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ESG integration in Private Equity – The carrot or the stick?

Maria Laura Tinelli

Maria Laura Tinelli, Acrux Partners Director

The integration of ESG considerations into a GP’s operations and fund management 
has been developing on the private equity industry’s for some time, both as a way of reducing material risks, as an opportunity to create value, or as a response to an LP requirement.  From all asset classes, Private Equity is particularly well suited to add value through ESG, because of its long-term investment horizon, its stake in corporate governance, and hands on approach to generating financial value through the optimization of a company’s use of resources, management, and growth.

The PE sector has grown considerably over the last decade,  driven by the availability of capital from institutional investors, of which Pension Funds are the largest contributors (having grown 6% per annum over the last decade to USD 35 Trillion in 2015) [1], and the delivery of superior returns as compared to all other asset classes over the long run, which makes PE suitable for a pension fund. As the industry grew, so did the demand and expectation from LPs and society at large (license to operate) for these investments to operate responsibly, making ESG part and parcel of how a GP needs to operate and deliver value at present.

However true integration of ESG by GPs in each stage of the investment cycle is yet to be mastered, and there is a gap between what LPs are demanding from GPs in terms of ESG integration and reporting and the use of this data to inform manager evaluation and feedback on performance, acting as a dis-incentive for GPs to take ESG reporting seriously, or see any added value.

Paradoxically, GPs have been integrating ESG historically in order to assess risks and leverage on strengths to generate growth, in this sense adding value through introducing these variables from due diligence onwards. However, over the last decade, with the surge in growth of the RI market, the development of regulation on the topic affecting LPs (Fiduciary Duty) and the demand of introducing ESG language and reporting as pre condition for funding; made these issues more of a tick in the box exercise than a integrated manner of adding value financially and to the societies in which these companies operate.

Two things need to happen, on one side there is a role to play by service providers such as Baxon and Acrux to coherently merge ESG reporting to standard financial reporting and data gathered from companies. The flow of this information from company to GP; and from GP to LP; needs to be be automated and equally proficient than routine financial reporting, allowing GPs to anticipate incidents and risks as they evolve. According to the PRI annual survey on PE [2], the majority of GPs are doing well in their ESG practices at policy, fundraising and pre investment levels, but do not have systematic processes in place for assessing and monitoring the impact of ESG issues on company value. It is imperative that this market gap is addressed.

Secondly, LPs need to start using this data, and feeding back to GPs. This will make the whole process and required investment to report on this worth the while,  and at the same time generate the much needed track record and benchmark to demonstrate that investing in this way, not only makes financial sense but also enables the increase of capital flow to this asset class.

 

PRI-PE-Report-on-Progress-2016-10

Source: PRI 2014/15 Report on Progress Private Equity

 

[1] TW Global Pension Asset study 2016, TW Global Alternatives study 2014
[2] PRI 2014/15 Report on Progress Private Equity (Download the Report)

Article by Maria Laura Tinelli, Director at Acrux Partners Ltd. Acrux Partners is an advisory firm focused on responsible and impact investing in Latin America. We assist our clients with the integration of environmental, social, and governance impact management into their investments.

Related documents: Baxon ESG Reporting – Integrated ESG reporting, the future is now