The expectations of regulators, investors and consumers regarding environmental, social and governance (ESG) initiatives for public companies have been mounting for some time, but they are also gaining traction in the private company arena, where more companies and investors are discovering that prioritizing ESG efforts can create value and improve their competitive advantage.
Over the past 18-months, a number of private equity firms, their limited partners and portfolio companies have heeded the writing on the wall, with some of the world’s largest funds channeling capital into green asset funds, among other ESG-friendly initiatives. A confluence of factors, including strong institutional investor interest in sustainable investing (particularly from pension funds) and rising public consciousness fueled by the pandemic and social unrest, as well as various regulatory actions, is driving funds to act now.
No hotter area on Wall Street
Among the signs that sustainable investing strategies continue to attract record inflows, a recent Goldman Sachs report stated that assets under management at fixed-income funds focused on ESG has increased from $57 billion in 2018 to more than $400 billion today. And, according to Bloomberg, more than $117 billion flowed into ESG funds between June 2020 and June 2021.
On the regulatory front, President Biden’s executive order on climate-related financial risk shows the U.S. federal government, including its financial regulatory agencies, is eager to incorporate climate risk and other ESG issues into financial regulation. The Securities and Exchange Commission (SEC) is one of the primary agencies leading the charge. This month, the SEC’s assets management committee voted to implement diversity disclosures by registered investment advisers and funds and strengthen ESG disclosures for public companies and investment products.
Still, for the most part, many smaller and mid-size private equity firms and portfolio companies are trying to catch up to their larger counterparts. For many, staying abreast of the slew of latest regulatory activity, news and market developments related to ESG alone is a challenge. As a recent opinion article in the Journal of Impact and ESG Investing put it, ESG has become “the catch‐all term for a disparate and confusing range of investment strategies – from low carbon or clean tech‐focused to those skewed toward gender, diversity and inclusion.”
According to the article, “the best protection for ESG investors against greenwashing or a misalignment of their portfolio and their values is to understand the motivation or world view behind the firm, investment teams, fund strategy and due diligence process.”
General considerations for private equity players
ESG initiatives come in various forms and include many considerations which private equity players can implement during the various phases of a fund’s life cycle. For example, portfolio companies seeking to go public — whether through the special purpose acquisition company route, a direct listing or traditional initial public offer — should consider including an analysis of ESG performance and reporting in their public company readiness checklist. Even those that are not pursuing an IPO may still need to meet specific ESG requirements if they want to do business with public companies.
When raising capital, the general partners should proactively scope ESG engagements to ensure they meet the criteria of the pension funds and other limited partners that are increasingly weighing ESG standards in their screening analysis and decision making. ESG factors should also be integrated into the private equity firm’s initial investment decision-making process. For instance, in the due diligence phase, the investment committee should consider requiring each deal to identify material ESG risks and opportunities and how they may be mitigated or managed.
During the portfolio management phase, private equity firms should seek to create value by making capital investments in sustainability opportunities identified through systematic monitoring of ESG issues and trends. Some of these initiatives may be new to the respective industry or may have been existing but weren’t discovered during due diligence.
Whatever the case, management should recognize that the value of doing things right could mean a higher outlay in actual dollars in the short term, but, in the longer term, it could increase the investee’s valuation and ability to operate, attract and retain in-demand talent, maintain a good reputation and avoid legal quagmires and regulatory scrutiny. The increased cost should be measured against these greater benefits.
Using SASB standards
More private equity firms are using industry-specific standards developed by the Sustainability Accounting Standards Board (SASB) to guide the disclosure of financially material sustainability information by companies to their investors. Available for 77 industries, the SASB standards identify the subset of ESG issues most relevant to financial performance in each industry.
Private equity is not specifically addressed as a standalone industry among SASB’s industry-specific standards; however, the asset management and custody activities industry, which includes companies that are engaged in private equity investment, is listed. Some of the ESG topics that SASB lists as relevant to this industry are transparent information and fair advice for customers, employee diversity and inclusion (D&I), business ethics and systemic risk management.
On D&I specifically, a private equity firm may choose to follow SASB’s recommendations on achieving a certain percentage of gender and racial representation for executive management, non-executive management, professionals and other employees. Additional D&I guidance includes fostering equitable employee representation across a firm’s global operations; maintaining policies that show transparency of hiring, promotion and wage practices; developing and disseminating diversity policies; and ensuring management accountability for equitable representation.
Private equity firms with multi-industry focus should consider using the SASB standards as a baseline for what would likely be the material ESG issues an investee company will need to report, manage or monitor. Take as an example the issue of food safety and the management of increasingly complex, global ingredient supply chains. There are severe repercussions for companies that fail to maintain high food quality and safety standards, including product recalls, trade restrictions and import bans. A private equity firm pursuing a deal in this space can refer to SASB’s engagement guide to develop a more comprehensive understanding of embedded risks and opportunities to integrate ESG. In this particular case of the ingredient supplier, SASB recommends the following lines of discussion:
- How does the company assess and address supplier performance on issues related to social and environmental responsibility?
- What is the company’s process to improve areas of poor performance?
- What is the company’s exposure to environmental and social risks arising from contract growing and commodity sourcing, and what strategies does it use to manage these risks?
The target company’s answers — or lack thereof — to these questions may lead to deal cancelation, a change in valuation, and/or a decision on what post-investment actions, if any, are needed. The insights gathered will also be of keen interest to a financial sponsor or strategic buyer during its own due diligence and hold period as the private equity firm exits the investment.
Kickstarting your ESG journey
An ESG program can be developed in multiple phases. A systematic but comprehensive process will ensure that the program achieves all of its goals steadily without overwhelming management. Following are some key actions that private equity firms and their portfolio companies can take now as they begin their sustainability journey.
- Discovery and strategy-setting – This initial phase involves developing and defining a firm’s sustainability objectives and related strategic guidelines. As part of this process, companies will identify key stakeholders, document the current state across the organization, and outline a future state roadmap for the program and perform a materiality assessment. For more established programs, it’s the process of assessing the maturity of the program and understanding the material topics for the business and stakeholders.
- Data management and development – Companies will need to invest time and effort in identifying the data supporting the analysis of sustainability material topics and build the data collection, aggregation and validation process. This step will involve building out data development or collection processes for each key performance indicator, determining data aggregation processes, and assessing the data repository solution, among other actions.
- Performance and reporting – Monitoring the program objectives and reporting comprehensively and transparently the organization’s ESG performances to stakeholders is critical aspect of building an effective ESG program. As regulators increase the rules around ESG disclosure, private equity firms should be able to drill down to see what’s under the hood of companies they invest in but have a comprehensive process to disclose that information to key stakeholders.
- Setting minimum ESG standards – Smaller to mid-size private equity firms can set their own minimum ESG standards using a combination of SASB’s industry-specific recommendations and other industry frameworks and guidance. Such an approach may incorporate the United Nations’ Principles for Responsible Investment (PRI) and align with principles from the Impact Management Project and the United Nations’ Sustainable Development Goals. A preliminary step may be to develop and formalize an ESG policy that informs key activities and defines how ESG integration supports and builds on the firm’s investment strategy.
Finally, on an ongoing basis, private equity firms will need to stay abreast of changes in regulations and market developments in order to make continuous and effective design changes or improvements to the governance and risk management framework supporting their ESG programs. Making routine enhancements to the program will help firms better address ESG risks and compliance requirements while also strengthening their internal control environment.
Rob Gould, Managing Director and Global Leader of Protiviti’s Private Equity Practice, contributed to this content.