ESG initiatives at the portfolio level can lead to investors

For many investors, environmental, social and governance considerations are now table stakes. As zero-net pledges become more common among limited partners, private equity firms are responding with funds specifically targeting companies “doing good.” 

The financial services sector — particularly private equity — has been ramping up adoption of responsible investment principles over the last decade. But turbulent economic times are spurring private equity to revisit ESG because investors want to know: How will my investment impact the planet, people and profits? 

More general partners are willing to realign their strategy with responsible investment as a step toward value creation and their fund’s competitive advantage with impact investors. Let’s take a look at ESG in context to understand how sustainability attracts investment.

Where did ESG come from?

ESG first appeared in April 2006, under the U.N.’s Principles for Responsible Investment. The PRI’s signatories recognized that long-term social and environmental concerns can be material to a company’s financial performance.

By signing, investors pledge to voluntarily:

1. Incorporate ESG issues into investment analysis and decision-making processes.
2. Actively own and incorporate ESG issues into their ownership policies and practices.
3. Seek appropriate disclosure on ESG issues from the entities in which they invest.
4. Promote acceptance and implementation of the Principles within the investment industry.
5. Collaboratively enhance the Signatories’ effectiveness in implementing the Principles.
6. Report on the progress of implementing the Principles.

Since 2006, the number of signatories of the UN PRI has grown to 4,000 investment managers. A 2022 ESG Global Study found that responsible investing is more significant than ever to:

• Investors: 28% consider ESG principles as central to where they invest.
• Asset managers: 42% are responding to client interest in ESG.
• Institutional investors: 63% are more likely to implement ESG into their investment approach.

Meanwhile, social and environmental factors of business have grown in significance to pension funds, endowments, foundations, shareholders, employees and customers. 

However, commitment to ESG by GPs at the fund level has been stymied by the lack of a uniform set of standards, making implementation difficult for PE firms. It also makes ESG metrics challenging for investors seeking a straightforward way to compare performance among sustainable investment funds or portfolios.

Shaping ESG standards

A universal framework for reporting on ESG called Stakeholder Capitalism Metrics was released in 2021 by the World Economic Forum’s International Business Council of 120 corporate members, in conjunction with the Big Four accounting firms. Simultaneously, the group announced support for the IFRS Foundation’s development of a global Sustainability Standards Board.

Also in 2021, a Sustainable Finance Roadmap asked G-20 members to focus on the sustainable development goals established by the Paris Agreement for 2030. 

Given the heightened attention to companies’ environmental and societal impact, boards have begun more actively managing ESG risks that affect financial performance, valuation and investment, among other considerations. 

ESG risk management

Private equity and venture capital are mitigating ESG risks in reponse to investor expectations and regulatory pressure. Financial institutions that overstate their ESG credentials, a practice also known as greenwashing, could be subject to financial penalties by the SEC or the EU under its Sustainable Finance Disclosure Regulation, accompanied by bad press.

Moody’s Analytics looked at the impact of ESG risk on 3,468 public companies between 2015 to 2019. Companies caught in ESG scandals lost 0.4% in market value on average over two months. 

Additionally they lost 1.3% to 7.5% in the stock market over 12 months, translating to a roughly $400 million loss for a typical company in the sample, whose median market cap was $11.7 billion.

How can GPs show commitment to sustainable investment?

The 35 ways to demonstrate a commitment to ESG principles are voluntary and aspirational. However, private equity should track ESG data reports on the nonfinancial performance of portfolio companies, especially after the high number of shareholder proposals for ESG disclosures this 2022 proxy season. 

Such ESG metrics as transparency of internal management, workplace inequities, misuse of funds, environmental impact and board accountability, build trust between GPs and investors. A commitment to engage in ESG at the fund and portfolio level demonstrates an understanding of the importance of managing reputational or “headline” risk.

