The focus on environmental, social and governance (ESG) as a means of creating sustainable value is on the rise. Institutional investors are increasingly considering nonfinancial performance, such as ESG issues, when making investment decisions. The three factors of ESG and the corresponding investment-related sustainability issues are:
- Environmental – Is the company environmentally responsible? Does the company use scarce resources wisely and address environmental risks such as climate change?
- Social – Is the company socially responsible? Does the company demonstrate high moral and ethical standards regarding diversity, labor practices, health and safety, and animal welfare?
- Governance – What is the company’s stance on issues such as executive compensation, transparency, diversity and shareholder rights? Effective corporate governance tends to be an indicator of management quality, and is often a precursor to a company’s stance on social and environmental issues.
ESG as a Private Equity Concern
Of all the sub-industries within the asset management industry, private equity (“PE”) is well-positioned to take the lead in integrating environmental, social and governance issues into the investment process (“ESG integration”). Due to the size of the industry (about 2.4 trillion in AUM ) and the characteristics of its business model, the PE industry has a tremendous opportunity to create social value and improve the environment and, in doing so, improve their financial returns.
In May 2015, CalPERS announced that it will require all its managers to identify and articulate ESG in their investment processes. It will factor into its decisions about hiring and monitoring external investment managers the degree to which managers assess ESG factors and integrate them into their processes. Anne Simpson, director of global governance, said that CalPERS considers managers that do not identify and manage these risks as having a “sub-par investment process”.
In October 2015, the DOL cleared the way for ERISA-governed plans to consider ESG factors. Interpretive Bulletin 2015-01 clarifies that ERISA plans may take ESG benefits into account as “tiebreakers” when investments are otherwise equal. When ESG factors have a direct relationship to the economic and financial value of an investment, “these factors are more than just tiebreakers,” the DOL statement said. Over the past several years the market has seen a marked increase in the number of public and ERISA pension funds mandating that their asset managers integrate critical ESG issues into their investment decisions.
Customizing Your ESG Program
Although many firms in the asset management industry are aware of the growing importance of ESG integration, not all firms are aware of how to customize ESG integration to their specific business model. The ESG considerations material to investment decision-making vary from firm to firm. For some PE firms, environmental factors are at the forefront; for others social or governance issues may represent the ESG themes key to decision-making.
In particular, PE firm may focus on value creation by improving eco-efficiency and environmentally sustainable products and services and other firms may focus on labor, health and safety factors affecting portfolio company stakeholders. Other PE firms may focus on whether portfolio companies have a robust governance structure which enables effective business review and control. Although effective governance has long been an integral facet of private equity ownership, PE firms may pay extra attention to anti-bribery, anti-corruption, and environmental & social performance reviews in the context of ESG.
Ultimately, the focus point of a PE firm will be largely driven by a fund’s individual investments and a firm’s investment mandate as the relevance of ESG factors differ from one geography to another, and one industry to another. Some examples of actions PE firms can take to improve their ESG integration, include:
- Consider environmental, public health, safety, and social issues associated with target companies when evaluating whether to invest in a particular company or entity, as well as during the period of ownership.
- Be accessible to and engage with relevant stakeholders either directly or through representatives of portfolio companies, as appropriate.
- Grow and improve the companies your firm invests in for long-term sustainability and to benefit multiple stakeholders.
- Encourage strict policies that prohibit bribery and other improper payments to public officials consistent with the U.S. Foreign Corrupt Practices Act, similar laws in other countries, and the OECD Anti-Bribery Convention.
- Respect the human rights of those affected by your firm’s investment activities and seek to confirm that your firm does not invest in companies that utilize child or forced labor or maintain discriminatory policies.
- Provide timely information to your firm’s limited partners on the matters addressed herein, and work to foster transparency about your firm’s activities.
- Encourage your firms’ portfolio companies to advance these same principles in a way that is consistent with their fiduciary duties.
When shaping your ESG policies and procedures you should consider current ESG trends and the effect they will have on your business. The three major ESG trends are:
- Setting ESG ambitions: Institutional investors, such as pension funds, are increasingly setting sustainability targets for their investment portfolios. For instance, the two biggest pension funds in the Netherlands, ABP and PFZW have set ambitious targets for 2020 to invest 58 billion euro in sustainable development investments, as well as CO2 reduction targets. Although most of these sustainability targets have focused on the investors’ public equity and bonds portfolios, investors are likely to begin to consider how they can set sustainability targets to their alternative investment portfolio, including PE funds. As institutional investors increasingly use sustainability targets, they will also want to measure them, which brings us to the second trend.
- Improving ESG monitoring and data availability: Institutional investors learn a lot about their public portfolio due to ESG disclosures by listed companies and firms such as Bloomberg, MSCI and Sustainalytics who collect this ESG data. However, investors have little visibility on the overall ESG performance of their private equity portfolio. Two PE fund-of-fund managers, Robeco and Adveq, have been leading the charge for collecting sustainability data of private equity funds and their portfolio companies. Solutions they have developed are now rolled out to the broader market. Sustainalytics recently bought ESG Analytics, a spin-out from Adveq. eFront, a reporting solution for private equity firms, released FrontESG in partnership with a French fund of funds, Swen Capital. Overall, these developments will mean more scrutiny of ESG performance of portfolio companies and data requests for private equity firms.
- Shifting towards ESG value creation: PE firms can begin to put a price on the additional value-add resulting from ESG improvements. The majority of investors see risk reduction as the main driver for integrating ESG issues into the investment process and the majority of firms are meeting the needs of their investors by effectively identifying ESG risks. However, PE firms are in the business of creating value, not just avoiding risks. PE firms, along with the rest of the asset management industry, are in the early stages of figuring out to quantify the value added from ESG integration. The PE community is not only realizing that sustainability does not need to be an add-on or compliance tick-in-the-box, but also that it can enhance their existing investment model. PE firms can also gain a competitive edge by sharing success stories from ESG integration with potential LPs.
How to Integrate ESG into Your Investment Strategy
PE firms that have not yet integrated ESG into their investment strategies will want to start requesting more information from their portfolio companies or potential portfolio companies. PE firms can gain valuable ESG information by requesting an integrated report that combines both financial and ESG (also called nonfinancial) information. This will enable the PE firm to better assess how its portfolio companies are creating value for the LPs, and the risks and opportunities they face. LPs with a long-term investment horizon—such as pension funds, sovereign wealth funds, and family offices—are especially attuned to this kind of information.
The firm will need to determine how to effectively use ESG information and how to successfully monitor ESG initiatives to improve portfolio company performance. The success stories from improving portfolio company performance through ESG integration will give a firm a competitive edge in the industry and ultimately, improve the firm’s bottom line.
ICSGroup’s ESG Practice Group can provide the help your firm needs to develop or enhance your ESG standards, policies and procedures and achieve effective ESG integration.