Five ways ESG is moving up the agenda in private markets

Diversity and inclusion have taken center stage…

The year 2020 will be remembered as a flashpoint for so many of the issues that govern how we relate to the world around us. Born out of the depths of a pandemic, a social justice movement sparked by tragedy has fundamentally reshaped the conversation around diversity, equity and inclusion (DE&I).

Within the private equity industry, efforts to add diversity that were already underway are being bolstered and those firms that are not at least professing their dedication to increasing their inclusiveness are becoming fewer and further between.

Pam Jackson, CEO of Level 20, a non-profit dedicated to improving gender diversity in the European private equity industry, says a recent survey in partnership with the British Venture Capital Association “confirmed that a lot of effort is being made to recruit women and diverse talent into the junior levels” of private equity firms. “The number of women at the junior level has increased significantly across the board, which is really positive and beneficial because unless you fill the hopper, nothing happens.”

One approach to ensuring recruitment efforts can successfully attract diverse new talent is to expand the employee search outside of traditional investment banking recruitment channels.

“Traditionally when you are hiring investment associates, you look to second-year investment banking analysts. We found that if we limited ourselves to hiring at the associate level, then we had to accept the candidate population that the banking community was hiring by default,” says MiddleGround Capital vice-president of human capital Kristen Baily. Her team reaches out to upcoming or recent graduates of diverse backgrounds, allowing them to source talent ahead of the investment banking recruiting cycles. This approach and other initiatives means about 60 percent of MiddleGround’s team comprises women and minority individuals.

North America head of private capital fund services at Northern Trust Kimberly Evans says that data on diversity and inclusion is of growing importance to private market participants.
“It is no longer enough for GPs to answer the top-level questions on this around ESG governance and metrics at the fund level,” says Evans. “Now they are being asked to go down to the portfolio company level to provide metrics across their investments. The LPs are saying, ‘Whatever the deal is, I want to know it meets these criteria and to project the impact that our capital investment can make.’”

…and environmental concerns continue to shape portfolios

The world would be much simpler if energy and power harvesting could be cleanly divided into the greens and the browns, but in reality, ‘clean energy’ is not so easily defined. And while many environmentalists would prefer that all hydrocarbon extraction were to be ceased immediately, EnCap Investments CFO Craig Friou says “it is important to appreciate that oil and gas have provided the cheap and affordable energy that has helped us to sustain daily life for many years, including electricity and reliable transportation. That cheap and affordable energy has dramatically improved quality of life and brought huge numbers of people out of poverty.”

That said, Friou adds that in the immediate term “it is essential for the development of oil and gas to be completed in a responsible way that minimizes environmental impact, minimizes emissions and takes care of the communities where development takes place.”

In order to ensure it is doing its part to facilitate cleaner energy production, EnCap recently held a final close on an energy transition fund, which gathered $1.2 billion.

Managing partner Jim Hughes says the decision to launch a dedicated energy transition fund was “based on both the opportunity to deploy and the opportunity to generate returns comparable with those in our traditional oil and gas and midstream funds.”

ECP is another firm thinking long and hard about the energy transition. Managing partner Tyler Reeder says energy efficiency and smart buildings are a “really interesting” area of the energy transition.

ECP founder and senior partner Doug Kimmelman adds that if one were to ask most people what the biggest contributor to decarbonization has been, they would most likely say that it was renewables. “The reality, however, is that progress in energy efficiency has had the most significant impact, followed by switching from coal to gas. Renewables come in at number three,” Kimmelman says. “It will take effective battery storage to really shift the needle there.”

ESG definitions are broadening…

EY Climate Change and Sustainability Services managing director Chris Hagler says ESG initiatives primarily began with a focus on environmental issues “because it is easier to get your arms around clearly defined sectors such as renewables or green infrastructure, compared with investments tackling social challenges such as diversity and inequality.” But now “LPs’ interpretation of ESG investment is widening.”

“In corporate America, broadly, our observations are that almost every company now appreciates the risk management piece of ESG,” Hagler says. “In the private equity world, meanwhile, the shift we have seen, even just in the past couple of years, has been extraordinary. The risk management component of ESG is still deemed critical, of course, but increasingly we are also seeing private equity funds set up dedicated impact vehicles in response to investor demand. They are using ESG to manage the downside but at the same time developing new funds to take advantage of an exciting opportunity.”

In EY’s 2021 Global Private Equity Survey, 47 percent of investor respondents said they plan to either increase or significantly increase their ESG investment over the coming two-to-three-year period, and 48 percent said they believe there are currently not enough ESG offerings to meet their needs.

…and there’s value in the added nuance

PwC ESG deals leader Aaron Gilcreast says private market participants are realizing more and more that “ESG issues are a business imperative that can affect long-term success.”

In the firm’s most recent responsible investment survey, 56 percent of respondents reported refusing to enter general partner agreements or turning down investments on ESG grounds. PwC ESG director Abigail Paris says: “Limited partners are highly engaged on these issues. They know such matters could result in value leakage when portfolio companies are being sold.”

But ESG isn’t only being viewed from the lens of risk mitigation anymore. “Compared with 10 years ago, there has been a shift from thinking about red flags for issues that might negatively impact asset values, to a strategy of value creation based on how a company is positioned for the future,” Paris says. “More firms see an advantage to engaging in ESG in this way.”

This is particularly true in the private markets. “In public markets, investors make a fair point in suggesting that ESG has been bid up so much that it is hard to find value. However, there is still an opportunity for returns in private markets,” Paris says. “PE firms can earn a return from an ESG turnaround: acquiring a company that is dirty in environmental, social or governance terms, cleaning it and selling it at a premium.”

Get ready, because full disclosure is coming

As ESG continues to move up the agenda, pressure on fund managers to show their work appears to be building rapidly. In order to stay ahead of the curve, managers would be wise to ensure they’re building the tools and relationships they need to manage this burden.

PwC ESG deals leader Aaron Gilcreast says, “From green initiatives to diversity in leadership and commitment to equity, justice and other societal issues, companies are more accountable to all stakeholders now more than ever.”

“For the private funds industry,” Fran Seegull, executive director of the US Impact Investing Alliance, says “the main thing to keep an eye on is the expectation that all companies may soon be required to disclose their climate risks. Some large public companies are already doing this, but the SEC is currently looking at whether climate disclosures should be mandated in a clear and comparable fashion across the US economy.

“The past year alone has shown the critical importance of the ‘S’ and ‘G’ issues alongside environmental factors, and we’re facing a significant opportunity for regulatory progress.”
While there is plenty of optimism in the industry that ESG policies are becoming more ubiquitous, Seegull believes there is still much work to be done in the US.

“In the US, we are lagging behind as we battle persistent misconceptions that ESG factors either aren’t material or that a reasonable investor isn’t interested in gleaning that information,” Seegull explains. “We know both of those statements are false – studies continue to show that ESG is effective for mitigating risk and often outperforms, and investors and other stakeholders are increasingly demanding access to this type of information.”

This article first appeared in affiliate publication Buyouts