By Eric Diec, De Montfort University
I have always been interested in financial markets and investments, and I have been investing since the age of sixteen.
In January I attended the LSE Alternative Investments Conference in London, the largest and most prestigious student conference on private equity, hedge funds, and venture capital. I was privileged to attend and engage with seniors in the industry and fellow delegates representing 111 universities and 110 nationalities. Highlights of the event included workshops and panel discussions with industry leaders, such as Farhad K. (COO of Blackstone Europe) Mark Corbidge (Head of PE Europe at Sun European Partners, LLP), Julian Salisbury (Global Head of Asset and Wealth Management at Goldman Sachs), Yaajan Govindia (Vice President at Goldman Sachs) and Simon Marc (Global Head of Private Equity at PSP Investments), just to mention a few. At the conference, many topics were touched upon, such as ESG, diversity, the macroeconomic environment, and geopolitics. ESG is a crucial subject when addressing the future, and ESG is here to stay. The private equity industry is still grappling with managing the challenges that come with it, including expanding compliance obligations and rising reporting needs from limited partners. The largest private capital companies, however, had already embedded ESG-aware investment procedures far before ESG became a media topic. The United Nations Principles for Responsible Investment (UNPRI) is the world's biggest voluntary corporate sustainability project with over 7,000 signatories, including over 1,000 private equity and venture capital companies – four times the number from five years ago. Europe has been the regional leader for ESG rules throughout public and private capital markets. The EU's introduction of the Sustainable Finance Disclosure Regulation (SFDR) last year was a cornerstone of this initiative; under this regulation, General Partners are integrating ESG considerations into their investment decisions and processes and launching impact funds that meet the SFDR's Article 9 requirements. These so-called "Dark Green" funds are committed to sustainable investing. Environmental implications are a relatively straightforward conundrum for many organizations, particularly asset-sparse IT and software firms. As ESG methods develop, the "S" in ESG is gaining popularity in social expectations. The next port of call is diversity, gender, equality, and inclusion, known as DEI.
Adaptation barriers
While studies have demonstrated that integrating ESG into dealmaking adds value, developing the skills to do so involves investment in and of itself. Many portfolio firms are hesitant to adopt ESG efforts because they view them as an expensive compliance exercise with no direct or immediate financial advantage, not to mention the political reaction against ESG in some U.S. regions. According to the 2023 Global Private Equity Outlook (Dechert, 2023), 65% of respondents cite the additional costs and resources required to retain qualified talent and build capabilities to identify, track, and manage ESG risks and opportunities as the most significant impediments to greater adoption of ESG initiatives in their funds or portfolio companies. This is closely followed by the difficulties of generating consistent paperwork to collect, monitor and assess ESG data, indicated by 58% of Europe, Middle East and Africa (EMEA) respondents, 64% of North American respondents and 70% of Asia-Pacific (APAC) respondents. Private markets are by nature less transparent than public ones. The absence of standards around what defines an ESG-friendly investment makes it difficult for private equity firms to analyse different deal prospects and make informed judgments regarding fund allocations. Forward-thinking private equity companies are overcoming these difficulties and reaping the rewards of being early adopters of ethical investment despite these obstacles.
Private equity businesses are under growing pressure from their limited partners (LPs) to include and integrate ESG. A variety of things drives investors. First, there is an awareness that sustainability is vital for the long-term viability of enterprises. A rising body of research demonstrates that boosting the ESG development of portfolio firms can have a meaningful influence on their financial performance, resulting in greater returns. Second, LPs are becoming more cognisant of the reputational risks associated with funding private equity teams who do not take ESG seriously because many institutional investors must answer to their fiduciary stakeholders. General Partners who fail to address LPs' concerns in the future may find it increasingly difficult to attract funds. When questioned about the primary factors affecting LPs' ESG-driven investment decisions, most respondents across all regions cite a fundamental shift in investors' investment policies or strategies. In contrast to family offices and high-net-worth people, the trustees and clients of pension plans, sovereign wealth funds, endowments, and insurance firms have more stringent ESG requirements. Thus, private equity companies that fail to address these issues run the danger of losing the support of their LPs and may find it more difficult to attract capital in the future. To fulfil the growing demands and expectations of their LPs and secure the long-term success of their companies, private equity firms must adopt a proactive and integrated approach to ESG factors.
Private equity exists to provide attractive risk-adjusted returns. 49% of EMEA respondents and 42% of North American dealmakers believe that LPs are primarily motivated by the potential for ESG integration to produce this outperformance. Just 30% of APAC respondents cite this factor, instead citing portfolio risk management as a significant factor in the decisions made by their ESG-driven investors. General Partners provide discounts to their initial backers, which encouraged European LPs to move up the maturity curve in their examination of General Partner progress by focusing on DEI progress inside their portfolios. The significance of ESG activities in the research process conducted by LPs when deciding where to invest is rated highly by respondents in all areas. Respondents evaluate precise ESG reporting requirements between 3.8 and 4.0 out of 5 as the critical emphasis of investors' ESG due diligence, with clear ESG fund policies rating between 3.7 and 4.0. When establishing new funds and facing pointed questions about how they integrate ESG into their operations and those of their portfolio companies, private equity firms would do well to bear this in mind (Dechert 2023).
Backlash and ESG progress
Meanwhile, there is increasing opposition against ESG. At least nine U.S. states have established anti-ESG rules in the form of investment resolutions, board of investment decisions, or attorney general judgments. In August 2022, the State Board of Administration of Florida, which controls the state's public sector pension system, passed a resolution prohibiting the fund from considering ESG concerns when making investment choices. In addition, a rising body of data reveals that Louisiana and Missouri have sold a combined $1.2 billion from BlackRock assets, strengthening the portfolio manager's ESG effort.
The claimed objective of these acts was to compel investors to prioritize financial returns over other factors. This disregards the fact that several studies have demonstrated a link between high ESG ratings and greater financial returns. Additionally, as CEO of BlackRock Larry Fink wrote in his much-read letter to CEOs in 2020, "Climate risk is investment risk", climate catastrophes around the world will have a significant impact on the global economy, and it is prudent to manage those risks. It can have a material impact on financial performance, thereby generating superior returns.
Conclusion
Attending the LSE Alternative Investments Conference provided an opportunity to learn about the latest developments and challenges in the private equity industry, especially in the area of ESG integration. Despite the benefits of integrating ESG into the deal-making process, private equity firms are facing significant barriers, such as high costs and resource requirements, difficulty in collecting and assessing ESG data, and the absence of ESG standards. However, LPs are putting pressure on General Partners to integrate ESG into their operations and portfolio companies due to growing awareness of the importance of sustainability, reputational risks, and potential financial returns. Furthermore, the emphasis on DEI progress is increasing in LPs' examination of General Partner progress. Despite opposition against ESG, the increasing number of signatories to the UNPRI and the introduction of SFDR in the EU suggest that ESG is here to stay, and private equity firms must adapt to these changing demands to remain competitive in the long term.
Reference
Dechert (2023). 2023 Global Private Equity Outlook. Retrieved February 22, 2023, from https://www.dechert.com/knowledge/publication/global-private-equity-outlook.html
The research was conducted by Mergermarket who on behalf of Dechert LLP polled 100 senior-level executives at private equity firms situated in North America (45%), EMEA (35%), and APAC (20%) at the beginning of the third quarter of 2022. The questionnaire includes both qualitative and quantitative questions, and all interviews were performed by telephone appointment. Mergermarket reviewed and compiled the results, and all replies are provided anonymously and in aggregate. To be eligible for inclusion, a business had to handle at least $1 billion in assets, and responders must not be first-time fund managers.