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Ready or not: ESG is coming

This article was first published in the Preqin Global Private Equity & Venture Capital Report on January 25, 2018.

Chris Ferguson, Preqin Solutions CEO

Chris Ferguson, Preqin Solutions CEO

ESG adoption in private equity is on the rise. A recent Preqin survey of more than 300 fund managers globally shows that 53% of respondents have established an ESG policy or have one pending. While encouraging, this data point alone may oversimplify the issue as historically ESG adoption figures can indicate a discord between policy and practice.

The private equity operating model and time horizon allow fund managers a significant opportunity to create environmental and social value within their portfolios while improving financial returns. But the practicalities of integrating ESG issues into all aspects of the private equity operating cycle – from initial screening of opportunities to due diligence and negotiating the deal, to oversight of the company while in the firm’s portfolio and finally capturing value on exit – remain daunting for many fund managers. A Capital Dynamics survey shows that while an impressive 94% of respondents incorporate ESG factors at acquisition diligence, only half of those are still tracking ESG at exit.

Investor Demand

ESG as standard practice across the private equity investment cycle is still in its infancy, yet recent investor surveys reveal an increase in the importance placed on ESG. A 2016 survey of global institutional investors by Schroders shows that 85% of investors based outside the US consider ESG factors in portfolio allocations, or expect to within the next three years. Separately, Preqin’s Investor Outlook, Alternative Assets: H2 2016 shows that 86% of investors consider ESG factors when making new fund commitments. While the standard for what constitutes satisfactory ESG implementation varies from LP to LP, most surveys show simply that more is better.

2016 survey of global institutional investors by Shroders2

This change is driven by both ethical and financial forces. ESG, and in particular environmental and climate issues, have a growing presence on the global political agenda. Investors also value the reduced investment risk and enhanced financial performance associated with sound ESG management. A study by State Street showed that 84% of investors are satisfied with the financial performance of their ESG strategies. A further paper from the University of Hamburg consolidated 3,700 studies on the impact of ESG. It showed a consistent and meaningful positive relationship between ESG factors and corporate financial performance, regardless of sector or period under evaluation.

ESG in the US

While 2017 will be remembered as the annus horribilis of the environmentalist in the US from a political standpoint, the shift towards a sustainable agenda outside of federal government structures is now inescapable. The adoption of ESG by financial institutions continues to lag behind the rest of the world, but a study by Callan Associates covering US investors shows that even this group is demonstrating an increasing interest.

Capital Dynamics survey - ESG Adoption

Another key factor when considering LP pressure for ESG adoption in US private equity is foreign investment. Preqin data shows that the percentage of foreign participation in US funds has grown from 13% to 25% in recent years. It is likely that, in the future, US fund managers will feel the pressure to adopt ESG policies from their international LP base.

Proportion of Capital Committed to the Average US Private Equity Fund Closed in 2010- 2017 by Investor Location

Reporting on ESG

As LP scrutiny on ESG grows, and frequent and reliable reporting of these issues becomes an expectation, the challenge for fund managers is to deliver and
differentiate. Fund managers require an effective means of collecting, consolidating and reporting on their ESG programmes.

The Capital Dynamics survey shows that 80% of respondents exhibit an appetite to invest in both portfolio company reporting on ESG and in their own ESG reporting to LP processes. Leaders in this field integrate ESG and traditional reporting to show how their advancements in ESG drive value creation within their portfolios, turning a traditionally cumbersome reporting process into a means of competitive differentiation.

Socially-responsible investment is more popular than ever. To keep up with market demands, fund managers should find ways to incorporate ESG across the investment cycle and make sure their investors know about it.

By Chris Ferguson, Preqin Solutions CEO

The 2018 Preqin Global Private Equity & Venture Capital Report is the most comprehensive review of the private equity and venture capital industry. For more information or to download sample pages, please visit The 2018 Preqin Global Private Equity & Venture Capital Report.

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