ESG in PE: responding to the demands for responsible investment
Success in adversity: PE’s continued boom in 2021
In the last 18 months, as the pandemic has gone from an initial short-term concern to an economic earthquake that has affected the global economy, the private equity (PE) industry has continued to boom. The value of PE deals globally has hit its highest level since 2007, totalling over US$500 billion in buyout deals in the first half of 2021. The number of deals announced in the same period reached an all-time peak of 6,298.1
Given the size of the PE industry and the generally increased focus on environmental, social and governance (ESG) factors, it is unsurprising that PE houses are coming under more scrutiny from investors, regulators and the wider public to address proactively the impact their operations have on the environment, society, business stakeholders and financial markets more generally.
A brief history of ESG in the PE industry
The influence of ESG on the PE industry is not a recent development. Its roots can be seen in the Walker Guidelines, first published in 2007 to increase transparency and accountability within the PE sphere. In particular, the Walker Guidelines provide for enhanced reporting obligations on portfolio companies which extend beyond the disclosure requirements for non-PE funded private companies. Although compliance with them is voluntary, these guidelines suggest that portfolio companies provide information on employees, social, community and human rights issues or explain why if this information is not contained in the company’s annual report.
Whilst the Walker Guidelines were specifically targeted at the PE industry, the Principles for Responsible Investment (PRI), launched in 2006 and championed by the United Nations, more widely sought to corral efforts on responsible investment across a range of institutional investors. The PRIs require signatories, amongst other commitments, to incorporate ESG issues into investment analysis and decision-making processes, and to seek appropriate disclosure on ESG issues from portfolio companies. The number of PRI signatories among PE houses is increasing, with European houses in particular having signed up. At present, PE signatories include heavyweights such as CVC Capital Partners, KKR & Co. and Bridgepoint Advisers.
It is therefore a mischaracterisation to say that PE houses have only recently started to focus on ESG factors. Whilst the pandemic has no doubt helped to accelerate the focus on ESG, PE houses have, for over ten years, reflected on their broader responsibilities as investors.
The current state of play
A review of their ESG policies is no longer an optional exercise for most PE houses. According to a BDO report published in October 20202, 57% of PE houses surveyed reported on the changes they have implemented to account for ESG principles in their investment process. In addition, 48% of PE houses reported in detail on the ESG impact of their investments.
The demand for ESG reporting is partly driven by limited partners, who in turn have their own demanding ESG criteria. However, many PE houses are not yet fully satisfying the “best practice” demands of their investors. For instance, in 2020, only 29% of PE houses made their full ESG policy publicly available and only 25% had a dedicated individual or team responsible for accounting for ESG factors in investment-making decisions.3 While robust analysis of the PE industry can be difficult due to reduced visibility as compared to public companies, research has suggested that only a small minority of PE houses receive reports from their portfolio companies on ESG factors, and many PE houses do not disclose whether ESG issues impact financial performance.4
As investors and the public have become better versed in ESG issues, the accusations against the PE industry of greenwashing have grown. Greenwashing, as defined by the UK’s Financial Conduct Authority, is “marketing that portrays an organisation’s products, activities or policies as producing positive environmental outcomes when this is not the case”. More recently, the term has come to encapsulate wider ESG claims in the PE industry, as claims have arisen that PE houses are able to distort data to reflect a more favourable public profile on ESG matters more broadly. The results of a 2020 survey published by Intertrust highlight that nearly half of respondents are concerned that, by using their own ESG scoring methodologies, they leave themselves open to accusations of greenwashing.5
In order to defend these attacks, PE houses must be able to point to clear written statements of their ESG intention, together with qualitative and quantitative data as to how these policies are applied in practice. The regulators have also become more actively involved in seeking to prevent greenwashing. In the EU, the Sustainable Finance Disclosure Regulation (SFDR) has already been implemented requiring PE funds marketed in the EU to include certain disclosures on how ESG is integrated into the investment decision processes, and identifying those funds which seek to achieve a positive ESG outcome. In addition, most PE firms will fall into the scope of the Investment Firm Directive in the EU (which came into force in June 2021) or the Investment Firms Prudential Regime in the UK (coming into force in January 2022). Each of these new regimes has significant governance and risk requirements including ESG considerations. In the US, a new climate and ESG task force has been set up to identify any greenwashing by firms to investors.
