Aberdeen Standard: ESG will be integrated across the industry soon

While engagement remains patchy in some regions, Aberdeen Standard Investments’ Alistair Watson, Alan Gauld and Stephanie Kempton expect ESG integration to soon become the industry norm.

This article is sponsored by Aberdeen Standard Investments

GPs had plenty to keep them occupied in 2020, including the move to remote working and the need to work closely with portfolio companies impacted by lockdowns. Despite these challenges, many have also spent time improving their environmental, social and governance performance.

This is a finding of a recent survey conducted by Aberdeen Standard Investments. A snapshot of private equity’s progress in ESG undertaken annually since 2015, the survey comprises responses from 104 private equity managers and 40 of ASI’s co-investment portfolio companies. We caught up with members of ASI’s private equity team, senior investment director Alistair Watson, investment director Alan Gauld, and investment manager Stephanie Kempton, to find out more about the survey results and how the industry is addressing ESG.

Why is ESG important to you as an LP?

Stephanie Kempton

Stephanie Kempton: Fundamentally, ESG is important to ensure we are good custodians of the money we manage on behalf of our clients. We see ESG integration as a hallmark of quality both at a GP level and when assessing co-investments.

Strong ESG management is essential to running good businesses and generating returns.

Alan Gauld

Alan Gauld: If you have a firm grasp of ESG in a business you can mitigate risks effectively, but we also see value creation stemming from this. ESG provides insight during the due diligence phase, protects downside and creates value during the investment. Research suggests that ESG leaders are more marketable on exit and are attractive to a broader set of buyers.

ESG is not new to us and responsible investment has been a longstanding focus of ours. Aberdeen Standard Investments has been a PRI signatory for over 10 years and became carbon neutral in 2019. Yet, we do see some who remain sceptical of ESG. They are entitled to be, but they cannot deny the $30 trillion capital shift that is underway towards millennials and younger generations. These are generations that care much more about sustainability factors than their predecessors. There is also regulatory pressure – for example, the UK government recently announced that climate-related disclosures will become mandatory for large private companies by 2025. You can put your head in the sand if you like, but ESG regulation is coming.

Alistair Watson

Alistair Watson: There is sometimes an allegation that ESG is just cosmetic – we want to get beyond that by starting with reporting and metrics and then demonstrating how change and value builds over time. We are looking for managers that make changes rather than just report on metrics. Companies that are performing resiliently despite the covid-19 disruption, often companies that are anticipating shifts in the way we work and live, also tend to score well on ESG measures. Importantly we are seeing a requirement for increased ESG action and transparency from our own institutional investors, particularly in Europe. Asset owners recognise the positive impact they can have in climate change and the drive towards net zero.

Why do you conduct the responsible investment survey?

AG: When we started the survey in 2015, it was becoming clear that ESG was going to be a major factor in the success of private equity investments. Yet we were getting inconsistent or little information from managers and portfolio companies, so it was designed to understand what was happening within private equity firms and their portfolios. When we analyse managers, we need to cut through the marketing around ESG and try to benchmark ESG performance with the aim to eventually help drive tangible improvement.

SK: The survey has an important role in our fund and co-investment decision-making and we have incorporated it into our investment processes. It is a good bellwether for how managers look at ESG and helps us analyse trends, such as the increasing importance of the UN Sustainable Development Goals, as well as how managers are progressing and what challenges they face.

Over the years, we have seen GPs continually improving, especially in Europe. Even with the pandemic in the background, GPs have continued to make progress in integrating ESG. In the latest survey, we also looked at the difference in ESG performance between small, mid-sized and large managers. Larger managers have generally invested more capital in ESG systems and people, which is resulting in better ESG data. However, we don’t believe that larger managers have a greater ESG cultural buy-in than smaller managers, it’s more a factor of resource.

