According to the American Investment Council’s 2022 Public Pension Study, at the end of FY 2021 U.S. public pension plans held an average of 11% of their assets in private equity (PE), with 89% allocating at least some amount to the asset class. Pensions & Investments reports the average allocation to private equity within college and university endowments is over 15%.
While not as large as allocations to public equities, it’s a LOT of money. So, we thought it would be interesting to discuss the role Environmental, Social and Governance (ESG) and sustainable investing play in the world of private equity.
Is ESG a “thing” in Private Equity?
According to an article by PitchBook (probably the best known source of data on private market deals and investing) ESG is having an impact on private equity as investors “increasingly acknowledge the materiality of risks beyond traditional accounting-based [data] and financial analysis.” A shift away from emphasizing short-term results is (slowly) making inroads in private market investing. And, since institutional asset owners are feeling increasing pressure from their stakeholders to incorporate sustainability across their investment activities, as limited partners (LPs) in private equity deals those institutions are pushing fund sponsors (the general partner, GP) to integrate ESG considerations in portfolio decisions.
Of course, this brings up the recent debate about ESG’s role in investing in general; namely shouldn’t an investor’s primary objective be to maximize risk-adjusted returns? And, as we have been saying for many years (long before the current brouhaha in the U.S. on this topic), the answer to that question is a clear “yes”. Actually, the answer is really, “yes, and…” – “yes, and ESG risks and opportunities affect returns over the long-term (and even in the short-term).”
Also, “yes, and we need to consider the time period over which returns are to be measured.” Public markets are often accused of being too focused on quarterly profits at the expense of long-term value creation. This issue of long-term, sustainable value is particularly relevant in private equity because exits for PE investments typically happen many years after a position is established. Yet PE funds often pursue short-term profits because valuations that determine quarterly fund returns can push portfolio companies to avoid cash outlays today that would boost long-term sustainability.
Why distinguish between public and private equity investing with respect to ESG?
Just about everything we discuss about E, S, and G issues affects private companies—from biodiversity to workplace diversity, cyber-security, supply chains, and the circular economy.
But when it comes to investing in private markets, evaluating and managing ESG risks can be more challenging than for public equities because data is generally less available. On the other hand, given that private market investing is long-term and investors have more of an influence on company management than in public markets, LPs and GPs may be in a stronger position to affect and benefit from the way ESG is integrated in a fund’s portfolio companies.
ESG matters to private market investors
Asset owners are incorporating ESG into their investment processes, including their private equity activities. According to PitchBook’s 2021 Annual Sustainable Investment Survey, 57% of LP respondents said they assess a GP’s ESG risk framework during manager due diligence. It should therefore come as no surprise that 61% of GPs who responded to the survey said they have implemented sustainable practices at the fund level. Actually, maybe it is surprising – we would expect the number to be even higher than 61%.
Having said that, there are some nuances among private market asset classes with respect to ESG initiatives. For example, private equity is not the same as venture capital in this regard, as PE deals involve more mature companies and more extensive due diligence than VC investing.
ESG risks for LPs to consider in fund manager selection
Integrating ESG factors into fund manager evaluations can give LPs insight on how a GP incorporates sustainability when making investment decisions. But what about the PE fund itself? If a GP lacks appropriate governance it faces reputational risks that could affect its ability to negotiate from a strong position, or even impact how it meets its fiduciary responsibilities.
The Institutional Limited Partners Association and the U.N.’s Principles of Responsible Investment, have both published due diligence questionnaires with ESG sections that LPs can use to analyze potential ESG risks in a GP’s investment processes. LPs may even impose some ESG-related parameters around how the GP can invest their capital when negotiating terms. PitchBook notes that LPs can also look for responsible investment policies or strategic ESG initiatives in a GP’s private placement memorandum (PPM).
ESG pre-investment red flags for GPs
This seems obvious, but maybe it isn’t, so we’ll point it out. As PitchBook notes, GPs should have a process for identifying potentially significant ESG risks that could affect a portfolio company’s long-term sustainability. They should be asking questions such as:
- Is the target company or its parent located in a high-risk country?
- Does the company have a history of serious human rights abuses or labor violations?
- Does the company have a history of failing to comply with industry regulations?
- Is there any evidence of a history of bribery or corruption?
- Has the company experienced any product boycotts, workforce actions, or negative social media campaigns?
GPs can gain some insight into ESG risks and how a private company is managing them by looking at data the company should be able to provide. This can include information on employee turnover, workforce diversity, data privacy and security incidents and audits, litigation data, employee injury and illness rates, among others. Again, these are the same issues we would expect active managers in the public equity markets to address.
GPs can also look at ESG risk scores for comparable public companies (such as OWL ESG’s Consensus Scores) and drill down into the details that go into scores and rankings (using OWL’s Detailed Data) to understand the risks a private company in the same industry may face.
ESG during the holding period and at exit
GPs and LPs can and should monitor ESG risks and opportunities throughout an investment’s holding period. ESG metrics that are trending in the wrong direction could negatively affect a valuation at exit. When GPs are preparing to exit an investment, they should conduct an ESG assessment to evaluate the portfolio company’s exposures and mitigation strategies. This is not only about looking for potential ESG-related problems—GPs may be able to attract a broader base of buyers or exit an investments at an “ESG premium”.
OWL ESG’s data and analytics can help private equity investors understand the KPIs and data used to assess ESG risks for public companies that are relevant for private market investing. Contact us to learn more.