LPs navigate shifting tides in the ESG landscape

ESG continues to garner support from investors in Europe and Asia while facing political headwinds in the US.

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After a period of heightened focus on environmental, social and governance issues, LPs have begun to recalibrate their ESG strategies amid escalating political pushback against such initiatives, particularly in the US.

Only 59 percent of LPs believe a strong ESG policy will lead to better long-term returns in their private markets portfolios, according to affiliate title Private Equity International’s LP Perspectives 2024 Study. This marks a decline from 69 percent in last year’s study and 74 percent two years ago.

Notably, LPs in North America exhibit the lowest level of confidence in the potential of ESG, with just 41 percent saying a strong ESG policy can improve long-term financial returns, in contrast to 60 percent of respondents in the Asia-Pacific region and a robust 79 percent in Western Europe.

In the US, the subdued optimism surrounding ESG comes at a time when the anti-ESG movement is gaining traction among the more conservative states.

For example, Florida governor Ron DeSantis passed a resolution in 2022 that prohibited state funds from taking ESG factors into account in their investment process. In Idaho, state entities engaged in investment activities are barred from prioritising ESG characteristics.

Meanwhile, in Missouri, secretary of state John Ashcroft issued a rule in June that requires broker-dealers to obtain investor consent before allocating funds to investments with non-financial objectives.

Yet in the more liberal states, some LPs have been showing a growing appetite for ESG investments. In its November board meeting, the California Public Employees’ Retirement System shared plans to double its climate-focused allocations to $100 billion by 2030. The pension also plans to triple the size of its ESG investment team to 15, affiliate title Responsible Investor reported in November.

“In the US, [ESG] is a polarised issue, but you are starting to see that breakthrough for the first time,” said an investor from a fund of funds during an LP panel discussion at the Impact Investor Summit: North America 2023. The event was held by New Private Markets in October.

“I think every time you see a large institution like [CalPERS] break through and be comfortable saying, we believe we can generate risk-adjusted returns that meet our threshold [and] also layer against certain sustainable themes, you are going to see more and more pensions and corporates lean in,” the investor added.

ESG investments are less controversial in the US’s northern neighbour. John Graham, president and CEO at Canada’s largest pension plan, CPP Investments, said in an October statement that sustainability “is an important factor at every stage of our investment process”.

At Caisse de dépôt et placement du Québec, the nation’s second-largest pension manager, ESG considerations are integrated into the entire portfolio, rather than being confined to a specialised ESG fund. “We don’t see ESG as a separate topic or a box-ticking exercise that needs to be done to reassure stakeholders,” says François Crémet, senior director of sustainable investing at CDPQ. “It’s one of our five investment priorities and we believe that performance and progress must go hand in hand.”

Despite growing political resistance in certain quarters, the proportion of LPs consistently considering the UN Sustainable Development Goals in their investment decisions is on an upward trajectory. The study reveals that 33 percent of LPs always factor in the SDGs, an increase from 28 percent in the previous year.

Meeting LP expectations

The study also indicates that GPs are getting better at meeting LPs’ ESG demands. The proportion of LPs rating their GPs’ execution of planned ESG strategies as ‘excellent’ has climbed from 4 to 9 percent in the past year, while the share of investors that view the frequency and quality of GPs’ ESG reporting as ‘excellent’ has doubled from 5 to 10 percent.

“If you look at the whole ecosystem, the capital allocators have a big opportunity to impact the whole private equity community,” says Joshua Adams, a partner at Los Angeles-based private equity firm OpenGate Capital. “I think they’ve done a great job of doing that. They’ve made everyone a lot more conscious about ESG.”

“We don’t see ESG as a separate topic or a box-ticking exercise that needs to be done to reassure stakeholders”

François Crémet

Diversity, equity and inclusion has become central to the ESG discussion within the LP community. According to the study, 58 percent of LP respondents either ‘agree’ or ‘strongly agree’ that a diverse workforce in a portfolio company is more likely to result in better commercial performance. Only 6 percent of LPs either ‘disagree’ or ‘strongly disagree’ with the statement. Meanwhile, 15 percent of LPs say their institution has refused a fund investment opportunity based on a lack of diversity and inclusion at the GP level, a slight increase from 13 percent last year.

Adams agrees that LPs have been placing greater emphasis on DE&I policies at GPs and their portfolio companies. “It’s always been part of the conversation. It just may not have been labelled as DE&I,” he says, adding that GPs are increasingly expected to provide detailed diversity data, reflecting a growing trend among LPs to incorporate such metrics into their due diligence process. “It’s becoming a reporting requirement for GPs today.”

CDPQ is a good example. According to Crémet, CDPQ aims to enhance DE&I both internally and externally. “We have specific internal targets to increase the representation of women and underrepresented groups at all levels in the organisation,” he says. “We’ve developed a structured diversity, equity and inclusion strategy. We expect and support our GPs to do the same.”