AW: In our co-investments, we can have a strong influence and get live data on how companies are managing ESG. In the latest survey, we included co-investments for the first time. We had a 95 percent response rate, so it provides useful ESG information across the portfolio: whether companies have an ESG policy in place and are tracking ESG key performance indicators, as well as ongoing ESG initiatives and important more specific topics, such as employee engagement and cybersecurity. In addition, it highlights areas of weakness and potential improvement – here, I would point to female board representation and measurement of carbon footprint.

Can you provide some examples of where you have seen progress?

AG: In 2018, 59 percent of respondents had an ESG policy; now that figure is 73 percent. Half of respondents are now PRI signatories, while in 2019, it was just 38 percent. The survey helps us with benchmarking and identifying who the leaders and laggards are. Those making most progress are not always the ones that are best resourced. By picking the right battles and having real buy-in, smaller managers can make a significant difference on ESG.

AW: A third of managers say their ESG plans are accelerating as a result of covid-19. Firms are aligning their investment theses with the SDGs, and some are becoming B-Corps or joining Initiative Climat International. The penny appears to have dropped, and we are now seeing real cultural emphasis.

Another key finding is that European managers have embraced ESG much more than those in the US or Asia. Why do you think this is?

AG: There is real momentum in Europe, and, while we are seeing encouraging signs, the US and Asia are behind Europe. Some of this is cultural, but it is also because Europe has been the genesis of ESG. Europe benefits from the political will of the EU and local governments to act on ESG issues and so the region has a head start. It just means we must engage more with some US and Asian funds – we do not screen out all investment opportunities that are not perfect on ESG grounds. We are happy to invest and work with GPs that are open and show a desire to improve their ESG credentials and are seeing definite improvements resulting from this engagement.

Where else is there room for improvement?

SK: The response to our question on diversity-related targets continues to be underwhelming. Only 23 percent were able to articulate the diversity targets in their portfolio companies, although 47 percent are intending to incorporate these in the near term. This will become more front of mind, especially as ILPA has launched its Diversity in Action initiative. Some GPs are running projects to help people of all backgrounds enter private equity or finance, but it must be a cultural shift, not just target-driven.

AW: Private equity-backed companies tend to have GP representatives on boards and since (reflecting the current make up of GPs) these are mostly male, that presents a challenge when you look at female board representation. Of course, we also want to see increased female representation in senior management teams.

How can you help GPs improve?

AG: Engagement is key. We invested a few years back, for example, with three smaller European GPs where ESG was not a major consideration but senior partners were open to implementing ESG and engaging with us. We supported them on areas such as ESG policy and what good implementation looks like. We can help support GPs because we bring a holistic view from across the market. The ESG practices of these GPs today compared with a few years ago are like night and day. As an LP, you should never underestimate the impact you can have just by asking the right questions.

AW: It can also help to talk about examples of best practice and positive change in our portfolio. We are not just looking to invest in ‘ESG perfect’ businesses, but also businesses that have a propensity to drive positive change in ESG matters. Industrials businesses are not always associated with positive ESG credentials, but, for example, we are encouraged by progress at investee company, Sulo (lead sponsor Latour Capital), a French-headquartered waste container manufacturer. Under current ownership Sulo was the first French company to be awarded the Circular Economy certification, due to its success producing waste containers made from 100 percent recycled and recyclable materials. Latour and management are striving to further increase the use of recycled materials from what is already a market leadership position.

How will ESG develop in private equity over the medium term?

AG: I believe that we are at the end of the beginning of the journey towards ESG being truly integrated. The last five years have been about firms developing their ESG policies and processes, setting the foundations in place. If we were to look at the European market five years from now, I am confident that ESG will be largely integrated into reporting and into LP-GP and GP-portfolio company discussions. This will be the way private equity does business and LPs will receive ESG metrics alongside the usual financial data. Regulation will accelerate change and we will likely see a more consistent approach to ESG reporting than at present.

AW: Over the next few years, private equity will move from a catch-up phase to one where ESG is measured and reported and the impact becomes more evident – with the increased cultural buy-in to ESG we are experiencing amongst private equity managers, we will see tangible results as well as the metrics.