ESG in private equity: from fringe to focal

Pension funds and institutional investors have for some time been allocating to alternative investments, including private equity, to seek additional returns and diversification. This is welcome progress and the pressure is now on private equity managers to step up to the plate and offer sustainable investment solutions.

Just as with listed equity, institutional investors in private equity are increasingly widening the scope of their analysis to include wider environmental, social and governance (ESG) issues, in addition to traditional risk-return analysis.

ESG covers a broad range of factors, some of which have the ability to impact the financial prospects of an investment. They include environmental factors such as air, land and water pollution, social factors like employee diversity and governance factors such as the existence of anti-bribery and corruption policies.

Many factors are driving the trend towards greater ESG integration. Technology is continually re-shaping the behaviour of businesses and consumers through game-changing developments in areas like artificial intelligence and robotics, autonomous vehicles and biotechnology. The UN’s 17 Sustainable Development Goals to be met by 2030 provide a framework that defines global development priorities and aspirations. National governments around the world are implementing new regulations relating to environmental pollution and waste disposal, workplace standards and corporate governance. Meanwhile, investors are prioritising responsible investment in their evaluation of investment managers.

The private equity governance model puts it in prime position to incorporate ESG metrics into value creation.

At a fundamental level, private equity is about the transformative power of investment. It serves a key role in financing new businesses and upgrading and futureproofing old businesses. In effect, the private equity governance model puts it in prime position to incorporate ESG metrics into value creation strategies.

Private equity managers can do this in two broad ways. Prior to investment, they can undertake research and due diligence to evaluate how sectors, value chains and business models are being shaped by ESG factors. This can be extended to individual companies to identify those businesses that can take advantage of ESG trends. Secondly, once invested, an ESG framework can be used to reveal new strategic and growth opportunities. Performance can be reviewed and progress formally reported as a standing agenda item for advisory boards, and a public ESG review can be integrated into annual accounts.

The global trend towards ESG integration in private equity means such processes are rapidly becoming necessary, rather than optional. This is where the Nordic countries and the Netherlands are ahead in pioneering ESG integration in private equity. Many large asset owners in that region take ESG considerations into account when selecting, appointing and monitoring investment managers for new mandates. In contrast, ESG considerations have been less of a priority for asset owners in the US largely due to questions over whether this breaches their fiduciary duty to clients. Times are changing, however, and sustainability is fast gaining traction among the US investment community. ESG integration also has some way to go in Asia, although progress is being made in some countries, notably Japan.

Companies that embed ESG into the core of their performance culture are better able to build a resilient organisation with a sustainable strategic agenda.

ESG is most powerful when truly integrated into an organisation – where it goes far beyond the initial phase of just focussing on risk mitigation through strong compliance and a ‘do-no-harm’ approach. Companies that embed ESG into the core of their performance culture have a better ability to build resilient organisations that have sustainable strategic agendas.

This is all the more important given the many uncertainties that businesses and investors face today. Political unrest, weak economic growth and unprecedented economic migration have become an everyday reality. Meanwhile, ageing populations, climate change and technological disruption all represent longer-term challenges. Businesses and investors aiming to prosper amid these disruptive forces will need to adapt quickly.

In this fast-changing world, many leading companies are benefitting from the positive impact of integrating ESG factors into their corporate strategy. Those that fail to prioritise ESG considerations will, in marked contrast, be held to account for their poor performance.

Mirja Lehmler-Brown
Senior Investment Manager – Aberdeen Private Equity