What do ESG disclosure and due diligence mean in private equity? What ESG policies govern firm and portfolio companies? How is ESG monitored in PE? We explain.
Written by Rio ESG
The numbers demonstrate the increasing importance of ESG to the private equity world.
ESG investing as a whole is growing. Between 2018 and 2020, total U.S.-domiciled sustainably invested assets under management, both institutional and retail, grew 42%, to $17.1tn up from $12tn. Meanwhile, KPMG found that the global value of sustainable investments managed professionally was estimated at $30tn as of 2019 — a 34% increase over two years.
Private equity has been no exception. According to EY's 2021 Global Private Equity Survey, 41% of PE managers with more than $15bn AUM said ESG initiatives represent a top strategic priority. Compellingly, this number decreases as AUM goes down: A third as many PE managers at firms below $2.5bn AUM report the same strategic commitment (14%).
The disparity between large and small firms shows how the biggest players in private equity are leading the charge on ESG. BlackRock's private equity teams, which account for $41.9bn AUM, have followed the direction of CEO Larry Fink, who wrote in January 2020 that climate change was "an investment risk." While he predicted that this would spark a fundamental reallocation of capital, he observed in early 2021 that the change — even under global pandemic conditions — "accelerated even faster than I expected."
The imperatives for private equity firms are clear. To embrace a forward-thinking strategy that balances planetary sustainability and superior returns on investment, firms need access to quantitative data and qualitative policy directives. What's more, corporate vagueness by way of general numbers, targets, and platitudes simply won’t cut it.
The status quo: Issues with transparency and adoption
Because their requirements aren't as stringent as those for public equity and companies, private equity firms "often lack reporting on ESG and have been criticised for lack of transparency," write Ken Pucker and Sakis Kotsantonis for Institutional Investor.
After examining 431 PE firms that invest and commit to PRI’s six principles, the writers reported that "fewer than one in eight publicly disclose that they receive ESG reports from their portfolio companies, and only 16 share whether ESG issues impact financial performance.”
Meanwhile, ESG reservations remain in private equity. Bain & Company reports that ESG investing continues to face scepticism in the private equity industry, especially in the US.
But Bain also notes that proactive firms “aren’t waiting for ROI studies to pan out...ESG isn’t just a nice thing to do. It is becoming a critical element in gaining market share, engaging employees and raising capital.”
The 4 elements of private equity ESG
How can private equity firms step up their ESG game? It helps to break down ESG into four key components:
- ESG due diligence for investments
- ESG policy that governs the firm and portfolio companies
- Monitoring the ESG performance of portfolio companies
- ESG disclosure to investors and the public
What does ESG due diligence look like in private equity?
Due diligence, when applied to ESG investing, means mitigating risk by better understanding the acquisition's risk profile and exposure, with an added emphasis on environmental, social, and governance performance.
This isn’t simply an exercise in “do-gooder” evaluation; it’s what stakeholders today demand. As a result, PE firms are increasingly taking ESG issues into account in the investment decision-making process. The 2021 EY survey notes that a majority of firms indicated that ESG risks are seriously or very seriously contemplated during decision-making.
However, they also note that "32% of firms still said they only consider these risks and opportunities on an ad hoc basis relative to an investment’s performance or don’t view ESG risks as important at all.”
Some PE firms may be lagging on ESG due diligence due to a belief that ESG performance is a “nice to have,” but not a “need to have.” However, there are other obstacles to ESG due diligence: namely, the lack of reliable data.
For a variety of reasons, ranging from the lack of universally accepted ESG benchmarks to the struggle to collect relevant findings, examining ESG performance during the investment due diligence process can be complex.
For starters, the small and mid-size companies that are most likely to be targets for investment or acquisition by private equity firms typically lack mature ESG reporting and available data.
ESG ratings are one important source of data for due diligence. The rating might report, for example, the carbon footprint of a company's operations, including its supply chain. But what ratings can't tell you is how much it might cost to reduce that carbon footprint by 5%, and what kind of financial efficiencies that will drive. It's these kinds of questions that PE firms often try to answer during the ESG due diligence process.
Without the right tools, PE companies are left to fend for themselves in evaluating factors such as:
- Human rights
- Supply chain issues
Software solutions like Rio can make the due diligence process more efficient by consolidating all kinds of ESG data within one platform.
Our guide to ESG ratings describes how business and investment leaders can understand their ESG scores quickly. It also includes guidance on how to improve sub-par ESG ratings. Access the ESG ratings guide.
What's included in private equity ESG policies?
EY finds that 85% of the largest PE firms have ESG policies — but the contents vary.
One reason is that most large and mid-size PE firms assign ownership of ESG policy to an ESG task force. But at smaller firms, that responsibility usually falls to the COO, CFO, chief investment officer, portfolio manager, or the board. Especially when this falls under the purview of one person already at workday capacity, this borders on leaving the results to chance.
Examining the components of ESG policies at private equity firms, the EY survey found these were the most common:
- Establishing a corporate social responsibility governance structure.
- Promoting employee participation in nonprofit activities.
- Regular external reporting on ESG initiatives.
Yet the survey also found that only 38% of private equity ESG policies included regular external reporting on firms’ initiatives to investors. The EY report notes that looking forward, "private equity firms’ reporting will need to be more digestible, customisable and accessible.”
PE firms may also have ESG policies that apply not just to themselves, but to portfolio companies well, in order to enforce a firm-wide commitment to certain targets or principles.
How do firms monitor the ESG performance of portfolio companies?
Monitoring the ESG performance of portfolio companies is critical for firms with a serious commitment to ESG. But it can be much more difficult than monitoring financial performance.
Standardised ESG data collection is key. Without consistent reporting practices across the portfolio, it can be challenging to understand and compare performance and progress toward targets.
ESG framework providers sometimes offer guidance for monitoring private equity investments. For example, PRI's ESG Monitoring and Reporting Framework breaks this down into 11 questions and action steps.
But at the end of the day, even an outstanding framework can only go so far. It can ask the right questions or prescribe the right steps. But it doesn't tell PE firms how to track qualitative and quantitative ESG metrics across a portfolio.
Technology can help. Rio's intelligent software bridges the gap by streamlining the ESG data management and reporting process.
And once a firm has consistent reporting and monitoring across their portfolio, they can begin to explore key topics, like the relationship between financial and ESG performance.
What ESG disclosure frameworks are used by private equity firms?
As we discussed, transparency is an issue for private equity when it comes to ESG. Regularly disclosing ESG performance using an established framework is the best way to overcome this issue.
Choosing the right framework for disclosure is a crucial step. These frameworks function as systems for standardising the reporting and disclosure of ESG metrics.
There are many frameworks to choose from, and some will have specific guidelines for private equity.
In the UK, the Walker Working Group has produced the Walker Guidelines for Disclosure and Transparency in Private Equity. Meanwhile, Rio recommends the World Economic Forum’s framework, updated in September 2020, for most businesses.
The KPMG Board Leadership Center also identifies another consideration for PEs to include in their frameworks: linking ESG to investment strategy and performance.
Our guide to ESG reporting frameworks helps users understand the plethora of frameworks available and make a smart decision in this crucial component of the ESG journey. Access the ESG Framework Guide.
Rio has strong expertise in this area and can support PE firms in their quest for clarity in disclosure. Our ESG software utilises artificial intelligence to help companies achieve one laser-focused goal: improve sustainability performance.
Our software also links financial, compliance, and governance information at the transaction level, and allows organisations to monitor and track performance within their own organisation and portfolio companies.
Interested in learning more about how can Rio help your firm? Get in touch.