I. ESG in the PE industry
In 2004, the then-UN general secretary Kofi Annan wrote a letter to 50 CEOs in the financial industry, urging them to further integrate sustainability into capital markets. This was the beginning of the PRI (Principles for Responsible Investment). Today, over 2,000 funds have signed the United Nations-supported PRI, up from 1,300 in 2013. The signees now have a combined $82 trillion AUM. PRI consists of six principles centred around the idea that long-term value of investors is best secured when investing into targets that are aware of the importance of ESG (Environmental, Social and corporate Governance).
During its transition from alternative investment option to mainstream way of investing, the private equity industry has also become increasingly concerned with ESG. This involves recruiting ESG-dedicated specialists, having higher sustainability requirements on potential targets and integrating ESG into every aspect of the daily operations of their portfolio companies.
“Poor ESG is indicative of a poorly run business, and for positive change to be really effective it must be driven by organizational culture,” Adam Black, Coller Capital Head of ESG said recently. A newly conducted ESG report by his firm shows that 89% of responding General Partners (GPs) are following and have formal ESG Policies, while the same percentage of responders say that ESG awareness require a special set of skills.
CFA UK has now responded to this demand by launching a four-level certificate in ESG Investing to stay up-to-date with recent developments and to integrate ESG capability more thoroughly into working life. Candidates will be able to take the exam in December 2019, and over 500 candidates have as of now already signed up to complete the course, showing that the interest in ESG is high both for employers and employees in the financial industry.
II. How ESG is integrated in recent deals
In the Private Equity industry, ESG is becoming an important part of the decision-making process for investments. According to a research by BCG, among 343 firms from 5 sectors, companies with strong ESG ratings get higher marginal return on the long term. 85% of the limited partners surveyed by Private Equity International strongly emphasized on responsible investment.
In 2017, the world’s largest pension fund (Japan’s Government Pension Investment Fund) with AUM of over 1.5 trillion announced their strategy to incorporate ESG factors as a top priority, and to allocate 10% of the general funds to sustainable investments. New Zealand Super Fund has announced a huge divestment of their investments in fossil fuel projects valued at $950M. Bain & Company’s report, based on a sample of 450 PE-led exits in Asia-Pacific region, shows that the median multiple on invested capital was higher for deals with social and environmental impact.
The evolution of ESG is not without difficulties: How should we appreciate, rate and rank ESG factors in a company? Which factors are more relevant for each sector? Certainly they are different: A company in the agriculture segment would not have the same ESG issues as a company in the energy production sector.
ESG Rating agencies such as Vigeo Eiris, ISS ESG and Sustainalytics have been created. Classic rating agencies and audit firms are also trying to fill this market (Bureau Veritas, SGS), and a globally shared standard could be the next thing we expect.
According to Deloitte Sitra and FVCA, a PE firm can be defined based on its current status of ESG maturity and role of impact into four categories.
III. What is the future for ESG in PE?
Cerulli Associates’ director said : ”We are in the beginning stages of adoption, with many firms just starting to build their ESG integration processes.” The development of Private Equity firms focusing on ESG is positive for the world’s ESG challenges, as private equity firms have influential and financial capabilities to create social responsibility through environmental improvement and social projects, while increasing returns for their investors.
However, it is still too early to conclude on whether this impact commitment and the ESG influence in Private Equity investments are creating value for investors although the current situation does look promising, looking at the Bain & Company sample of 450 APAC PE exits where the multiples for ESG deals were significantly higher than for other deals. According to the research firm Cerulli Associates, one “significant” challenge that asset managers are facing currently is the lack of ESG data. This is confirmed by Deloitte “there is enough information available, but concrete procedures are missing or they are still emerging.”