The path forward
As more PE houses embrace the ESG movement, the importance of having a clear ESG strategy to maintain a competitive edge when seeking investment has become increasingly apparent. From a legal perspective, in addition to compliance with any obligations it may have under SFDR, there are a number of tools that a PE house can use to improve its ESG profile.
- Concrete policy commitments: PE houses should document their approach to ESG in a publicly available document. Such a document should set out a PE house’s core ESG principles, as well as a summary of how ESG factors are embedded into the investment process. Sponsors may also elect to require their portfolio companies to adhere to specified ESG standards.
- Reporting: ESG reporting in PE houses is threefold: (i) reports published regarding PE house’s own corporate approach; (ii) reports published by the PE house and addressed to its investors, including the use of sustainability linked debt facilities; and (iii) reports published by portfolio companies and addressed to the PE house. Reports made to limited partners may include an explanation of the PE house’s ESG policy and its implementation in its annual or quarterly reports. Reporting may also be more mechanical, such as a requirement by limited partners that the PE house make a representation on each drawdown notice that the relevant fund is in full compliance with the PE house’s ESG policy. Where not already implemented, PE houses should consider requiring portfolio companies to make disclosures on a range of ESG factors as part of their annual reports. The PE house should carefully consider the extent to which the nature and scope of any such disclosures are prescribed by it. Finally, PE firms may wish to consider voluntarily complying with SFDR as a matter of “best practice”’ even if it is not directly applicable to it and its fund products.
- Scoring and screening: as PE houses set out reporting requirements for their portfolio companies and seek further information from potential targets, defining a robust and defensible approach to scoring will be critical to defending accusations of greenwashing. Furthermore, using appropriate horizon scanning of investments at the research and pre-due diligence stage to understand the prevailing ESG risks will support investment decisions.
- Due diligence: PE houses should incorporate questions on ESG factors in their standard due diligence questionnaires. The British Private Equity & Venture Capital Association (BVCA) has provided some guidance on areas to be considered more carefully at due diligence stage. For instance, in February 2021, the BVCA published guidance on diversity and female entrepreneurship which proposed that PE houses include diversity and inclusion (D&I) questions during due diligence. Such questions may include a request for the demographic data of teams and samples of policies and strategies that support D&I. While poor feedback on ESG factors may not in and of itself preclude investment, areas for improvement should be investigated and post-completion actions to address the concerns raised at due diligence should be taken and reported on internally.
- Training: PE houses should not assume an understanding amongst their employees of ESG matters. Annual training on legislative changes, current ESG trends and the PE house’s own internal policies will ensure that ESG considerations are pervasive within the firm as opposed to being rhetoric that is not implemented in practice. Similarly, PE houses should consider inviting management teams to training sessions which give guidance on what portfolio companies need to do to comply with the PE house’s prescribed ESG standards, as well as what is expected in terms of annual reporting on ESG factors.
While the growing dialogue on ESG may seem like the corporate governance trend du jour, it is clear from the increasingly prescriptive legislative framework, as well as the formalisation of ESG policies at investor and PE house levels, that a focus on ESG is not a passing trend. As investors become more sophisticated in their review of PE houses’ ESG records, in order to remain competitive when it comes to fundraising, sponsors will need to ensure that their ESG policies and implementation thereof reflect the industry’s best practice.
To find out more on the green halo effect and ESG in PE debt documentation, read the second article in this series on ESG in PE.
1FT, “Private equity breaks 40 year record with $500bn of deals” (1 July 2021)
2BDO, “Two thirds of private equity houses now take ESG into account, but more progress remains to be made” (19 October 2020)
3BDO, “Two thirds of private equity houses now take ESG into account, but more progress remains to be made” (19 October 2020)
4Institutional Investor, “Private Equity makes ESG promises but their impact is often superficial” (June 2020)
5Private Equity Wire, “PE houses reveal concerns on impact measurement, lack of standardised data, and greenwashing amid fast-rising ESG focus” (23 June 2020)