By Daram Pandian, Associate, Private Equity & Venture Capital, and Peter Dunbar, Head of Private Equity, PRI
The private equity industry is predicted to manage more than US$11trn by 2026, according to Harvard Business Review. The roughly 10,000 firms operating in the space already oversee more than 20 million employees at about 40,000 portfolio companies. As the authors point out, this represents a huge opportunity to tackle climate change and other major sustainability challenges.
In fact, they argue that these issues cannot be solved without the involvement of private equity firms and their portfolio companies.
So, it is a positive sign that nearly 75% of the 633 private equity investors that reported to the PRI in 2021 (598 investment managers and 35 asset owners) said they assess ESG materiality for individual companies – which we consider best practice – rather than only looking at industry-level factors. Most used geopolitical and macroeconomic considerations (53%) and the Sustainability Accounting Standards Board standards (33%) to do this.
Our 2021 reporting data indicates where investors already demonstrate best practice and where they can still improve. This blog post highlights some of these areas, as signatories prepare for the upcoming reporting cycle.
Investment policies need to be tailored to company stage
The good news is that 96% of private equity signatories reported that they include asset class-specific guidelines in their responsible investment policies, although this doesn’t tell us how well these are implemented. Furthermore, only 31% of these include guidelines on how they adapt their ESG approach to different company stages and strategies such as venture and growth capital.
Investors need to tailor their policies for early-stage companies or where they do not have control positions to make clear how their responsible investment approach is relevant and viable. For instance, the start-ups that venture capital investors target can have fluid business models and limited resources, making it more difficult to identify ESG risks and opportunities and to collect ESG data.
Incorporating ESG commitments into fund terms not yet standard
Only 46% of private equity investment managers said they incorporated responsible investment commitments in Limited Partnership Agreements (LPAs) as a standard, default procedure for funds closed during the reporting year or within the previous five years.
Adding such commitments to LPAs (15%) or side letters (45%) upon client request was more common, while 16% said they did not make any formal responsible investment commitments at all during the reporting year.
There is very little transparency on what these commitments are, but anecdotally we hear that they often lack substance, with wording such as “best efforts basis” sometimes used to water them down . To make such commitments more robust, private equity investors can refer to our guidance on fund terms, or consider adapting these ESG clauses to private equity , when drafting such documents.
Due diligence practices are strong; valuation considerations can improve
Most private equity-focused signatories consider ESG factors in their pre-investment processes – 88% reported that they used these to identify risks that affected investment selection and 84% discussed such factors at their investment committees or equivalent level.
Signatories are also recognising that ESG incorporation can be used to add value, not just mitigate risk, with 66% reporting that they identify opportunities for value creation for most of their investments.
Looking at ESG due diligence, 59% send detailed questionnaires to target companies, 76% conduct site visits and in-depth interviews with management and personnel, while 47% hire third-party consultants to conduct technical due diligence on specific issues.
However, clearly there are still challenges in linking ESG factors to valuation metrics (a trend that mirrors our findings on responsible investment practices in infrastructure.)
More than 80% of respondents said that ESG factors did not impact their financial assumptions for the holding period of the target company (e.g., capital and operational expenditures, revenue, cost of capital) or the price they offered or paid for any of their investments during the reporting year.
And while 69% of private equity managers share their high-level responsible investment commitments with potential buyers at exit – such as their PRI signatory status – only 49% share ESG performance data on the asset or portfolio company being sold.
More transparency is needed and would benefit those signatories that have made genuine improvements to their portfolio companies during their holding period.
Over time, we would expect more signatories to report that ESG factors do impact their entry valuations. Anecdotally, many GPs take the view that future buyers, including peers, will pay higher multiples for companies where, for example, science-based targets have been set.
Additionally, selling those companies may be easier, either because there are a larger number of potential buyers, or because some of the hard work on ESG incorporation at a company level has already been done, putting future owners in a better position.
Portfolio company ESG strategies and board requirements developing
As private equity strategies (particularly toward the buyout-end of the spectrum) allow investors to drive change within portfolio companies, it is encouraging that 63% of investment managers report that they address any ESG risks or opportunities identified during due diligence in their 100-day plans or equivalent tools for prioritising urgent post-acquisition tasks.
Additionally, 79% reported that they support their portfolio companies in developing and implementing an ESG strategy.
Just over seven in ten investment managers require their portfolio company boards to discuss material ESG issues at least once a year while a similar proportion assign them responsibility for ESG matters.
Almost half support their portfolio companies by finding external ESG expertise such as consultants or auditors and 59% share best practices across their portfolios, such as how to implement environmental or social management systems.
One area that requires more focus is training: just under one-third of signatories reported providing ESG training to portfolio company c-suite executives while less than a quarter say they do so for other portfolio company employees.
Given the lack of sustainability experience often found on SME boards, education is particularly important. Board directors cite a lack of knowledge, data, and capabilities as the number one barrier to address ESG matters, according to a report by the Boston Consulting Group and INSEAD Corporate Governance Centre.
Linking incentives to ESG performance in portfolio company management remuneration is also a nascent practice. Only 10% of private equity signatories reported doing so for all or most of their investments.
Almost four in five signatories reported tracking specific ESG KPIs. These included emissions, energy, water, DEI, and health and safety-related metrics. While 49% said they set targets to improve on past performance, only 26% do so using industry benchmarks or standards, and only 21% use global benchmarks or thresholds such as the SDGs or Paris Climate Agreement.
Preparing for the next reporting cycle
There are many signs that private equity investors are starting to embed best practices into their investment processes, but to really contribute toward making the industry sustainable, investors need to go further.
The PRI blog aims to contribute to the debate around topical responsible investment issues. It is written by PRI staff members and occasionally guest contributors. Blog authors write in their individual capacity – posts do not necessarily represent a PRI view.