Companies across different industries are keen to make a positive impact on the wider society and environment while accomplishing their commercial objectives. The private equity industry is no exception.
According to a recent survey by Preqin, approximately 53% of the 300 respondents have established an ESG policy or have one pending.
Where do LPs and GPs see the value of ESG?
Limited partners (LPs) consider ESG integration as “an opportunity to generate long-term sustainable returns while fulfilling their fiduciary duties”, reviewing ESG policies in 86% of new fund commitments they make. General partners (GPs) go further and view it not only as a means to boost their credentials and competitive advantage, but also as a way to improve the financial performance of their portfolios.
Fig. 1 illustrates that, in a 2018 survey by Preqin, 58% of the 300 private capital managers reported that monitoring and reporting on ESG considerations provides them with a competitive edge. Moreover, 39% of them adopted these practices because they see a potential to create value, while 35% see it as an enhanced risk management approach.
Historically, ESG activities have been limited to ethics-based negative screening, which involves refraining from investing in certain sectors, businesses or practices. However, for a modern-day investment program to be successful, ESG needs to be at the heart of business practices and strategy. To maximise effectiveness, ESG strategy needs to be systematically embedded throughout the life of the fund – right from setting objectives for the fund, through screening and deal closure and continuing with actively monitoring the performance and reporting it to stakeholders. Here’s how:
The objectives defined in this stage form the stepping stone for the rest of the life cycle. For the holistic integration of ESG considerations within the investment process, it is important for LPs and GPs to clearly understand, define and align their expectations. A clearly defined strategy helps apprise portfolio company selection, inform data gathering and drive performance measurement. As a starting point, any strategy should consider the global context in which the prospective portfolio companies would operate and the most material ESG risks confronting them. Ideally the fund should also commit to a compliance framework at this stage to ensure that ESG risks are viewed and evaluated through a consistent lens by the portfolio companies, the fund manager and the fund LPs. Often GPs will become signatories to organizations that hold them accountable to regular reporting (such as Principles for Responsible Investment, PRI) to demonstrate their commitment to these factors.
Screening and due diligence
In the screening and due diligence phase, ESG criteria help in assessing a company’s quality and risks. GPs must align their evaluation of potential portfolio companies with investors’ ESG priorities and mandates. To be effective, alignment on these priorities should have been achieved during fundraising and in the framework selection. Portfolio managers sometimes establish an internal scoring system that can be used to assign an ESG score to the portfolio companies in the screening and due diligence phase. These ESG scores may be used as benchmarks to compare how portfolio companies rank against other companies in their industry, but also to serve as the baseline for the ongoing monitoring and measuring phase. Data is gathered from companies through questionnaires, public records of accident and injury, and investigation of legal and newsworthy events.
Monitoring and measuring
Monitoring and measuring ESG performance help LPs and GPs see the multifaceted impact of their investment activities. This phase helps GPs identify potential anomalies and develop action plans to mitigate them. Further, it enables them to compare ESG-related best practices among their portfolio companies. This stage essentially involves constructing ESG key performance indicators (KPIs) and putting in place governance and accountability structures that are aligned with the responsible investing strategy defined in the earlier stages. These non-financial KPIs should hold equal importance as their financial counterparts. To encourage staff and portfolio companies to meet these targets, investors or private capital managers can use incentives similar to those used for meeting financial ones. Private capital managers can leverage frameworks built by leading organisations in this space, such as PRI or CDC. The framework adopted by the GPs should be flexible enough to consider the regional and operational differences among their portfolio companies.
Managing ESG factors enables the creation of long-lasting impact. It helps improve the financial performance and reputation of portfolio companies, which in turn helps GPs to exit at a higher exit multiplier and maximize opportunities for subsequent fundraising. Sound monitoring practices reduce potential for surprises during due diligence by other GPs in a private exit, and potential for reducing or controlling headline risk can contribute to the risk-weighted value of the asset compared to other assets in the same industry.
Effective reporting, through all the above stages, is equally important as managing and monitoring ESG factors. LPs are proactively engaging with the GPs to better understand their portfolio operations and gain assurance that the GPs are committed to responsible investment practices established in the fundraising phase. As illustrated in Fig. 1, 48% of the 300 participating portfolio capital managers mentioned that LPs requested them to monitor and report on ESG factors.
The following illustration (Fig. 2) from PRI neatly clarifies the value proposition of reporting.
GPs act as the linchpin in data gathering and reporting from and to key stakeholders. Congruent with the theme of holistically measuring the performance, ESG and financial reporting cycles should be well aligned. A key question that GPs face during the reporting process is the assessment of “materiality”, i.e. deciding what information is relevant to be reported to the LPs and other external stakeholders. According to the PRI LP Responsible Investment DDQ Guidance,
“materiality encompasses quantifiable impacts on financial performance and investment returns, reputational risks and broader potential consequences on business operations.”
Despite the research showing the benefits of ESG integration into the investment cycle, what makes private capital managers shy away from it is the daunting task of gathering and monitoring ESG data. To see a complete picture of their fund performance, private capital managers need tools more robust than Excel. Preqin Solutions’ ESG & Impact module is a simplified tool that helps streamline ESG data management alongside financial data.
Want to know more about how our ESG and Impact module can help you put returns in context?