Friday Letter Only partly responsible

GPs are struggling to live up to LPs' demands for ESG excellence. Some need to raise their game, quickly.  

It's fair to say that there are mixed feelings about environmental, social and governance (ESG) and responsible investing within the GP community. Some managers are entirely convinced it's a crucial way to add value to their investments. Others see it as little more than window dressing; an unavoidable public relations exercise.

In some ways, though, it doesn't really matter which camp they fall into. The fact is this is a subject GPs can't afford to ignore, particularly if they're planning to hit the fundraising trail any time soon. For investors – particularly big investors – a serious ESG strategy is now mandatory. Like it or not, GPs need to be making a concerted effort.

The trouble is, of course, that it's easier said than done – as a new report released this week by PwC reminds us. The consultancy surveyed 17 buyout houses (including six of the top 10 biggest global groups): it found that around half didn't have any kind of responsible investment policy, while only about 40 percent had a formal system in place to measure their ESG effectiveness – a metric in which LPs are increasingly interested.

By way of mitigation, the recalcitrant GPs pleaded a lack of internal resources and the difficulty of finding the right expertise in-house. These are not trifling concerns. Some GPs argue the more time they spend tracking and reporting ESG issues, the less time they spend working on their portfolio companies – which, they say, is ultimately what will deliver real value to their investors.

Equally, some GPs do not feel they can justify having a fully staffed ESG team in the way that some of the biggest firms do. So instead, they're trying to train their internal teams and bring in expertise from outside where necessary. Inevitably, this squeeze on resources means they are often having to focus their ESG efforts on specific companies, as opposed to the whole portfolio.

This might make for some nice case studies. But it's not enough for big LPs any more. Their expectations are higher; they want to see evidence of an across-the-board strategy. And many GPs are manifestly falling short.

At a time when there's so much else to worry about, it must be tempting to put this issue on the (low carbon) backburner. However, this is not an option. LPs' interest in this area is unlikely to wane; in fact, according to the PwC study, most GPs expect it to increase. In today's fundraising environment, that makes ESG excellence a necessity for GPs, not a 'nice to have'.

This should not be a scary prospect, however – even for the industry laggards. For a start, LPs are not unreasonable in their demands. BC Partners hasn't traditionally been known for its commitment to ESG; but while it was on the fundraising trail last year, LP sources say it went to great lengths to persuade potential investors that it was changing its ways. Judging by the success of its fundraising, that seems to have worked. This suggests LPs are interested not just in a GP’s current position, but also in their direction of travel. So it’s all the more important for GPs to redouble their efforts in this area and continue their progress, however hard it may be.

The second, and perhaps the most significant motivation, though, is that measuring the impact of ESG is likely to prove to GPs that responsible investing actually creates tangible value within their portfolio. Trying to quantify this value remains more of an art than a science; in such an incipient field, there is still relatively little standardisation. But moves are afoot, on both sides of the Atlantic, and early signs are promising. Perhaps the highest profile example in private equity is that of Kohlberg Kravis Roberts (winner of PEI’s Responsible Investor of the Year in North America award this year): it claims its Green Portfolio Program has already had a combined ‘financial impact’ (i.e. cut potential costs) of $365 million to date. Numbers like these should be enough to persuade every GP that ESG is an area in which it’s worth investing.