Over three-quarters of private fund leaders believe that a stronger ESG vision and culture will ultimately drive value in their business, according to our Private Funds Leaders Survey 2021, conducted in partnership with MUFG Investor Services. “It is very clear to us that responsible corporate behaviour and the consideration of ESG factors have a positive influence on long-term financial performance,” said Jeff Pentland, managing director at Northleaf Capital Partners.
However, it is LP pressure that remains the most significant driver behind greater ESG monitoring and reporting, and an overwhelming 86 percent of respondents said that LP questions on ESG have become more detailed over the past 12 months.
Investor demands were followed by a firm’s own social responsibility goals, competitive forces and valuation creation objectives as reasons for enhancing ESG practices. Interestingly, regulation was seen as the least significant factor.
Meanwhile, ESG considerations play an equal role in due diligence and value creation. Just under half of respondents described ESG as either critical or very important when assessing potential transactions.
The same proportion said that ESG was critical or very important for adding value in the businesses they buy.
“We have already seen positive correlation between ESG progress and the performance of our companies across a number of different metrics, such as improved costs, efficiencies and an improved, more engaged workforce,” said Ruth Lane, head of investor relations and ESG officer at ATL Partners.
“We believe that robust ESG programmes at our portfolio companies inherently lead to better outcomes in the form of safe, healthy and motivated employees,” added Brian Ramsay, president of Littlejohn & Co.
But while private markets leaders recognise the importance of getting ESG right, the operating models to support those practices remain immature. Almost three-quarters of respondents exclusively receive their ESG data from their portfolio companies, but close to 90 percent described their ability to do so as at least slightly challenging. This is unsurprising when 64 percent employ a fully manual process.
And even where some degree of automation has been achieved, a lack of industry-wide uniformity remains a problem.
“Metrics that are easily quantifiable are automated and those that are more qualitative are tracked via ongoing dialogue with our portfolio companies,” said Ramsay.
“But the lack of standardisation around reporting metrics and ratings make it challenging for GPs to benchmark themselves against their industry, as well as for LPs to compare ESG programmes across their portfolios.”
Meanwhile, although close to two-thirds of respondents rely on an internal ESG team entirely, 34 percent expect to move toward an outsourced model over the next three years. Northleaf is one firm that believes in leveraging external expertise.
“We have sought to enhance our ESG risk assessment capabilities across our due diligence and portfolio management processes through a partnership with RepRisk,” explained Pentland.
“RepRisk provides a software platform that allows us to systematically identify and assess material ESG risks. The system also allows us to set up watchlists on a mandate-by-mandate basis and then to track how every individual investment is performing from an ESG perspective.”
In the expectation that climate considerations will become more important, Northleaf has also entered into a partnership with Climanomics, the Climate Service’s SaaS platform, to enable climate risk reporting aligned with the Task Force on Climate-related Financial Disclosures framework.
What metrics to monitor?
The most commonly monitored ESG metric is company diversity, followed by board and management composition. The least-tracked metric is waste, followed by carbon. “We track a number of ESG metrics, both as a firm and across our portfolio companies. Some metrics are consistent across our companies and some are company-specific,” said Lane. “For example, as a sector-focused fund manager targeting aerospace and logistics, we try to lead by example and track the environmental impact we make due to our travel.”
“We track a variety of health and safety metrics, diversity statistics and some environmental metrics,” said Ramsay. “Each portfolio company is different and so we tailor our programme to fit their needs.”
And yet, despite a clear increase in focus on ESG at all levels, less than half of respondents are able to definitively prove a positive correlation between ESG and investment performance at a portfolio company level. This is, in part, a question of maturity. Longer and deeper track records will be required to provide empirical evidence of ESG’s impact on value creation.
But Gareth Whiley, managing partner at Silverfleet Capital, believes that equating ESG with returns misses the point. “We don’t look for a correlation between returns and ESG and continue to argue that this is a slightly odd way of looking at things,” he said. “We believe we need to be responsible investors, not ignoring the financial costs, but certainly not only because we can justify that there is a financial benefit.”