ESG in PE: the past and the future

Private equity (PE) has a long history of engagement with environmental, social, and governance (ESG) considerations, as detailed in the first article in this series. Recently ESG concerns within PE have increased however, and are currently going through a rapid transition due to increased investor demands, new regulations, and a rapid change in social expectations of business. The result is that ESG is no longer a distinct investment strategy or an add-on to ”normal” investment practices, but has become a common trend within PE.

PE’s consideration for ESG is partly due to the longer-term nature of PE investments, as opposed to the more frequent trading that often occurs in more liquid and public markets.

Furthermore, PE firms are incentivised to consider all factors that might be relevant to value generation on exit from the investment. These considerations have often spanned factors that might not be branded “ESG”, but which historically might have simply been deemed risks and opportunities in respect of a fund’s portfolio companies. Part of PE’s approach to ESG is to link ESG considerations with value creation, which might happen in other asset classes but often less explicitly.

This article provides an overview of the ESG considerations of the various entities involved in PE funds; namely, the limited partners (LPs), the general partner (GP) and/or manager/adviser to the fund, and the portfolio companies that comprise the fund’s investments. The extent to which ESG considerations are relevant to each of these entities is due to the nature of their economic role within the fund structure, and the regulatory and reputational considerations that apply to the entities involved.

LPs: investor-driven demand for ESG

The LPs within a PE fund structure can be comprised of a range of different investors, including institutional investors, family offices, and wealthier individuals. Their economic interests are aligned with the long-term nature of the fund and the need to maximise the financial value of the portfolio companies on exit.

Pension schemes are increasing their investments in private markets due to facing a demographic timebomb. Scheme members are on average ageing faster and living longer than before. This demands that pension schemes find innovative ways to secure higher investment returns, and particularly in an environment of chronically low interest rates.

Sustainable investing has grown in public and private markets, partly because of strong demand from pension funds. Underpinning this demand from the schemes is their members’ desire to achieve ESG outcomes and to access the higher investment returns that have been associated with sustainable investing.

This ”pull” from investors has been accompanied by a “push” from policymakers. UK occupational pension schemes are subject to several requirements relating to their stewardship policies, disclosures to scheme members, and consideration of ESG factors in their investment decision-making. In addition, the Government will require the phased adoption of the Taskforce on Climate-related Financial Disclosures (TCFD)¹ (as mentioned in the second part of this series), and the G7 economies agreed in 2021 to mandate similar disclosures. The EU’s Sustainable Finance Disclosure Regulation (SFDR) goes further, requiring a broader array of public (rather than only scheme member) disclosures.

Insurers are similarly impacted by demands for ESG from their clients, from policymakers, and on their own initiative for financial and non-financial reasons. The UN Principles for Responsible Investment (UN PRI) were followed by the Principles for Sustainable Insurance in 2012. More recently, insurers have received a nudge from UK regulators, which require consideration of climate risks within insurers’ prudential risk framework and stress testing. The SFDR and TCFD requirements are also beginning to bite.

It is not only institutional investors that are driving ESG demand from LPs. Family offices and wealth management clients are showing increasing interest, again for both financial and non-financial reasons. Younger investors display a marked interest in ESG matters. As wealth transitions to younger generations, the demand for sustainable investing is expected to grow.

These trends are likely to continue, not least because the regulatory ”push” continues apace. In addition to the full implementation of the previously mentioned regulations, a host of new reforms can be expected, such as the introduction of “green taxonomies” and green investment product labels in the EU and the UK, and the expectation of ESG reporting requirements in the United States.

GPs, investment managers, and advisers: value creation and reputation

While LPs are a source of ESG demands, GPs and their investment managers or advisers have their own incentives and direct requirements.

For one, PE and venture capital (VC) funds are increasingly subject to regulations. The previously mentioned SFDR requires alternative investment fund managers (AIFMs) to make detailed disclosures to the public (and not merely to their own investors) at both the manager level and at the product level. In summary, the SFDR requires managers to:

• formulate policies at the manager level in respect of sustainability risks, potentially in respect of due diligence in investment decision-making (identification of the so-called “principal adverse impacts”), and in relation to remuneration;
• assess the impact of sustainability risks (and principal adverse impacts if the manager has a due diligence policy) on all funds; and
• specific disclosures for funds classified as Article 8 or “light green” (funds that promote ESG characteristics), or Article 9 or “dark green” (funds that pursue ESG objectives). At a minimum, firms must integrate ESG risks into their investment decision-making (which in the absence of other ESG characteristics is termed Article 6 or “grey” funds).

