ESG, the Ultimate Purpose Playbook for Private Equity ESG, the Ultimate Purpose Playbook for Private Equity
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August 30, 2021

ESG, the Ultimate Purpose Playbook for Private Equity

Guy Barnes, Managing Partner, Private Equity Co-Leader
Kevin O’Neill, Co-Founder & Managing Partner, Private Equity Co-Leader
Hannah Taylor, Associate, Technology & Private Equity

The maturing role of ESG

Making the world a better place is now a top-of-mind private equity strategy. Over the last decade, the focus on ESG – environmental, social, and governance criteria – has shifted significantly, driven by regulatory developments, increased pressure from LPs, and higher expectations of company values from employees, candidates, and society at large. Meaningful commitments, investments, and actions around ESG initiatives are more important than ever for funds to differentiate themselves — and create greater value.

As the ESG definition matures, the scope is broadening, with firms moving from addressing the “E” and “G” to tackling wider social issues; the pandemic and the Black Lives Matter movement have specifically brought diversity, inclusion, and social impact into the spotlight. As a result, organizations and investment firms alike face pressure to demonstrate transparency and action. Additionally, they face pressure to have the data to back up their positions.

“Most companies will need to progress their ESG focus substantially to not only adhere to new regulatory developments but to go beyond them if they are to attract capital, talent, and deals in a highly competitive market.”

Greater scrutiny requires more forward-thinking measures, and most companies will need to progress their ESG focus substantially to not only adhere to new regulatory developments but to go beyond them if they are to attract capital, talent, and deals in a highly competitive market.

Regulatory changes are creating an interesting ripple effect

A particularly significant change is represented by the introduction of the SFDR, or Sustainable Finance Disclosure Regulation, which came into effect earlier this year. Lip-service and “greenwashing” will no longer go unchallenged: there is now an obligation on behalf of asset managers and other financial market participants to disclose precisely how they are considering ESG risks in their investment decisions. This includes citing information in fund documents such as periodicals and investor reports, as well as online – consistently, publicly, and thoroughly. For the first time, all institutional investors will be required to divulge precisely what the ESG risks across their portfolios and targets are. And if they are found wanting, they will have a duty to explain why. Further changes are likely to take place over the next few years as the remaining objectives stipulated by the EU Taxonomy come into force, and the Biden administration plays out: companies must act swiftly and proactively to prevent themselves from falling behind. 

The consequences are far from immaterial: should they fall short of adequate disclosure requirements and substantive ESG efforts, investors stand to lose their access to capital. As standards are raised and more investors make commitments to reduce investments in companies and industries that do not meet ESG criteria, the pool of capital available to companies that do not score highly on these metrics is shrinking dramatically. Adherence has progressed from a “nice to have” to a critical aspect of an investor’s decision-making process. Greater transparency around such issues will be imperative not only to a fund’s access to capital but also to the value of assets at exit.

“Adherence has progressed from a ‘nice to have’ to a critical aspect of an investor’s decision-making process.”

This push is reflected in the scale of capital being invested in ESG-oriented funds and their subsequent success (relative to non-ESG funds), alongside an increased awareness and urgency to step up efforts to address environmental and governance issues. According to the Pitchbook 2020 Sustainable Investment Survey, 95 percent of LPs are either already evaluating ESG risk factors or will be increasing their focus on ESG risk factors in the coming year. The Principles for Responsible Investment (PRI) signatory list now includes close to 3,000 investors, pension funds, and asset managers globally: signatories must have ESG criteria integrated for 50 percent of the assets under their management – a considerable commitment given that noncompliance or failure to sign the agreement could result in the delisting of asset managers. 

The underlying force behind many aspects of this sustainable finance “revolution” can be attributed in part to the world embracing sustainability goals such as Net Zero 2050: but at a micro level, to financial markets acknowledging that investors have a responsibility to account for potential harm caused by activities they are financing. That upside cannot be the only consideration in investment decisions. To manage risk, you need tools, data, and information to report on it reliably. 

There is also a growing recognition that, contrary to historic claims, ESG investment comes at the expense of fund performance, ESG factors can reduce costs, improve productivity, and create enhanced opportunities around customers, LPs, and government relations, directly contributing to top-line growth. This is something that “return first” funds cannot ignore. 

Until now, there has been limited data on sustainable fund performance over the long term. But new studies are beginning to emerge, demonstrating the companies that rank well in ESG measures regularly outperform the market and that their employees are more engaged and satisfied. Although such reports are nascent, the increasing demand for data from new regulatory developments will add considerable weight to such findings over the next few critical years.

Emerging ESG roles

Institutional investors are steadily building up their ESG capabilities by hiring a head of ESG or entire teams dedicated to the function. In the case of private equity, the head of ESG role is expanding to one that is strategic, operational, commercial, and importantly plugged into all portfolio companies, management teams, and investment decisions. 

