Comment: The year ESG went mainstream

2021 saw the letters E-S-G catching up to the letters I-R-R as the most important acronym in private equity. Assets in global private equity funds have surpassed $4trn, institutional investors are increasing their exposure to PE every year, and PE is taking more large public companies private. The sheer sums involved make it clear that PE could have significant influence in promoting the flow of finance to companies that embrace best-practice on ESG, and help shape the direction of those that don’t, just yet.

As we embark on 2022, we find ourselves in a place where the need to pay attention to ESG affects every stage of the lifecycle of most PE funds. Many top financial sponsors are now signed up and working to be compliant with industry best practice standards, which seek to integrate ESG within all fund processes. For example, Hg, Permira, Towerbrook, Triton, Partners Group and others are members of Initiative Climat International (iCI), a global climate initiative for the PE industry that is supported by the Principles for Responsible Investment (PRI). Other financial sponsors follow the recommendations of Invest Europe, which has produced highly comprehensive ESG best practice guides for PE. And in the EU, regulation in the shape of the Sustainable Finance Disclosure Regulation is starting to bite on AIFMs marketing new funds.

Future proofing for exit

In recent months, we have seen PE bidders pulling out of auctions on ESG concerns, with sellers achieving lower multiples as a result, and IPOs of companies backed by PE being postponed due to ESG issues. This highlights how important ESG is becoming to the ultimate goal of realising superior returns for investors, which is only doable if the business can actually be sold or IPO’d five years or so from the point of investment.

It is becoming increasingly common for private equity investors (and is recommended by the industry initiatives discussed above) to insist on the inclusion of steps towards ESG policy formation and implementation within a plan included in the shareholder agreement with the portfolio company and its management at the outset of the investment. This kind of approach was previously the purview of plans for the improvement of ABC/sanctions policies. A financial sponsor will also be in a good position to keep the management team of a business on their toes in hitting any ESG performance milestones that are set; arguably, they may find it more straightforward than a public company, which reports on profits quarterly, making it difficult to undertake long-term investment without impacting shareholder dividends in any given year. Some sponsors, such as Montagu Private Equity, have added a ‘sustainability committee’ to the usual trio of remuneration, audit, and compliance committees, meaning ESG issues will be regularly considered as part of portfolio company governance processes.

Similarly, on environmental concerns, PE managers are increasingly looking to understand what portfolio companies operating high-carbon assets can do to reduce emissions at the point of investment to ensure the company is competitive within its sector in five years’ time. One example of this is EQT’s goal of transitioning to 100% renewable electricity across its portfolio of 100+ companies, which it began implementing in 2020. As a result, Fenix Marine Services, a large logistics company in EQT’s infrastructure portfolio, managed to switch fully to renewable energy within the same year.

Measuring and benchmarking, for purpose and profit

Still, the question of disclosure around ESG metrics continues to plague investors at both LP and GP level. How will an LP, GP, or a portfolio company know how it is performing on ESG, relative to peers? If LPs and GPs are to make ESG-responsible investments, they need to be able to tell what these are. LPs request regular ESG performance information from GPs in which they are invested, and such metrics are a growing area of due diligence for GPs in acquisitions.

There is still a great deal of confusion regarding various reporting frameworks in place for both LPs and their portfolio companies. Until now, companies (on top of any legally mandated disclosure, for example by way of the Sustainable Finance Disclosure Regulation or the Taxonomy Regulation), have adopted one or a number of voluntary frameworks and guidance (e.g. TCFD, SASB, GRI, etc). Because all of these are somewhat different, performance becomes hard to compare.

In October 2021, a number of GPs and LPs launched the ESG Data Convergence Project, the first set of standardised ESG reporting metrics for the private equity industry. The project is an agreement between participants to standardise the measurement and reporting of six ESG metrics. The information is shared between participants and with Boston Consulting Group, which produces benchmarks using the data. The success of the initiative depends on wider industry uptake, but even then the industry is fragmented. For example, the Private Market Pilot is another similar initiative amongst other high-profile fund managers.

Although both the ESG Data Convergence Project and the Private Markets Pilot show a commitment to ESG disclosure, it will be difficult to achieve the level of standardisation and transparency needed without universal metrics which apply to all companies – after all, companies change hands frequently, particularly in the PE secondary market, and it’s difficult to track their progress if they change ESG reporting methodology every time they change investors.

This is why many large investors support the newly-created International Sustainability Standards Board (ISSB), which has been tasked with developing a “comprehensive global baseline of high-quality sustainability disclosure standards to meet investors’ information needs”. This is intended to be the sustainability reporting equivalent of the International Financial Reporting Standards, and at COP26, IFRS announced the publication of a set of draft disclosure standard prototypes which will form the basis of a consultation in 2022. These standards will be voluntary, as are the current various ESG disclosure frameworks and guidance, but there are good indicators that they could be made mandatory in various jurisdictions. They will certainly be adopted in new legislation to be passed next year in the UK as outlined in the Treasury’s Green Finance Roadmap in October 2021. And for financial years commencing from April 2022, UK regulations will require high level TCFD reporting by large public interest entities, large private companies and LLPs.

For funds and AIFMs regulated under the EU SFDR, there will be ongoing disclosure requirements against a list of 12 mandatory Principal Adverse Sustainability Indicators. Entity level obligations for disclosure of aggregated PASIs apply also for large AIFMs, and on a comply or explain basis for smaller AIFMs. These indicators do not all map well onto standard environment, health & safety due diligence, so they need to be integrated into transaction processes, and then frameworks set up for post-acquisition reporting. New funds will also have to disclose alignment against the EU Taxonomy Regulation criteria starting in 2022.

What’s next?

2021 showed us that the PE industry is converging around an approach that takes into account the entirety of the lifecycle of a PE fund and backs the approach of incorporating ESG as part of a fund’s core operating principles. Backed by further regulation around disclosure, and a recognition that ESG concerns can go not only to reputation but also to financial performance, we could see PE influencing large private companies to embrace ESG for good.