The SFDR’s disclosures are detailed, comprising a series of mandatory metrics such as carbon emissions and human rights, and optional disclosures such as water use and social and governance matters. The requirements have driven a demand for ESG-related data from managers and about portfolio companies.

Product labelling systems, such as the green fund label, Febelfin, tend to be framed for the benefit of retail investors. The idea is to help ordinary investors easily identify a fund’s objectives and the type of investments that it can be expected to hold. Such labels have not been significant in PE due to its typically non-retail investor base. Nonetheless, the effect of the SFDR is to compel managers to classify their funds as Article 6, 8, or 9, although EU policymakers state that product labelling was not their intent. LPs are increasingly demanding that GPs designate their funds as Article 8, 9, or an intermediate category (“mid-green”). The rationale is to meet the demands of their own clients.

The EU’s Taxonomy Regulation imposes further demands. Managers will be required to disclose a key performance indicator: the proportion of the manager’s investments that are environmentally green, as classified by the rules. The UK’s own version is likely to follow suit. As noted in respect of LPs, UK asset managers and most listed companies will also be required to make TCFD disclosures.

The regulations go beyond public and investor disclosures. The EU has legislated for reforms that require AIFMs, MiFID investment firms (which encompasses many PE firms), and other financial institutions to take account of ESG risks in their investment decision-making, risk management, and governance. Regulated firms are expected to treat ESG risks in a way that is comparable to market risk, credit risk, or other factors that are material to their investor’s outcomes.

Recent regulatory demands have given greater impetus to an ESG trend that was already underway in PE, albeit at a slower pace, and it received a further nudge through the Covid-19 pandemic. By nature, PE firms seek to identify the companies and technology of the future, particularly at the VC end of the scale, and inevitably some of these companies encompass solutions to environmental and social problems. Stewardship and a close engagement with governance is a traditional concern for PE firms.

Beyond direct ESG outcomes, many PE firms increasingly recognise the importance of a company managing its ESG risks and promoting good ESG outcomes through rounds of funding and eventual exit. Setting long-term incentives for management that encompass non-financial objectives, and providing educational support, particularly to those portfolio companies that do not have in-house ESG resources, is increasingly integral to maximising the financial value of a manager’s investments.

These ESG concerns have been reflected in PE firms and investment managers becoming signatories of the UN PRI. The PRI provides GPs and managers with guidance as to how to integrate ESG considerations throughout their business, from deal screening and due diligence through to stewardship of portfolio companies.

In 2015, the UN also provided 17 distinct Sustainable Development Goals (SDGs), and beneath which there are hundreds of targets and indicators. In 2020, the UN issued specific SDG-related guidance for PE funds. The SDGs are useful to PE firms because investment objectives can be linked to specific ESG outcomes, such as clean water and good quality education. Consequently, PE and VC funds are increasingly adopting the SDGs as part of their investment strategies and disclosing their performance in their PRI reporting.

The issue has become how to measure portfolio companies’ performance in a manner that is accurate and comparable across investments, and how to disclose these metrics to LPs in a way that is transparent, useful, and that helps investors to comply with their regulatory and other obligations.

To that end, a new initiative, led by CalPERS and Carlyle, goes further still. Seeking to work their way through the mass of voluntary and regulatory standards, a partnership of 7 GPs and 9 LPs have agreed to collaborate on the creation of “a critical mass of material, performance-based, comparable ESG data from portfolio companies”. Collaboration on this scale (representing over £4tn in investment) is not only likely to shift PE’s approach to ESG, but also compares favourably with asset managers and asset owners that are in some cases struggling to operate within several different ESG frameworks.

Portfolio companies: acting for the long-term

Portfolio companies are recipients of the ESG demands made by their investors. Such companies might have an ESG ethos or targets of their own.