It is a role that requires breadth as well as depth – subject matter expertise in one area of ESG will no longer suffice, and more advanced funds have taken to forming a bench of professionals with complementary backgrounds to seamlessly work across a fund’s portfolio. To be considered a leader in such initiatives, firms are moving from assessing basic compliance and risk management to forming a longer-term approach to creating value, embedding these practices across the investment life cycle and at all levels, including the advisory ecosystem that surrounds private equity. ESG percolates due diligence, value creation, deal strategy, finance, and operations, and is impossible to avoid for those in the orbit of investment activity. 

“Investors do not prioritize cyber security in the same way they would the role of CEO or CFO at the beginning of an investment cycle.”

Another ESG challenge that global investment firms are turning to executive search and leadership consulting firms to solve is cybersecurity. In fact, cybersecurity is cited by institutional investors as the top ESG concern their investments face. The “S” of ESG now includes data and technology failings and will require greater consideration than previously allocated. Although the appointment of Diversity and Inclusion-focused professionals has been on the rise for some time, the position of chief information security officer remains scarce. Only 16 percent of private equity portfolio companies have a CISO or equivalent function in place. Of these, 46 percent were inherited. This suggests investors do not prioritize cyber capability in the same way they would the role of the CEO or CFO at the beginning of an investment cycle. Investors are beginning to address this by appointing a CISO, and/or augmenting technical due diligence pre- and post-acquisition to mitigate risk accordingly. But few are fully prepared for this element of risk assessment. 

More generally, companies have begun to focus on building out sustainability committees and have even gone so far as to name board members who are advocates for change, whether preemptively, or as the result of shareholder pressure. 

Consider, for example, Exxon’s recent board turnover where Engine No. 1, an investment firm “purpose-built to create value by driving impact” landed three board seats. Although eight Exxon nominees were re-elected to the twelve-person board, the firm shocked the street by winning these board seats. Time will tell if Engine No. 1’s methods can be mirrored by others looking to make a big impact, and quickly. Afterall, if it can happen to a fossil-fuel giant like Exxon Mobil, is any company immune to the groundswell of support for ESG initiatives?

Where will ESG-savvy experts come from?

The vital importance to private equity of rapidly addressing these topics raises the question: where will these environmental, social, and governance experts come from? ESG-focused consultancies pre-date the current rhetoric around climate change and sustainability. ERM (Environmental Resources Management) was formed in 1987, itself a private equity portfolio company of Charterhouse, OMERS, AIMCo, and more recently KKR. And many firms that now have a dedicated ESG consulting offering – Jacobs, AECOM, and Ramboll, as some examples – were born out of Environmental, Health and Safety efforts around industrial and engineering activity more than twenty years ago. 

More recently, leading strategy consultants have forged sustainability practices, largely comprised of consultants from traditional sectors with a high carbon footprint (such as oil and gas), and consultants focused on specialist topics such as circular economy, or else heavily focused on climate change. Few have truly addressed all topics contained by the acronyms – something we are likely to see a shift in over the next few years to address increasing demand from core client bases. 

“Few leading strategy consultants have truly addressed all topics contained by the acronyms – something we are likely to see a shift in over the next few years.”

Already, we are seeing consulting firms form partnerships with or invest in third parties: for example, consider Accenture’s investment in ESG data platform Arabesque S-Ray, BCG’s collaboration with Italian business Eni and Google Cloud to launch a sustainability data platform focused on supporting companies in their energy transition journey, or Bain & Company’s investment, alongside CVC, in the French-based sustainability rating provider EcoVadis. There’s a growing trend in the professional services sector of enhancing environmental, social and governance credentials quickly. Yet revisiting the idea of ESG professionals needing to work cohesively across all aspects of a fund’s investment activity and acknowledging that to do so requires breadth and depth around ESG content in addition to a cornucopia of strategic, financial, and operational skills. Investors need to look beyond the usual talent pools to find such individuals. 

In another decade or so, we may well see the emergence of fully-fledged sustainability professionals well-acquainted and equipped to tackle all topics under the ESG umbrella – the number of sustainability degrees and courses offered by higher education institutions has risen dramatically, and now encompass ecological, economic, policy, and social studies, combined with certificates in sustainability leadership and management. But at present, such experience is likely to come from a handful of sources, including funds that were early to onboard ESG appointments, who have since flexed their consulting muscles in an operating environment and developed in parallel with the widening definition of sustainability. In light of increasing scrutiny, such executives are likely to need specialist expertise (for example, human rights knowledge or cybersecurity credentials) to meet new requirements and bolster their efforts. 

Time will tell what the future holds regarding the ongoing ESG evolution. In the meantime, focus on opportunities today to enable transformation and impact worth being proud of tomorrow. This is the era of standing up to stand out, and of migrating from selling goods and services to doing good and being of service.

This article was originally published in Hunt Scanlon’s 2021 Global Private Equity Talent Leadership Report, “Designing the New Private Equity Talent Blueprint”.