Does it pay to be good?

New Private Markets spoke to a dozen experts in search of the ESG holy grail: an empirical link between sustainable investing and improved financial returns. Here's what we found.

From Larry Fink to Mark Carney, scientists to civil society groups, a diverse set of voices appears to be in remarkable agreement: this can’t go on. ‘This’ being the current global economic model, about which you no longer have to speak in hushed terms to suggest might be in need of revision.

The facts speak for themselves. Carbon dioxide is being pumped out faster than at any point in the past 66 million years, inducing ever-costlier weather events; the natural world humans rely on for survival and for doing business (‘ecosystem services’ to be technocratic) are being hammered with mass extinction level pressures (pressures which are unleashing pandemics); levels of inequality have reverted to pre-industrial times in some countries and as a result of this mix, social strife is on the rise.

Private equity executives prepared to speak openly acknowledge that somewhere along the line things started to head in the wrong direction. “For many, many years it was a good balance of people making enough money with society benefitting, then in the 80s and the 90s things started to change,” said a global buyout fund executive. “I think about the shift from defined benefit to defined contribution pensions. Profit maximisation became the sole focus of business. [But] now there is a new generation of CEOs saying, ‘things have to change’.”

“For many, many years it was a good balance of people making enough money with society benefitting, then in the 80s and the 90s things started to change”

Global buyout executive

But what that change looks like for private equity is hard to define. One reason for this is because metrics to measure ESG impact and outcomes are disparate and can be cherry-picked, often frustrating LP efforts to fully understand the underlying company picture. “I don’t want a big glossy corporate report,” said Emanuel Eftiumiu, head of ESG at independent private equity fund of funds manager Alpha Associates. “For example, if a GP has six funds they might pull together a glossy report saying 60 percent of their portfolio has increased green energy, but that doesn’t tell me much about my individual investment. What I really want is a line-by-line overview.”

Paul Viera, founder of investment fund EARNEST Partners and of ESG ratings agency Harmony Analytics said the lack of unifying ESG metrics “is creating chaos. People are running around, colliding, discordant with one another. No one has stopped to say, ‘what are the definitions of ESG and how do we measure them’.”

A question of faith: the link between ESG and financial returns

Viera believes that the answer to this chaos lies with the capital owners. “We can’t move forward unless we get a coalition of owners together who can agree on what the definitions and measurements are.” Viera said a key condition for uniting LPs in this common cause is proving the relationship between a good ESG profile and better returns, something he has made a start on. “Our data show that those with the best ESG profile have the best returns and the worst have the worst returns. Our data goes back seven years, which is not long enough to prove it proof positive. But it is incontrovertible that if you have less drag you will go further, and if you have more propellant, you will go further.”

Proving this relationship with hard data is akin to the holy grail for ESG proponents in private equity. The dozen or so people spoken to for this piece all said it should be the case, but the data so far is piecemeal or anecdotal. “I haven’t seen a good study for private equity that could give you empirical data that says better returns come from better ESG,” said Marc Goebbels at ESG consultancy Tauw.

“ESG metrics are so intertwined with financial performance it’s almost impossible to determine what proportions of returns have been driven by ESG alone,” said Ellen de Kreij who is responsible for the implementation of Apax’s sustainability programme. “[However,] by building more sustainable businesses it is almost a natural evolution that you are building higher value businesses.”

Adam Black, partner and head of ESG at secondaries firm Coller Capital, directed me to a 2020 NYU Stern study of 1,000 individual research papers on ESG and financial performance in listed companies and funds, which appears to show a positive relationship, with integration strategies outperforming exclusion strategies. But for private equity? Black said that in his experience ESG has a part to play in enhancing the exit multiple. Another anecdotal, not empirical, proof point.

“Quite a lot of people in the industry are still sceptical about ESG”

Emanuel Eftimiu

And in the absence of this empirical proof, the value of ESG as an essential element to an investment strategy is growing in acceptance but is not universally held. “Quite a lot of people in the industry are still sceptical about ESG,” said Eftimiu. “But there is an evolution happening, because climate change is really happening, and external pressures and factors – from investor pressure to civil society to regulation – have had a profound impact in recent years.”

It is unquestionable that things are changing. But de Kreij echoes Eftimiu on a lingering scepticism, pointing to some LPs – usually seen as the driver of ESG improvements – as less progressive than they are often billed. “There is still a reticence [from LPs] to really demand ESG improvements alongside financial returns. There is still that worry that addressing ESG issues can compromise financial returns,” said de Kreij.

Others tell a similar story: “Our LPs expect us to have an exclusion list and to do something on ESG – but they do not define exactly what we should do or how we should do it,” said Robert Sroka, director of ESG at European GP Abris Capital.

So, what will drive ESG improvements in the industry? For Eftimiu, the answer is clear: “The primary driving factor for ESG disclosure and improvements has to come from the top – it has to be regulation.”

Regulatory options

One piece of regulation that would appear placed to make an impact is the EU’s Sustainable Finance and Disclosure Regulation, which requires disclosure of sustainability measures for funds with a declared ESG strategy and tightens disclosure around explicit impact funds.

“What I like about SFDR is that it means most firms will have to explain how they integrate ESG into their investment process, and that’s welcome. I think it will drive reflection and if it leads to greater disclosure then great,” said Black.

“I think it’s the right approach generally to force fund sponsors to be more transparent which might eventually also have an impact on investment policy – and eventually also on the general business behaviour of portfolio companies,” said Patricia Volhard, a partner at law firm Debevoise & Plimpton. “Fund sponsors can choose to be more or less ambitious as to their ESG strategy, but they have to be transparent and clear about it.”

For others, the absence of regulation is a central factor in the lack of unifying metrics. David Ramm, a partner at law firm Baker Botts, said: “Why do we not have a uniform ESG methodology? Because ESG is still not backed up by significant regulation. Everyone is making up their own criteria. We do need that consistent methodology.”

Many say it is the E in ESG where regulation will really shift behaviour. “Five years from now it is almost certain there will be stronger climate regulation. Whether we are talking 1.5 degrees or 2 degrees there will be huge policy changes needed. If you face that reality and undertake that exercise in considering how the policy world will look [in the near future], it will give you nice additional insight into those sectors to invest in, those companies that are best in class,” said Goebbels at Tauw.

Policy is the missing ingredient in the push to net-zero emissions by 2050, according to Shami Nissan, head of responsible investment at Actis: “We have the capital and the technology to get to net zero, what we don’t necessarily have yet are the policy and regulatory environments.”

Some executives said a company’s emissions profile will become an increasingly important element in a successful exit process. “When you come to exit, a buyer will be able to see where they are on the path to zero emissions and if they aren’t making progress, the multiple will come down, maybe even struggle to sell,” said Jean-Rémy Roussel, a managing partner at CVC and head of the firm’s operations team. “CEOs will know that to have an exit value you need to move [on ESG].”

Greater transparency and regulation around ESG will not, however, solve what will remain tricky ESG-related investment decisions. “What’s more impactful? To buy a non-polluting cloud business or buy a polluting business with potential to improve and reduce its environmental footprint?” said Roussel.

With private equity a significant and growing owner of the global economy, how firms answer this question – and how they view and act on ESG – will be consequential to our shared social and climate future.