In addition, portfolio companies in a wide range of sectors are becoming subject to, or might eventually become subject to, regulatory ESG requirements.

We have already noted the EU’s Taxonomy and the UK’s proposed version, and the roll-out of TCFD-related disclosures in the G7 economies. So far, these requirements apply to large or listed companies. Consequently, many PE portfolio companies are not likely to be required to implement those disclosures, although there are good reasons that those companies or their investors might propose to opt-in to the disclosures. Some, such as BlackRock’s Larry Fink, have argued for the inclusion of private companies to prevent such companies pursuing “capital arbitrage” to avoid climate-related commitments.

Many jurisdictions are beginning to consider a more wide-ranging and detailed company ESG disclosure regime. Policymakers’ ambition is for companies to report on metrics (beyond a narrow range of climate and environmental objectives) that are relevant to their sector or material to the company. It is hoped that this transparency will result in good ESG outcomes by incentivising the disclosing companies to improve their reported metrics and to achieve their publicly disclosed plans. Beyond reputational implications, it is hoped that transparency might change the cost of capital because of company’s ESG past and planned behaviour. Put simply, better ESG performance might attract more, and therefore cheaper capital, while companies that perform poorly in ESG terms might struggle to fund themselves at comparatively low cost. Of course, achieving this outcome on a market-wide basis assumes that capital arbitrage cannot or does not happen.

Policymakers face several dilemmas in forming their frameworks that, in turn, could impact the demands that are placed on companies. First, regulators must decide whether disclosures should be mandated only for public companies or for private companies too; and if the latter, whether there should be a size threshold. Second, which stakeholders should be primarily served by a disclosure framework? Some suggest that the frameworks should “follow the money” and prioritise investors’ needs; others argue that activists, governments, and other interested parties should be provided for. Finally, how prescriptive should the requirements be? For instance, should companies have latitude to decide which metrics are relevant to their business, and what is the right balance between qualitative information and specific, comparable data points? There are trade-offs and market implications involved in each of these decisions.

Examples of disclosure frameworks include the EU’s proposed Corporate Sustainability Reporting Directive. The European Commission plans to legislate in 2022 and envisages that the framework will cover around 80% of European companies. Meanwhile, the UK plans to create Sustainability Disclosure Requirements. The scope of companies to be subject to the regime is not yet clear, but the intention is to align company reporting requirements with rules that will also be applied to certain types of funds and asset owners. In the US, the SEC has asked for public input on how to incorporate ESG into its market-wide integrated disclosure rules.

These new disclosure frameworks might apply directly to PE portfolio companies, to PE funds, or to LPs. Even if a fund, its portfolio companies, and investors are exempt from the rules, some might wish to opt-in to the requirements for financial or reputational reasons. Practically, this would mean aligning their public or investor disclosures with the regulatory rules and integrating the necessary inputs and outputs in the portfolio companies (for instance, in terms of the measurements that underpin the metrics).

There are several benefits that might arise from this. Relying on existing frameworks, market-recognised metrics and calculation methods could spare GPs, LPs, and companies the challenge of developing their own approach from scratch. A degree of standardisation across portfolio companies might also be desirable. Moreover, aligning a portfolio company’s disclosures with regulated frameworks could become a useful or crucial element of the fund’s exit strategy. Depending on the company’s growth trajectory, such disclosures might even become a regulatory requirement over a specific size threshold.

Where next for ESG in PE?

Absent of a significant shift in social values, the trend to sustainable investing will continue. PE’s and VC’s role as a selector and facilitator for the economy of the future means that the focus on ESG in this sector is also likely to grow.

Private markets will not be entirely insulated from ESG regulations for the reasons outlined in this article. This also means that PE firms can be expected to be subject to the same concerns that sustainable investing faces in other asset classes. We have already noted the challenges of robust and comparable data. Related to that, there are public concerns about greenwashing (that is, companies making ESG claims that they cannot evidence). Questions about “green bubbles” will persist, and lurking beneath those worries, the question as to whether sustainable investing will effectively change companies’ cost of capital to reflect their ESG performance. The proximity of ESG considerations with financial value in PE places the sector near the forefront of answering these questions.

¹ See the first article in this series for more detail about the roll-out of TCFD.