ESG in private equity: a moment of glory?

Marta Zadravec

ESG has gained more traction in the private equity industry in recent years. Moreover, ESG has become a core demand from limited partners (LPs) amid consumers behaviour change and the growing climate change concerns of socially responsible millennial investors.

That said, ESG considerations in private equity are being formed within contracts more frequently, and LPs can use their leverage and “walk away” if their terms are not met. With dedicated and active management, ESG investing can help firms increase return rates and outperform the market.

There has been an “evolution” among private equity managers in integrating ESG over the last three years, said Michael Cappucci, senior vice president, from Harvard Management Co. He also mentioned that ESG is now core to LPs expectations.

Investors in different regions often have different priorities for ESG investments and employ distinct strategies for influencing the behaviour of portfolio companies. In Europe and the United States, social and environmental concerns may be paramount, while in Japan, corporate governance and diversity are at the top of the list.

ESG Success in Private Equity

PE firms are moving along with ESG objectives, as long-held concerns of trade-offs between maximized returns and ESG investing have been challenged. Over the years, compelling evidence has emerged showing that the return on investment value can be magnified by incorporating ESG factors into the decision making process. Morningstar research found that investors can build global portfolios tilted toward high-scoring ESG companies without compromising return.

However, many investors make a similar mistake by focusing on a global ESG objective, instead of the factors that affect their operations and performance in a financially material way.

We can agree that a couple of months have been unprecedented. However, we have seen sustainability funds outperform their peers since the COVID-19 crisis began and across the first quarter, both in developed and emerging markets. Again, figures from Morningstar suggest that in the period through February 28, which saw the biggest downturn in stock prices globally, “the returns of nearly two thirds (65%) of sustainable equity funds ranked in their category’s top half.

More than four-tenths (43%) placed in the top 25% of their group and only 10% were in their peer group’s bottom 25%”. Morningstar data also shows that in March, when market activity saw further downturns as countries began to implement lockdown measures, 62% of ESG-focused large-cap equity funds outperformed the global tracker.

ESG in Private Equity Industry: Actions and Intentions

In 2020, private equity firms have raised more than $370bn of commitments to funds that integrate ESG principles into their investment decisions, according to data provider Preqin. However, a recent survey by Institutional Investor found that fewer than 10 per cent of 8,810 global private equity firms, with a total of $3.4 trillion under management, are signatories to the Principles of Responsible Investment.

ESG in private equity is here to stay, as well as ESG investment opportunities will increase over the next three-five years. However, the lack of harmonization of sustainability frameworks is a brake to ESG integration. The survey also found 53 per cent of respondents admitting they are not using any ESG framework like the Sustainable Development Goals (SDGs) and Taskforce on Climate-related Financial Disclosure (TCFD) to identify opportunities at a tactical level.

Therefore, private equity firms should consider setting a strategic vision and fostering a culture that sees ESG as a significant value creation opportunity.

The next stage is that investors will not just want a commitment to ESG – they will also want tangible proof of how the private equity fund has delivered on that commitment.