ESG ratings agencies, once a peripheral player even for publicly-traded companies, are now working their way into the private equity industry. The fact that demand from the private equity sector exists for their product suggests the industry may be moving toward greater transparency.
“We’re sort of in the infancy of standardizing an [ESG] approach here, because it is very company-specific and very focused on materiality,” said Marija Kramer, head of ESG at ratings agency ISS. “But I do think we’re trending towards more standardization around how to evaluate private companies across ESG.”
As public companies boasted about their commitments to ethical investments, ESG ratings companies sprung up in response, promising to give investors a clear view of how seriously companies were taking their commitments. ESG ratings agencies are heavily involved in the green bond market, which grew to more than $200 billion in issuance last year.
These agencies are now turning their eyes to private fund portfolios. But the limited disclosure private organizations provide could present a challenge to widespread adoption.
“If you look at ESG ratings, disclosure is a key element of how well you’re rated, or how good your ESG rating is,” said Trisha Taneja, head of sustainable finance at Deutsche Bank. “So I think by default, the whole ESG data marketplace is skewed towards public companies.”
Who they are and what they do
While ISS – which itself is owned by private equity firm Genstar Capital – has provided “solicited ratings” to private companies and PE firms for a few years, other firms are just beginning to develop private market capabilities.
For French ESG rating firm (and Moody’s Investor Services subsidiary) Vigeo Eiris, it’s merely the beginning. Vigeo Eiris began offering its services to private funds and companies about two months ago, but they follow a similar playbook as many other agencies, focusing on what they call the “materiality” of ESG commitments, according to Agnes Terestchenko, chief executive of Vigeo Eiris USA.
Sustainalytics’s foray into private markets began when the firm established its Sustainable Finance Solutions team in 2014 to provide second-party opinions on green bonds. As it grew, it added a unit dedicated to providing its ratings to businesses, said Jean-Claude Berthelot, associate director of sustainable finance solutions at Sustainalytics.
In 2018, the firm began receiving requests for ratings from private companies and formally began providing them in 2019. Clients can either share the ratings with other companies, investors and others directly, or they can be included in Sustainalytics’ investor database where investors can view the ratings and metrics on the agency’s site, said Berthelot.
ISS, for its part, works with private companies either seeking an IPO or trying to improve external communications to establish an ESG framework, usually by looking at risk and opportunity, comparing the company with public peers and making some guesstimates, according to Kramer.
For PE firms seeking ratings, ISS creates a matrix of information that needs to be collected among its portfolio companies. Factors include climate-related corporate governance, human rights and community.
“We’ll use some modeling capabilities that look at things like the geographic location a company has offices in, the products and services that they’re producing, the size of the company, the assets and things like that,” said Kramer.
“We’ll [then] push that information down as a request to the private company, get data back and then we’ll do an assessment as we would a public company.”
The firm will then create an estimate for a particular criterion, such as carbon emissions. The estimate can offer a view into what a private company’s exposure is on any given issue.
Willingness to disclose is a must
“Private companies typically don’t put all of this into the public domain, which is why there has to be an interest and a willingness” on their part, Kramer added.
Sustainalytics also requires that desire to share what is typically non-disclosed information. Without it, such ratings are next to impossible for private companies.
“The only thing which is a bit different [from public market modeling] is we necessarily require their goodwill and involvement in sharing this information with us,” said Berthelot.
And private market participants may have to assume a higher level of disclosure and transparency if they want to drive the overall move towards ESG-focused investing forward.
“If there is more disclosure and transparency from private markets on how they’re incorporating ESG and what sort of tangible benefit they’re realizing on returns, I think that could help drive the market forward,” said Deutsche Bank’s Taneja.
Market forces for good
But market forces appear to be doing their work here too. Though public and private companies alike have been left to develop their own definitions and strategies for ESG, both have an interest in knowing what investors are seeking and how they stack up against their peers in ESG in order to accurately articulate their stories, according to Kramer. And being able to assess ESG-related business risks and opportunities requires a measure of standardization as well.
“I do think that [ESG] sort of pivoted from an investor-driven application to companies actually seeing the value in sustainability and putting their own programs in place internally, because they too think that it’s an important variable to their own viability in the long term,” said Kramer.
This shift is was echoed by the world’s largest asset manager earlier this year when it reported one of the strongest quarters ever in illiquid alternatives, even amid the economic chaos precipitated by the covid-19 pandemic.
“The pandemic we’re experiencing now is further highlighting the value of sustainable portfolios,” said BlackRock chief executive Larry Fink. “We’ve seen sustainable portfolios deliver stronger performance than traditional portfolios during this period.”