Private equity faces growing pressure from investors who expect their asset managers to consider environmental, social and corporate governance (ESG) factors. It’s a big adjustment for an asset class that has been slower to adapt than public equities and fixed income. The ground began shifting in March 2013, when a group of 40 private equity investors, ten private equity firms and 20 trade associations from 11 countries went public with a blueprint for integrating ESG filters into investment strategies.
The Environmental, Social and Corporate Governance Disclosure Framework for Private Equity aimed to help structure conversations between private equity managers, or general partners, and their limited-partner investors. Tom Rotherham-Winqvist, London-based adviser to the CEO at Institutional Investors Roundtable, a Paris-headquartered group that hosts biannual gatherings for institutions, co-chaired the effort. “The LPs were saying, ‘If there’s a sense that we’re not asking for this stuff, let’s ask for it with a consistent voice,’” he recalls. “It was seen as, ‘If there’s a desire from the LP community to get more disclosure, it’s our job to help the GPs understand this and deal with it in an effective way.’”
Among the LPs who had a hand in drafting the document is Tim van der Weide, Amsterdam-based adviser for responsible investment at €170 billion ($211 billion) Zeist, Netherlands-based pension fund manager PGGM. The framework is objective- and principle-based, he says. “Now people are looking for a bit more guidance, so we’re trying to see if we can get to something like an ESG Disclosure Framework 2.0.”
Major private equity groups, like the Toronto-based Institutional Limited Partners Association, now refer to ESG factors in their due diligence recommendations; the International Private Equity and Venture Capital Valuation Guidelines published by the Brussels-based IPEV Association also mention them. This year the United Nations’ Principles for Responsible Investment initiative issued a report for signatories seeking to integrate ESG into private equity.
In early 2015, PRI will release its first survey on ESG progress in the private equity business. Among the findings: Nearly three quarters of 100 LP respondents said they were making ESG factors part of manager selection, and 85 percent of 121 GPs surveyed noted that taking ESG into account had helped pinpoint risks and opportunities for value creation. Fong Yee Chan, PRI’s London-based senior manager of nonlisted assets, says her organization will follow that report with a “deeper dive in LP guidance” — a list of sample questions that LPs can ask GPs to better grasp the role of ESG in a private equity firm’s strategy.
When applying ESG filters, GPs tend to look for risk mitigation and savings opportunities in companies they already own, says Andrew Malk, founder and managing partner of Malk Sustainability Partners, a La Jolla, California–based ESG consulting firm. That could mean finding ways to boost resource efficiency, reduce waste and cut down on packaging, Malk explains. More-sophisticated private equity firms ask for quarterly or annual sustainability reports, and some are adding filters to the company selection process, he says.
Observers agree that private equity’s interest in ESG is being driven mostly by LPs’ own sustainable-investment mandates, which are much more common in Europe for compliance reasons. In North America the move toward fossil fuel–free portfolios by some endowments and other institutions could eventually make an impact.
Private equity is well suited to ESG integration, PGGM’s van der Weide says. An LP typically has a bigger controlling share in a private portfolio company than an investor in a public corporation would, plus much greater access to information about portfolio companies, he notes. Longer hold times also mean that common ESG measures will more likely yield financial benefits for an investor.
But Rotherham-Winqvist of Institutional Investors Roundtable says he still sees resistance among GPs, who complain that it’s tough to make meaningful changes because every LP has a different ESG-related concern. Also, smaller private equity firms often can’t afford to hire the staff to make a real commitment to ESG, he notes.
Still, he predicts that as more private equity firms set their sights on companies in less regulated emerging markets, where problems like bribery and corruption are common, the benefits of ESG filters will become clearer for GPs and LPs. “In a hyperregulated market like the U.S., you can make the argument that all you need to think about is following the rules,” Rotherham-Winqvist says. “It’s pretty hard to take the same frame of reference when you’re going into Indonesia.”