This article is sponsored by RSM.
In Europe, the ability of a private equity firm to demonstrate its commitment to environmental, social and governance issues has evolved from a nice-to-have into a necessity. LPs have demanded reporting keep pace. The same level of attention paid to ESG matters historically had not been as common among the swathe of mid-market managers that comprise the bulk of the US industry. But things are changing. Anthony DeCandido, RSM financial services senior analyst and audit partner, outlines where this segment of the market is headed with its approach to ESG concerns.
When you talk to your private equity clients about ESG, what is the one key emerging theme?
In a word, data. There is a growing interest in the market in data and where it comes from. That was not the case five or 10 years ago. If a GP or an LP is uncertain about a data point, they want it to be validated. Today, data is obtained by surveys and self-reporting, which is one of the biggest issues with ESG.
In the case of a publicly listed company, there are filings to sift through and numbers to measure. Private businesses are under no similar obligation. The marketplace, including investors, recognizes this, as well as that managers may have an interest in presenting particular data – whether they are fundraising or looking for exposure.
Validation of those numbers is going to be more important than a GP simply saying: “Here is our ESG strategy and this is how we drive it.” There is a concern that the numbers could be skewed, making the whole exercise pointless. In general, asset managers and investors are looking for a higher standard of reporting and that is driving developments in ESG.
The state of play in the private equity industry today feels like the early 2000s, when there was a lot of attention given to public businesses and new requirements for internal controls, governance and reporting. The industry knows that it needs to organize in a more productive and suitable way, and yet there is not an ESG reporting requirement.
A whole new market could be uncovered if a regulator with enough credibility emerges and says this is no longer just a nice-to-have, but it is a requirement to report on your ESG strategy and impact. The whole landscape will change when that happens.
What does best practice reporting look like?
The GP holds the answer to that. It depends on their goals, objectives and stakeholders. It depends on where the firm is in their lifecycle. An early-stage fund is looking to attract assets and build reputation, so their focus may fall on marketing. A later-stage fund with a track record may be looking more at its legacy and where they are going to be five or 10 years from now. They may be looking to showcase their sustainability effort at a broad level. This could be in a 12-page report that highlights their success stories.
Is getting the data difficult?
Asset managers have so much good data in plain sight but the struggle is to accumulate it in a useful way. Sometimes we need to bring to their attention what they have as well as what they are missing. Sometimes it is eye-opening for managers to realize that so much of what they have already been doing can be incorporated into an ESG strategy. It is not all brand new. What is new is the increased interest in ESG issues, such as workplace safety, emissions control and hazardous waste.
How do you get over the issue of managers picking and choosing metrics?
Performance assessments are one solution. We can help companies benchmark one type of investment strategy against another and measure across their suite of investments. If you are a private equity firm with a sector strategy – for instance, in healthcare, tech or industrial products – there will be a common thread whereby we can produce comparable measurements. It’s vitally important that the manager understands where they rank amongst their peers.
A manager may also be interested in measuring a managed portfolio in one industry against a separate position investment in another industry. Positive results can be showcased and marketed. Where results are less than ideal, it is a good sign when a GP is sufficiently self-aware to admit they failed.
There are ESG reporting templates out there from the Institutional Limited Partners Association, the Principles for Responsible Investment, Invest Europe and the Sustainability Accounting Standards Board. What impact are they having on standardization or validating measurements?
The two that are having the greatest impact on our client base are SASB and PRI. PRI puts out sustainable development goals, which encompass some key measurement targets, such as diversity, food and hunger, workplace safety, energy emissions – some of the core tenets that are consistent across a lot of different businesses.
That is an easy framework to follow. You can advise using the 17 sustainable development goals in a way that is comparable to a heat map. Not every company is going to show brightest on every one of those initiatives, but they are most likely to have coverage on some of them and you can showcase the progress of one versus another.
There seems to be a conflict between generating reporting metrics that are specific to a firm or fund that convey the impact of ESG initiatives and generating something you can benchmark against other GPs.
Absolutely. That is where the rubber hits the road. GPs have been focused on driving returns; now they have to drive returns as well as showcase an ESG strategy. Managers need to be sufficiently comfortable in their own skin to acknowledge where they are today regarding their ESG approach and to show their stakeholders where they want to go.
Some GPs work with their investor base to understand what their goals are and how they can help drive that strategy. For our clients in the middle market, the investor base runs the gamut from the largest institutional investors down to local high-net-worth individuals. Their priorities are very different. A high-net-worth individual may not care so much about a firm’s ESG approach.
Demonstrating a tangible link between ESG and value creation is a persistent challenge for all GPs. Why is this difficult?
A lot of our clients struggle with measuring ESG impact in a way that is useful to their business and stakeholders. As I mentioned, there is a lack of reliable ESG performance data today. In response, many consulting firms are developing their own measurement systems. Our approach is to work alongside the management team to develop measurement tools in a way that is no different from the assurance services we provide when clients ask us to help them with their valuation marks.
What is more important to US mid-market managers: E, S or G?
In the US, there have been quite a few high-profile social movements, such as #MeToo, as well as increased sensitivity to the role of women in the workplace and diversity. So, if a company fails on a social issue it is more likely to lose points than with an environmental one. Right now, making a mistake of the ‘E’ is more forgivable than on the ‘S’ and this is why the ‘S’ gets more attention.
Looking forward, do you see the scope of ESG-related topics expanding?
In the US middle market space, not yet, but only because there is such confusion today regarding where to start. A lot of our asset management clients have financial backgrounds and are comfortable with technical frameworks like Generally Accepted Accounting Principles. There isn’t a similar framework that is universally accepted as GAAP is on the financial end. I do think that the middle market is looking for a single framework that presents a system, method and set of objectives and measurements that managers can follow.
Mid-market implementation of ESG
As part of the RSM US Middle Market Business Index – a survey of approximately 700 business leaders – we compiled a fourth-quarter 2018 report on corporate social responsibility, diversity and inclusion
The results showed that nine out of 10 executive leaders believe that CSR is a critical strategic imperative. But only 38 percent of them have organized a CSR strategy.
In private equity, middle market firms are generally first to follow. They are watching the KKRs and the Blackstones to understand what these groups are doing and what is best in class. These are large firms and their activities are scalable. However, for middle market firms to implement a productive ESG program, they might have to devote half the time of one full-time person in a team of just 10-15 people. There is just not enough scale. Employing external advisors is the way they get over that lack of resource.
Good firms have been interested in ESG for a long time, but in the past their investor base was not as concerned about it as they are today. Now there is equal emphasis on both risk management and value creation, and a growing interest in demonstrating not just what they are doing, but why they are doing it. Businesses in general are more interested in promoting their values and this is key to attracting talent among millennials who want to understand the mission of the company where they work.