ESG in 3 Acts
If you’re a fan of Hollywood cinema, you’ll notice that most screenplays follow a three-part structure. Act I introduces the characters, their world and their motivations. Act II presents an obstacle or conflict that challenges the characters’ strength or capabilities. In the final act, our heroes forge a new path to resolve the crisis or save the day.
Private equity’s navigation of the current challenges presented by the implementation of environmental, social and governance (ESG) policies reflects Act II of this journey. During the first act, the industry saw more fund managers adopt ESG policies. Whereas 10 years ago, ESG policies were the realm of European funds or American mega-buyouts, today, most private equity funds would agree that ESG policy is required to attract institutional commitments.
After a year that gave us the combination of a pandemic health crisis, greater focus on climate change and stark awareness of racial injustice, the application of ESG policies has become more complex. Moreover, limited partners (LPs) and fund managers alike have become more focused on enhanced company operations tied to the implementation of ESG analysis, resulting in more pressure to create meaningful ESG standards and comparable disclosures.
ESG Resources for Fund Managers
Carbon Disclosure Project (CDP): Guidance for Companies
Climate Disclosure Standards Board (CDSB) Framework
Global Reporting Initiative (GRI): Standards for Sustainability Reporting
ILPA: ESG Roadmap and Resources for Limited Partners
ILPA: Diversity & Inclusion Roadmap for Limited Partners
What Is ESG?
ESG policies in private equity investing are used to analyze risk factors related to the environmental and social impact and governance of portfolio companies. This goes beyond just focusing on social impact goals or just promoting energy transition away from carbon-based fuels. And for private equity investors, ESG applies to all companies, from software to financial services and from energy to manufacturing.
Private equity investors have an advantage over investors in public securities when analyzing companies’ ESG risk factors. Because fund managers take ownership stakes and work directly with portfolio companies, they have access to more information and can influence company operations. Moreover, the long-term nature of private equity is aligned with the goals of responsible investment. Fund managers typically follow a framework, such as ones they designed for their specific investment processes or the one outlined by the United Nations Principles for Responsible Investment (U.N. PRI), to assess and monitor ESG factors from the deal-sourcing stage, investment decision, ownership and eventual exit.
Identifying portfolio companies’ ESG risks may be challenging because ESG factors differ by industry. The Sustainability Accounting Standards Board (SASB) has created industry-specific disclosure standards of financially material sustainability information, which serve as a guide. For example, the dimension of “social capital” includes data security and customer privacy for financial service companies, while focusing on customer welfare and product labeling for food and beverage producers. These standards can also be applied within ESG frameworks, such as the U.N. PRI.
The adoption of ESG policies is growing in the private equity industry, with notable regional differences. EY’s 2021 Global Private Equity Survey found that 92% of European managers have an ESG policy, compared to 64% and 67% of managers in North America and Asia, respectively.
LPs’ role in ESG
Over the past 5–10 years, LPs’ due diligence inquiries about responsible investment motivated more fund managers to adopt ESG policies and procedures. Not surprisingly, these questions emanated from LPs’ need to assess ESG risks in their own portfolios. According to Pitchbook’s 2020 Sustainable Investment Survey, 95% of LPs are either already evaluating ESG risk factors or will be increasing their focus on ESG risk factors in the coming year.
The importance LPs place on fund managers’ ESG policies continues to increase. A recent survey by Private Funds CFO found that 88% of LPs say that ESG is a consideration when evaluating managers, up from 81% last year. In addition, 38% of LP respondents indicated that ESG forms a “major” part of the due diligence process, compared to 31% last year.
Diversity as a greater ESG risk
The past year not only accentuated the focus on ESG, but also prompted greater emphasis on one social dimension: diversity. After the death of George Floyd sparked protest marches and forced a national reflection on racial equity, the private equity industry is having more meaningful conversations about diversity. In EY’s 2021 Global Private Equity Survey, 74% of fund respondents indicated that they have launched or are launching a diversity and inclusion initiative, and 56% indicated that increasing gender representation was a top talent management priority, compared to only 47% in 2020. At the end of 2020, the Institutional Limited Partners Association (ILPA) launched the Diversity in Action initiative, which included 120 LP and GP signatories at the time of writing.
