Despite its assumed entrenchment within the private markets, environmental, social and corporate governance issues are frequent figures in newspaper headlines – and not for wholly positive reasons. In the US, progressives dismiss ESG-focused investment programs as ‘greenwashing,’ arguing that they only provide PR cover for the same old bad behavior, while conservatives believe them to be part of the liberal ‘woke’ agenda that will sink the economy by eschewing profits in favor of expensive, feel-good initiatives.
In contrast, Europe is doubling down on its commitment to ESG priorities, with several efforts underway to ensure those three letters live up to their best intentions.
But private fund CFOs don’t have the luxury of pundits or activists to simply rail against the trend even if they wanted to, instead needing to find ways to make ESG work for the firm and its stakeholders. Larger, established firms can afford to bring ESG expertise in-house, but for those that can’t, ESG lands in the CFO’s lap.
As such, CFOs have largely accepted that ESG needs to be more than language that gathers dust in the back of a PPM. And investors have become increasingly vocal about ESG risks, requesting massive amounts of data around ESG metrics. CFOs have responded by doing their best to tailor their programs to the unique needs of their investment strategy.
However, the common thread among CFOs is that, for now, the ESG challenge is predominantly one of data management. Tracking ESG requires a second portfolio of data that needs to be collected, vetted and reported, with the caveat that there’s no standardized methodology, which raises concerns about how best to measure behaviors that affect multiple departments in the same portfolio company.
The best answer that many have right now is to focus on tapping expertise, either by hiring more staff or bringing in external consultants, getting leadership to buy into the process and remembering that any incumbent ESG program will continue to evolve for years to come.
Walking the walk
Right now, CFOs are taking ESG issues seriously. “We always paid attention to these issues, but we’ve crossed that Rubicon and recognized that ESG is here to stay,” says April Evans, CFO at Pace Healthcare Capital. “An increasing number of LPs are very interested in using their investment dollars to speak specifically to ESG issues.”
This doesn’t mean that investors are all turning into environmental activists. “LPs want to understand their exposure [to ESG risks] along a certain series of metrics,” says Melissa Dickerson, CFO at Genstar Capital. The consensus is that while there are investors looking to drive toward audacious goals like net-zero emissions in the next few decades, some just want GPs to take a proactive approach to mitigating risks.
In a 2022 survey by Intertrust Group, 96 percent of CFOs said that ESG is important to their LPs. In the same report, CFOs said that 77 percent of LPs want live or daily updates on portfolio performance, and 56 percent expected the same on ESG matters.
Meanwhile, 69 percent of respondents to Private Funds CFO’s Private Funds Leaders Survey 2023 reported that increasing demand from LPs is driving adoption of greater ESG monitoring and reporting in their firms.
The data dilemma
Many CFOs agree that amid the wider ESG push, one key part of any such initiatives will always end up on their desk: data management. “ESG professionals don’t tend to be data gatherers,” says Dwight Cupit, CFO of Bregal Investments. “But that’s what the finance function does. We have the systems and the processes to collect data, so we’ll do that, and pass it along to our ESG staff for interpretation.”
But gathering effective data on this topic is not a simple task. Cupit recently invested in a separate tech system to gather and export ESG data from portfolio companies. “We had a portfolio monitoring system that might have been able to do some of the work, but after collaborating with our ESG team in a long process, we decided it was worth investing in a separate solution.”
The dilemma isn’t merely managing massive data sets, but also the lack of a common methodology, and sometimes even a sense of the best metrics to use. “CO2 is easy to track because it’s something that can measured, but what about data that’s spread across multiple functions?” asks Dickerson. “Some of them require gathering data from HR, operations and finance, and unlike accounting practices that have developed over years and years, this is all new.”
Michael Braun, CFO of Germany-based investment firm Golding Capital Partners, says having a common methodology is crucial to success, “because if every single player is developing their own ESG toolkit, it won’t work… Investors might be grateful for the data, but then face the burden of reconciling all those separate [Microsoft] Excel spreadsheets into their own report. We’re only going to get ahead of the curve around sustainability if we have a European, or even better, a global toolkit for managing this data.” In lieu of that, how are CFOs tackling all the work?
96%
Proportion of CFOs who say that ESG is important to their LPs
Source: Intertrust Group, ‘The future private capital CFO: Unleashing potential in the ESG era’ 2022
56%
Proportion of LPs who expect live or daily updates on ESG matters
Source: Intertrust Group, ‘The future private capital CFO: Unleashing potential in the ESG era’ 2022
69%
Proportion of fund leaders who say increasing demand from LPs is driving adoption of greater ESG monitoring and reporting in their firms
Source: Private Funds CFO
Private Funds Leaders Survey 2023
Addressing such demands often involves hiring in-house ESG experts, but not everyone has the capacity to do so. “To a shop, everyone I know has an ESG policy in place,” says Pace Healthcare Capital’s Evans. “The larger shops have ESG officers, but for smaller firms, it falls to the CFO to not just craft the policy, but then also manage its implementation, to ensure we’re doing what our policies say we’re doing.”
Half of the respondents to the Private Funds Leaders Survey have an internal ESG team, but 40 percent outsource some part of their program. Those with the means to hire internal staff are big proponents of it, but CFOs agree that specific expertise is a necessity, no matter how it’s contracted.
“We outsource, because we want to partner with folks with real domain expertise, in the way we would tap SEC-trained attorneys to tackle regulatory matters,” says Genstar’s Dickerson.
The lack of common methodology only ups the need for expertise. “There are multiple different paradigms out there from the [Organisation for Economic Co-operation and Development] to the EU’s [Sustainable Finance Disclosure Regulation], and our ESG consultant is invaluable in sorting through them all,” adds Dickerson. But for CFOs with the resources, they’re fans of their internal ESG staff.
“We’ve been lucky to have built a large, dedicated, ESG team, which makes it so much easier for me,” says Cupit. Even for CFOs that get lucky, there’s still plenty to do.
“We work very closely with our director of ESG and director of impact, but processing ESG data and preparing the reports is part of the CFO unit,” says Braun.
And hiring ESG staff comes with the added bonus of demonstrating the firm’s commitment to the process, which helps win over skeptics.
“For private equity firms, ESG has to start with the leadership,” says Cupit. “When we hired an ESG team, that showed our commitment to this process.”
Private equity firms are not immune to the lingering skepticism around ESG. “So many of my peers have, like me, been pleasantly surprised by our leadership’s willingness to get on board with ESG priorities once we lay out the benefits logically,” says Evans. “But there are those that still resist this idea of looking beyond whether an investment will simply make money, without realizing that considering other factors can improve returns as well.”
“I think the biggest single change we’ve made to our ESG program is that it’s been elevated on our investment committee, so every investment memo now has an ESG section,” says Cupit. “Now if someone doesn’t address ESG issues in the investment memo, it’s not getting to the investment committee, so the deal team learns quickly to get that included.”
An evolving discipline
However, CFOs are aware that no ESG integration may ever be ‘complete.’ “ESG programs are living, breathing things,” says Evans. “We may learn down the road that one component or metric, that made sense five years ago, doesn’t make sense anymore. So, we revise it and might tighten some processes or find a way to be more granular around a particular issue.”
Braun adds: “The solution to the status quo is to focus on collecting and evaluating data, with the idea that there will be constant reassessment in the coming years.
“Do we see a positive development? Is this transition pathway credible? So, each year builds on the last one to get more effective.”
In doing so, a firm’s ESG program becomes, in itself, sustainable – and clearly no one expects sustainability issues to move out of the spotlight anytime soon.
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