By Anna Follér, Head of Sustainability, Sixth Swedish National Pension Fund (AP6)

ESG incorporation best practice

Anna Follér

Private equity has made great leaps ahead in ESG and sustainability in recent years. According to the latest report on ESG in private equity by PwC, the key to unlocking this progress has been the realisation within the industry that ESG can be used to create value. Meanwhile, growing levels of collaboration and peer pressure within private equity are helping to increase the pace of ESG integration further.

Today, basic ESG integration in private equity is a question of good hygiene, while advanced ESG integration offers a competitive edge. The private equity model is particularly well-placed to embrace ESG. The General Partner (GP) fund managers tend to hold controlling or significant minority stakes in investee companies, for relatively long but defined ownership periods. This provides an effective model for bringing about change and development in portfolio companies. Private equity is also a highly competitive industry: where ESG is identified as a value creator, policies, processes and organisational capacity are quickly adapted to maximise that value.

Basic ESG integration in private equity is a question of good hygiene, while advanced ESG integration offers a competitive edge

Historically, asset owners have primarily focused their responsible investment efforts on the asset classes where they make their most significant allocations, usually public equity and fixed income. Whilst this makes sense, the recent progress on ESG within private equity allows them to extend responsible investment to this part of their portfolio.

Collaboration and better data are key

Similar building blocks underpin robust ESG frameworks in private equity for both Limited Partners (or LPs, the asset owners who supply the capital) and GPs. While the former primarily evaluate and monitor private equity firms, and GPs evaluate and monitor portfolio companies, current leading ESG practice is similar. It is characterised by:

  • Top-level buy-in and advocacy;
  • Dedicated responsibility;
  • Capacity and access to expertise;
  • The identification and addressing of material ESG issues, including critical ones such as climate change and diversity, equity and inclusion;
  • The integration of ESG factors into investment sourcing, due diligence and decision making;
  • Robust frameworks for monitoring, engagement and reporting; and
  • Leading by example (with internal ESG policies and measures).

When investment teams see ESG as a value creator, it will affect sourcing, due diligence and active ownership strategies: different investment opportunities will emerge in the deal pipeline and portfolio company boards will start to systematically address ESG issues in strategy and monitoring.

It is crucial that investment teams have access to sustainability expertise with experience and knowledge about financial markets in general and private equity specifically. On that front, it is encouraging to see how the private equity market is building in-house ESG expertise and appointing ESG specialists to increasingly senior roles.

The linking of incentives to ESG outcomes is another emerging element of ESG integration. Some firms are tying carried interest to ESG indicators, and last year a number of ESG-linked financing solutions were launched, providing opportunities for portfolio companies to obtain better financing rates if they meet ESG targets.

In terms of ESG themes, two subject areas have emerged as priorities. Diversity, equity and inclusion (DEI) and climate change are considered by both GPs and LPs as key areas to address, both internally as well as in their portfolios. In relation to climate change, several private equity firms have recently announced that they have set science-based climate targets. These commitments, together with the recently launched Science Based Targets initiative private equity sector guidance, show the increasing readiness of private equity to take action on climate change in a way that makes sense for the sector.

For such a competitive industry, it is striking how private equity welcomes discussions around ESG and how open peers are to collaborate and compare notes. This collaboration is critical to move individual organisations and the industry as a whole forward. Some excellent illustrations of private equity collaborative engagements include the PRI-supported Initiative Climate International (iCI) and the ESG Data Convergence Project, supported by the Institutional Limited Partners Association (ILPA).

As LPs increasingly formalise ESG integration in private equity, diverse LP ESG requests risk creating inefficiencies for GPs. If the industry can come together to support common standards for ESG integration, a more robust result will emerge at a lower cost for all. Using the common standards and guidelines in the market, such as the ILPA/PRI LP Responsible Investment Due Diligence Q uestionnaire, is a first step to address such inefficiencies. By building consensus regarding data requests, LPs can also support the emergence of comparable ESG data at the portfolio company level, facilitating the benchmarking and evaluation of portfolio companies as well as contributing to the evaluation of GPs’ ESG performance.

Today’s sustainability challenges will persist, but others will come to the fore

Using an ESG lens as an additional perspective for identifying risks and value creation opportunities is undoubtedly becoming mainstream in private equity around the world. LP pressure, regulation and the quest for talent will continue to support that process. Alongside, scrutiny is bound to increase. Quantitative and qualitative data to support commitments and statements will be requested from stakeholders. The use of impact methodologies will also increase, answering stakeholders’ demands for evidence of the real-world impacts of ESG programmes.

Using an ESG lens as an additional perspective for identifying risks and value creation opportunities is undoubtedly becoming mainstream in private equity around the world

The world’s sustainability challenges will continue to inform the agendas of business and investors, with a continued focus on climate change and increasing focus on other planetary boundaries, such as the protection of biodiversity. And, while climate change will continue to pose physical threats to society, the call for a just transition will increase the focus on human rights and the more equal distribution of wealth.

Meanwhile, increasing digitisation will bring immense efficiencies and opportunities while also creating new issues for companies and investors to address through responsible investment. When repressive regimes use technology to control and monitor citizens, what is a company’s responsibility, and what should an investor look out for? In the continuously changing landscape of responsible investment and ESG, these are questions that will increasingly be on the minds of responsible investors trusted with the stewardship of future generations’ resources.



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