Accounting firm BDO, which studied the environmental, social and governance (ESG) policies of 100 private equity (PE) houses with UK operations, found that PE firms are increasingly having to prove to investors they take ESG issues seriously.

While the majority have started to make their investment portfolios more responsible from an ESG perspective, progress stalled slightly during COVID-19 as PE houses focused their attention on supporting portfolio companies through the worst of the pandemic.

Sarah Ziegler, Private Equity Director at BDO, says some PE firms risk falling behind as comprehensive ESG rises up investors’ agendas.

“The majority of private equity firms now understand that integrating ESG into their investment decisions can help boost returns. For this to work, portfolio companies should be able to clearly show how they follow ESG guidelines,” said Ziegler. “Some firms are doing this well, but there are still some that need to improve. The uncertainty experienced in the heat of the pandemic was felt across the industry and that understandably required critical attention. However, limited partners will soon start to notice if PE houses start falling behind on their ESG commitments.”

The study revealed that in 2021, 57% of UK PE firms clearly set out the changes they have implemented to make their investments more ESG-focused. Just over half (55%) of UK PE firms now adhere to the United Nations Principles for Responsible Investment (UNPRI), the world’s most-recognised set of ESG principles. This is up from 49% in 2020.

Approximately half (48%) of UK PE firms now report in detail on the ESG impact of their investments - unchanged from the previous year, and close to a third (29%) of UK PE firms now have a dedicated individual or team responsible for embedding ESG into the investment process – up from 25% in 2020.

Rallying to prioritise ESG

As the post-pandemic recovery takes hold and private equity-backed businesses accelerate their growth plans, private equity houses are rallying to prioritise their ESG credentials, says BDO.

PE firms often apply ESG screening pre-transaction to identify any ethical red flags at a prospective investee company. Firms are also conducting specific due diligence before any potential deal and a rising number are educating their investment committees on relevant ESG considerations.

More firms are now also beginning to report in detail on the ESG impact of their investments. This includes carrying out ongoing ESG monitoring post-transaction and ensuring managers report on the ESG impacts of their portfolio companies to their limited partners. While progress has been made in some areas, BDO says there is clear room for improvement. A third (34%) of PE firms are yet to publish their own set of ESG principles and only 29% have a dedicated ESG team.

ESG investing leads to better returns

There has been scepticism towards ESG from some in the private equity sector in the past, but firms are more aware than ever of how having strong ESG credentials can act as a key competitive advantage.

Sarah Ziegler added: “Firms that demonstrate not just a commitment to ESG but data to prove the impact of their approach are now in a better position to attract investment.

She continued: “Investment consulting firms and Placement Agents, who act as ‘gatekeepers’ for institutional investors, are also paying closer attention to the ESG policies of PE firms, and in particular the substance behind those policies.

“PE houses should embrace reporting requirements and use environmental KPIs to capture the link between environmental and financial performance. An increasing number of studies have shown that ESG or sustainable investing leads to better returns across a range of asset classes, including private equity.”