Perspectives: An ESG revolution

ESG is increasingly a deal-breaker for LPs and GPs are responding by stepping up their game.

Investors are scrutinising the ESG credentials of their private equity managers like never before. “While ESG is a relatively new priority for LPs, interest is not only increasing but accelerating,” says Jennifer Choi, managing director of industry affairs at the Institutional Limited Partners Association.

Indeed, ILPA published the ESG Assessment Framework earlier this year to provide LPs with a foundation for their own assessments of ESG integration by GPs. “The framework is intended to help LPs compare the relative maturity of ESG integration across managers and to identify areas to probe during the diligence process,” Choi says.

“ESG in private equity has changed dramatically,” agrees Roy Kuo, head of alternative strategies for the Church Commissioners, which manages the Church of England’s endowment.

“When I joined the Church Commissioners, we were pioneers in this space, and we were often pushing on a closed door, particularly outside Europe. But over the past two to three years, the industry has done a 180 on these issues. We always try to encourage our GPs to act in more responsible ways – to incorporate that formally as part of their investment framework but also to ensure it is part of their culture. We score and rank managers and then track their progress over time.”

“There is a widely held understanding now that ESG creates value for investors,” says Bart Molloy, partner at Monument Group. “They recognise that sustainable and ethical investment is an important part of the equation and so it is something LPs are evaluating and tracking.”

The days when a strong environmental and social approach was deemed to come at the expense of financial performance is also long gone. According to affiliate title Private Equity International’s LP Perspectives 2022 Study, just under three quarters of LPs believe that the adoption of a strong ESG policy will lead to better long-term returns in their private markets portfolios.

Natasha Buckley, a vice-president with responsibility for ESG at HarbourVest, says: “Strong ESG policy adoption means having an approach to ESG that adds value to your investment strategy and has the full buy-in of the firm leadership and investment teams. We believe a robust approach to ESG is a proxy for fund excellence, which is why we factor that analysis into our investment decisions.”

And, broadly speaking, LPs are pleased with the progress that GPs are making. Around nine in 10 investors are at least somewhat satisfied with their GPs’ performance in the areas of implementation of planned strategies and the frequency and quality of reporting.

“Reporting on ESG is no longer optional,” says Ali Floyd, senior vice-president at Campbell Lutyens. “And for the best GPs, it is clear that it is something that is managing partner and investment team business, and not something to be outsourced.”

Buckley adds: “GP reporting on ESG is evolving from reporting on policy and process with some anecdotal studies to giving a more detailed overview of the ESG risk and opportunity profile of the fund as a whole, including measurement towards pre-identified targets.”

But while 48 percent of respondents believe their GPs are taking climate risk seriously enough when it comes to their own investment policies, 29 percent actively disagree with the statement, suggesting an inconsistency of approach. A little under half of investors have requested to avoid an individual investment for ESG reasons.

Marking the cards

“ESG can certainly affect an LP’s evaluation and ultimately their decision,” says Molloy. “Obviously, there are many components that go into a yes or no, but we often see a score card or a consultant’s evaluation of a fund where ESG is weighted prominently.”

Buckley adds: “In increasingly rare instances where a GP refuses to engage on the topic or provide any transparency, that would certainly be a cause of concern. We also take a cautious approach to ESG reputational risk factors when viewing individual investments on behalf of our clients and have, at times, declined investments based purely on ESG issues.”

Diversity, equity and inclusion is also increasingly becoming a part of the picture. “As with ESG, LPs are not just looking at the current situation but also the manager’s plans for the future,” says Molloy. “It is an evolution and LPs understand that. But they want to see a well thought out strategy for improvement and to see that strategy being implemented.”

“ESG and DE&I will continue to be something that will occupy investors’ minds,” says Rishi Chhabria, partner and head of sales for North America at Campbell Lutyens. “A GP that can show a track record of thoughtfulness around these two very key initiatives commands attention from investors who are awake to how important these factors are not only to the future, but also to driving diversity of thought which should lead to better outcomes.”

To that end, LPs are increasingly diligencing ESG and DE&I at a portfolio company level as well as at a fund level. “Our anticipation is that this is going to be the market standard in the next five years and GPs are being thoughtful about both factors throughout their organisation and their portfolio companies,” Chhabria says.