1. Responsible investing as a strategic priority

The rise of ESG has been one of the most notable developments within private markets over recent years. For many private equity firms and their investors, ESG is now much more than a tick-box exercise – it is a strategic priority.

ESG considerations carry increasing weight within GPs’ investment strategies and value-creation efforts across their portfolios. Two-thirds of the firms surveyed for PwC’s Global Private Equity Responsible Investment Survey 2021 listed value creation as one of the top three drivers of their ESG activities. This is more than 20 percentage points above factors such as investor pressure (41 percent) and value protection (40 percent), and far higher than regulation (12 percent) and reputational risk (17 percent).

Private equity executives who expect to capture an ESG premium in businesses they are considering exiting

Source: EY’s 2021 Global Private Equity Divestment Study

Private equity firms that are concerned about compliance with ESG regulation

Source: PwC’s Global Private Equity Responsible Investment Survey 2021

Private equity executives who agree that their firm and its investments should be taking greater responsibility for their carbon footprint

Source: Apex Research, What is Private Equity Doing in the Fight Against Climate Change?

This shift has led to changes in how ESG management activities are resourced within firms. Ian Povey-Hall, executive director and global head of sustainable finance and impact investing at recruitment firm Acre, tells Private Equity International that within generalist GPs there has been a growth in centralised ESG teams that can support their firms’ transition “to an ESG-compliant and sustainability-driven proposition”.

The focus of these centralised teams is also evolving. “This centralised function is shifting from being more regulatory and client-driven to a strategic and value-creation role, working much more closely with, and sometimes embedded in, investment teams,” says Povey-Hall. “Sustainability is being seen by more investors as a driver of outperformance, as opposed to just a prerequisite of a firm’s regulatory and societal licence to operate.”

LPs are also eyeing the relationship between responsible investing practices and outperformance. According to PEI’s LP Perspectives 2022 Study, 74 percent of investors believe adopting a strong ESG policy will lead to better long-term returns within their private markets portfolios. And although the PwC survey indicates that investor pressure and regulation are lower down the list of drivers for firms’ ESG efforts, there is no doubt that LP and regulatory pressure is intensifying. Evidence and consideration of ESG form a major part of the due diligence process for 57 percent of respondents in the LP Perspectives 2022 Study, compared with 38 percent the previous year. In a similar vein, the proportion of LPs for which evidence of diversity and inclusion at the GP level plays a major part in due diligence increased from 14 percent in 2021 to 28 percent in 2022.

At the same time, private equity firms are getting to grips with a more onerous regulatory landscape. This includes compliance with new legal regimes such as the EU’s Sustainable Finance Disclosure Regulation, which came into effect last March, and the UK’s Environment Act, which passed into law in November.

2. Initiatives developed by the industry, for the industry

Efforts to step up ESG-related monitoring, measurement and disclosure practices have been complicated by difficulties in data collection, reporting and benchmarking across private equity funds and portfolios. “The private equity industry lacks standardised, performance-based ESG data from private companies, despite a proliferation of ESG frameworks,” says Julia Jaskólska, lead for ESG and co-investments at California Public Employees’ Retirement System. “That prevents allocators from being able to track ESG factors across their broader portfolios.”

To help address this, a group of LPs and GPs representing $4 trillion in assets under management, led by CalPERs and Carlyle, established the ESG Data Convergence Project. According to its launch announcement in September, the project aims to “streamline the private equity industry’s historically fragmented approach to collecting and reporting ESG data in order to create a critical mass of material, performance-based, comparable ESG data from portfolio companies”.

“Sustainability is being seen by more investors as a driver of outperformance, as opposed to just a prerequisite of a firm’s regulatory and societal licence to operate”
Ian Povey-Hall,

To do so, participating GPs will track and report on six metrics across their portfolio companies, including Scope 1 and 2 greenhouse gas emissions, renewable energy, board diversity, work-related injuries, net new hires and employee engagement. This data will then be aggregated into an anonymised benchmark by Boston Consulting Group. As Chloë Sanders, head of ESG at CVC Capital Partners, notes: “Everyone has a rough idea of what good looks like for each KPI, but until we have the ability to benchmark by sector, that data doesn’t completely come alive.”

The ESG Data Convergence Project is not the only way the industry is working together to drive progress on ESG issues. In November, the Science Based Targets initiative released tailored guidance for the private equity industry to facilitate the adoption of science-based targets that align with the goals of the Paris Agreement. The guidance was supported by Initiative Climat International – a community of more than 130 private equity investors that aims to address climate change – as well as the UN-backed Principles for Responsible Investment.

The guidance is indicative of the growing focus on emissions reduction and climate risk mitigation, particularly in light of November’s 26th UN Climate Change Conference of the Parties, which catapulted global warming to the top of the agenda.

“Everyone has a role to play in decarbonisation and if the ambition is to reach net zero, you really can’t ignore private equity, given the scale and scope of the industry’s investments,” says Adam Black, head of ESG and sustainability at Coller Capital. “Yet private equity is also important because firms can get so much done on this if they choose to – they can be really granular and get things done quickly.”

The impetus to act among GPs and to take accountability for their wider carbon footprint is becoming increasingly apparent – more than eight in 10 private equity executives believe their firm and its portfolio companies should be taking greater responsibility for their carbon footprint, according to research by Apex Group.

There is still some way to go, however. Among investors polled for PEI’s LP Perspectives 2022 Study, fewer than half either strongly or somewhat agree that GPs are taking the risks of climate change seriously enough within their own investment policies and practices.

3. Emerging areas of focus

The term ‘natural capital’ has been swirling around private markets ESG circles of late. In August 2020, HSBC Global Asset Management and climate change advisory and investment firm Pollination Group announced a joint venture to establish HSBC Pollination Climate Asset Management. The partnership aimed “to create the world’s largest natural capital manager”, according to the announcement, and claimed to be “the first large-scale venture to mainstream natural capital as an asset class”.

Since then, other natural capital-focused strategies have taken shape, including Nuveen Natural Capital, a new business unit that combines Nuveen’s farmland investment business, Westchester Group Investment Management, and its forestry specialist, GreenWood Resources.

Westchester president and chief executive Martin Davies, who leads the new business unit, says the firm’s new strategy is an extension of the work it has done before: “Historically, the only thing we have thought about that we benefit from investments in farmland and timber is [the] food, fibre [and] timber that is produced. But now there is a much greater realisation that there are many other benefits that are derived from investing in those natural capital assets – biodiversity, water quality, carbon sequestration. It’s not as if it’s new, but it’s a different way of thinking about it.”

Meanwhile, the spotlight is turning to areas, such as human rights, that have perhaps garnered less attention than other ESG-related issues at the forefront of the responsible investing conversation. “Human rights has always been an important topic, but what has changed is the level of awareness about these issues and the availability of information,” says Carmela Mondino, head of ESG and sustainability at Partners Group.

Incoming regulation is set to place additional human rights compliance, reporting and monitoring requirements on firms and portfolio companies. Germany’s Supply Chain Due Diligence Act, which comes into force from January 2023, requires companies within its scope to take appropriate measures to comply with human rights and environmental standards in their operations and supply chains.

The issue is also on investors’ radars. During a panel discussion at PEI’s Responsible Investment Forum: APAC Investor Day in September, Anne-Maree O’Connor, head of responsible investment at the New Zealand Superannuation Fund, said: “In terms of our reputational risk and the issues that are raised with us, human rights is really up there. It’s one of the issues that we get most focus on from stakeholders.”