ESG demands are putting pressure on private equity to effect change in portfolio companies. That pressure is coming vertically from limited partners (LPs) and general partners (GPs), and horizontally from across the competitive landscape. But first, what exactly is ESG?
Interestingly, that’s where the divergence begins. Most public conversations in the wider business world, beyond the private equity space, are focused on the ‘E’ – environmental – and the drive to net zero. However, most of private equity’s focus is on the ‘S’ (social) and ‘G’ (governance), together with ‘social impact’ – although they’re still maintaining a very public articulation of the importance of the ‘E’.
That rings true logically as well. If we look at the early days of private equity and, in particular, primary investors, one of the key benefits brought by those investors to a business was the professionalisation journey. That meant the introduction of systems and processes that enabled good governance and rigorous testing of decision-making, together with more consistent and structured reporting. When this was overlaid with better policies, from ‘people’ to ‘compliance-focused’ ones – such as anti-money laundering – it took a rough diamond along a journey to become a polished gem.
Subsequent to this came specific regulations, such as carbon reduction commitments, which started indirectly to change the mindset of private equity and portfolio management. They caused the aggregation of certain traits, such as carbon reduction, by encouraging private equity firms to consolidate their portfolios. Regulation began to drive behavioural change.
Taking stock
In European private equity, at least, we’re in a position where there’s increasing regulation, which impacts the wider private equity space – from LPs and their behaviour on the one hand, to regulations that directly target GPs on the other. These regulations often overlap and are unhelpful – for example the interaction of Taxonomy and Sustainable Finance Disclosure Requirements (SFDR). Overlaid on this, some private equity funds are seeking to distinguish themselves as ESG-focused.
Much of the regulation – whether applicable to GPs or LPs and whether directly or indirectly applicable – originates from the EU. For LPs, this means it mostly has an impact on European LPs based in the EU (and still the UK) that typically aren’t sovereign wealth. It doesn’t apply to US LPs in the same manner. Often, US LPs see GPs with a focus or purpose on messaging in this space as ‘soft’ or ‘not returns focused’. GPs might moderate their messaging depending on which LPs they’re raising capital from and certain GPs not addressing this at all (publicly) because of those factors.
At the other end of the spectrum is internal compliance. European LPs are demanding heightened, regular reporting in this area, often about a specific set of key performance indicators (KPIs) that aren’t consistent and can create an administrative headache for GPs. Whether regulation will lead to some standardisation of these requests remains to be seen, but that’s far from certain.
Skills gap
We see some GPs as being fully articulate, with sincerity, about the benefits of a focus on ESG and social impact. They typically have a set of internal KPIs that they’ve monitored for a good few years and they can explain the journey of improvement of the portfolio through these metrics and how that leads to better financial returns at exit. These buy-out houses are ones that have focused on this area for a considerable period of time and are generally primary investors.
These firms are typically hiring people who have a direct focus on ESG or business transformation and are actively creating environments for sharing best practice and thought leadership across the portfolio. The logic is that each portfolio company will be on a journey and at least one other portfolio business will have faced the same challenges.
Currently, the most pressing challenge is the battle for talent, coupled with the diversity and inclusiveness challenge. I know of one enterprising GP who created an app-based system for this and for delivering content.
The final categories of houses are less focused in this space, but do on occasion hire people who have some form of remit on ESG. These individuals tend to sit within finance and focus more on the reporting side rather than being external facing. These houses don’t see the direct benefit of ESG, but instead see it more as a means to an end and/or an administrative requirement. But the number of firms that don’t have an ESG focus or resource is diminishing rapidly.
It’s interesting to see the different skill sets valued by GPs. Therefore, the ‘ESG role’ varies significantly from a finance, compliance, operational and consulting background, depending on how the GP approaches ESG themselves. Some GPs, for example, are poaching quality talent from large corporates, where those roles have been more established for many years. As one GP put it to me, the ideal scenario is when the specialist ESG role is no longer needed because each member of the investor team has those skills embedded. Until then, the competition for expertise is continuing to heat up.
One final thought is about the market generally and the target businesses, rather than LPs. Considering the wider industry benchmarks in this space, UN principles of responsible investment funds are increasingly looking at what they want to project to the market, recognising that each has its own set of rules and regulations that need to be followed on a daily basis. Different GPs are going down different routes, with many pausing, unsure of the benefits of selecting one or multiple paths.
With money comes risk
In simple terms, the expectation must be more regulation, with a hope that there may be some consistency or clarity in this space. Ultimately, though, the old adage rings true: ‘cash is king’.
As LPs focus and demand more from GPs in this space – either by reporting obligations or wider concerns – it will force behavioural change through to GPs, who need access to capital. There’s increasing evidence that improved returns will drive a focus from GPs.
If we go way back to before the days of private equity, pre-1930s, there was only a focus on upside in business valuations, with very little weight on risk factors. The Wall Street crash and the subsequent depression dramatically changed the views of investors regarding risk. The next 25 years saw coalescence around risk factors and prudence in accounting terms, with consistency of valuations coming from that. Smarter investors earned their corn by understanding sensitivities for risk. Now, on the limited data available (most of which is closely guarded), there’s a strong argument that ESG and social impact factors will follow this route over the next period.
One final consideration must be the banks. They’re under huge stakeholder pressure to provide facilities linked to ESG metrics, in a way we’re yet to see in independent debt funds. Coupled with the international momentum towards promoting ESG-linked lending, this could, in time, flow through into capital adequacy requirements. That could potentially counteract existing regulatory restrictions and allow banks to lend more in total and to buy-outs. If this happens, we could see the banks resurging into mid-market private equity, taking ground back from debt funds – which will have a knock on to transaction appetite and behaviour, too.
About the author
Andrew Green is a corporate partner at Addleshaw Goddard, a Corporate Finance Faculty member firm. He specialises in M&A, private equity and joint ventures.