Some firms are putting their money where their diversity goals are. Last year, EQT announced two subscription lines (for €2.3 billion and €2.7 billion) that incorporate into credit terms ESG-related key performance indicators (KPIs) and 40% female board representation goals. In February 2021, Carlyle Group’s $4.1B credit facility announced that it set a 30% board diversity goal tied to the credit terms of its facility. As LPs continue to emphasize ESG investment goals, the market for ESG-linked subscription lines may grow, but demand will likely be dominated by European funds.
The challenges of measuring and reporting
In keeping with ESG policies, funds typically provide LPs reports about how companies have mitigated ESG material risks, such as reducing their carbon footprints or changing their board structure. Often, these reports can be more qualitative than quantitative, and an ongoing challenge is aggregating very different types of risk factors within companies and across portfolios.
The lack of measurement standardization often creates metrics that are not comparable. Studies of public company ESG metrics provide insight into the data challenge and show that the reporting is not consistent. A study by ESG consultant Sakis Kotsantonis and Harvard professor George Serafeim finds that data reported by companies lack agreement on terminology, measurement and consistency. For instance, the study finds more than 20 ways that companies report employee health and safety data, which leads to inconsistencies in analysis and lack of comparability.
International groups, such as the SASB, World Economic Forum (WEF) and International Financial Reporting Standards (IFRS) Foundation, have called for an effort to establish a globally accepted system for corporate disclosure, including sustainability and traditional financial information. Doing so would improve consistency and comparability of ESG disclosure. Establishing these standards would benefit private equity managers, as well, and lead to more transparency and standardization in ESG reporting to LPs.
Regulators push to standardize ESG disclosure
Considering the lack of standardization and impact on investors, American and European regulators are taking steps to provide guidance on adequate disclosure and reporting. Recently, the Securities and Exchange Commission (SEC) created a Climate and ESG Task Force in the Enforcement Division. The mandate of this team includes reviewing company disclosures for material gaps or misstatements related to climate risks and ESG strategies. John Coates from the SEC’s Division of Corporate Finance recently suggested that the SEC could play a role in creating an effective ESG disclosure system for companies. While highlighting the value of creating a single global ESG-reporting framework, he also acknowledged the complexity and cost of doing so.
These SEC actions mirror what is already happening in Europe. In March, the European Union (EU) began implementing the Sustainable Finance Disclosure Regulation (SFDR), which imposes ESG disclosure and reporting requirements for investment firms, fund managers and other financial service participants. This so-called “anti-greenwashing” regulation aims to standardize ESG reporting in Europe. Large private equity firms are required by SFDR to disclose principal adverse impacts (PAIs), i.e., how sustainability risks are incorporated in their investment decisions. The challenge will be collecting data from portfolio companies and remedying inconsistencies in quality and disclosure across those companies to ensure comparable metrics. The European Commission is expected to endorse a draft of the regulatory technical standards for disclosures early next year.
Corporate Responsibility Report
Interested in First Republic’s approach to ESG? Read our 2020 Corporate Responsibility Report.
The implication of these regulatory actions on private equity is still unclear. It is likely that regulators will focus first on managers with primarily environmental or social impact strategies, and then turn to the funds with the most established ESG programs to review gaps or misstatements in their disclosures. Given the increasing importance of ESG analysis in private equity investing, fund managers will face new challenges in navigating this regulatory guidance and possibly new reporting requirements.
Moving to the next act
During the past year, the global threat to public health, increasingly extreme climate events and renewed focus on racial inequity altered the lens the industry uses to view responsible investment. In addition to changing many aspects of private equity funds’ businesses, these challenges increased the complexity of funds’ navigation of ESG disclosure, already tested by the lack of a common approach to ESG definitions, measurement and reporting. To fill this gap, the SEC and European Commission have taken steps to enforce a common standard in ESG disclosure.
How will our fund manager heroes apply their skills to surmount challenges faced in Act II of this ESG tale? Given private equity’s history of overcoming numerous trials with continued growth, we expect that fund managers will adapt to new guidance on standards and create new best practices for responsible investments.
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The content of this publication is for information purposes only and should not be considered as legal, financial, accounting or tax advice, nor as an investment recommendation or an endorsement of any investment fund. First Republic Bank makes no representations, warranties or other guarantees of any kind as to the accuracy, completeness or timeliness of the information provided in this publication. You should consult with your own professional advisors to fully understand and evaluate the information provided in this publication before making any decision that could affect the legal or financial health of you or your business.