -- Investment Companies and Individuals
• The Drivers and Challenges of ESG for Private Equity
• Family Offices and Regulatory Scrutiny Following Archegos Capital Management Implosion
• Investing in a Venture Capital Fund: Tax, Regulatory, and Finance Implications