GPs need to engage, be open and transparent with LPs in regard to challenges they
face and how they can improve returns. Meanwhile, LPs are encouraged to be demanding of GPs, but tolerant at the same time — and this is particularly relevant in relation to the integration of ESG.

— Patrica Ward, Redington director for private markets, 2022 SS&C Intralinks LP Survey.

ESG initiatives vary according to a PE fund’s focus, a portfolio’s board, growth stage and market. However, evidence is building that ESG at the fund and portfolio levels raises capital and manages risk. 

Sustainability investors seek return

LPs use ESG due diligence to understand if a company may be profitable, socially, environmentally and governmentally responsible in the long term. 

The frameworks for sustainable investment (formerly dubbed “socially responsible investment”) can guide investors seeking new opportunities for return from companies with a positive effect on people and the planet. This way, ESG helps LPs avoid risk and discover new investment avenues.

A recently published survey of decision-makers from 1,262 companies with more than 250 employees in countries around the globe, conducted by the Centre for Economics and Business Research for Moore Global, found links between ESG and profitability.

Highlights from the September 2022 report include

• 80% of decision-makers surveyed noted ESG has become more critical in the last three years.
• Companies in the U.S. and Europe that didn’t regard ESG as necessary experienced revenue growth of 4.9% from 2019-2022. 
• U.S. company leaders who held ESG in high regard reported 10.4% revenue growth; European leaders’ revenues increased by 9.3%.
• Businesses with public ESG determination reported an average profit increase of 9.1%.
• Leaders engaged with ESG increased revenues by $3.1 trillion, comprising $2.1 trillion in the U.S., $930.5 billion in Europe and $58.8 billion in Australia.
• Committing to ESG increased headcount by 9.9% versus 4.8% not committing.

The survey showed that capital chases growth opportunities underpinned by ESG goals. In the U.S., 84% of respondents following ESG had an easier time raising money. 

In the IT, accounting and finance industries, ESG significantly helped attract investment, the survey found. Conversely, 28% of the public sector companies reported no difference in investment despite a focus on ESG.

ESG initiatives meet investor expectations

Private equity GPs are feeling pressure from regulators, especially in the U.S., to boost environmental compliance. According to Pitchbook’s 2022 Sustainable Investment Survey, addressing the environment is their top priority, and improving return with an ESG framework is their second-highest priority. 

However, implementing a sustainable investment program looks different for every PE firm and portfolio. 

Sustainability applied

Weaving sustainability principles into investments has taken hold over several years. In the U.S., 35% of respondents to the Pitchbook 2022 Sustainable Investment Survey reported beginning to use an impact investing approach more than five years previously. 

When asked what steps were the most important to full integration of ESG, the top two were:

1. Having a strategy for sustainable investment at the firm level.
2. Measuring sustainability program performance.

Developing a sustainability program is a complex undertaking. Of the six principles for responsible investment, ESG includes a wide array of topics, including business ethics, diversity and equity practices, supply chain management, environmental implications and policy transparency. 

Start an ESG initiative with outsourced business services

For GPs, implementing sustainable metrics across portfolios has advantages like adding strategic and nonfinancial considerations to an investment strategy that increases ROI and manages reputational risk. And operationalizing ESG metrics like decarbonization or human rights standards is a complex endeavor. 

Any movement a GP may take toward sustainable development goals requires careful planning and proper resourcing to achieve.

Escalon Services supports ESG initiatives

Escalon business services for private equity can support setting, promoting and reaching sustainable development goals at the portfolio level. Here are essential ways Escalon can help the bottom line of a portfolio as it puts ESG to use.

• Fractional CFO oversight of portfolio FP&A.
• Compliance services.
• Outsourced HR can shape the new company culture.
• Dashboard access and up-to-date financial data and reports to monitor progress against business performance.

Want more? Contact Escalon to discover how our outsourced business services, such as accounting, HR and CFO services, can support your firm and portfolio. Talk to an expert today.