PE leads the way on ESG

When people talk about ESG and responsible investing within private equity, it’s usually referred to as a work in progress – there are some GPs that take it very seriously, and some that ignore it altogether. But the consensus is that there are far fewer people in the latter category these days than there were a few years ago, if only because LPs are so keen to make an issue of it now.

This is all true, of course. But in drawing attention to the industry’s shortcomings in this regard, it’s easy to overlook the fact that it’s arguably doing a much better job than all the other places where investors might choose to park their money.

At a panel on responsible investment at the recent EVCA LP conference in Geneva, Sanjay Mistry, a director in investment consultancy Mercer’s Private Equity Fund of Funds group, drew attention to a new study Mercer has just released. This suggests that across all the various investment strategies, private equity managers are doing a better job on ESG than anyone else.

The study looked at no fewer than 5,175 multi-region multi-asset class fund management strategies – nearly a quarter of which were in alternatives – and assigned ESG ratings to each one using a four point scale. The highest category, ESG1, was awarded only to those managers that have fully integrated ESG factors into every aspect of their organisation and their operations – investment idea generation, portfolio construction, the implementation of active ownership practices, and so on. At the other end of the scale, the ESG4 rating was given to those laggards who were behind on all these issues, and showed little inclination to catch up.

“The way money is being managed is evolving,” explains Andrew Kirton, Mercer’s global chief investment officer. “Our role is to help clients achieve better investment outcomes, and we believe ESG analysis and active stewardship practices support this.”

The first point to note is that very few managers seem to be doing ESG really well: only 9 percent of all these strategies were awarded the top two ratings (ESG1 or ESG2). Although Mercer is keen to stress that the bar has been left deliberately high, to make the top rating more aspirational, that’s a good indication of how much room there still is for improvement. 

But the other salient point is that private equity has a higher proportion of strategies in these top two categories than any other asset class: 26 percent (albeit most of which were in the second category). By way of comparison, property had 19.6 percent of strategies in the top two categories, infrastructure 18.1 percent (all of which were in the second category), equities just 9.1 percent, and hedge funds a measly 2.4 percent. (So private equity can legitimately claim to be ten times better at ESG than hedge funds).

So why is private equity leading the way? It’s partly because Mercer is now including more renewable energy and cleantech funds within the asset class. But Mistry told Private Equity International that there were three other important reasons. The first is the industry’s high level of active ownership and engagement with company management. Then there’s the increased interest in this area from potential corporate suitors; in other words, if you know that a big public company with ESG obligations is a possible buyer of one of your assets, there’s a strong incentive to prepare the company for sale accordingly. 

Finally, the growing emphasis on risk management within private equity – to include environmental and social risk – also apparently tends to result in them scoring highly. (Unlike an equities manager, GPs can’t just trade out of a position that looks like it’s going bad).

But what of the laggards? How can they raise their game? Again, Mistry says it’s all about embedding ESG within your processes and throughout your team. An in-house specialist can help here, he suggests: they can act as an internal champion, educating the rest of the team and making them aware of the issues. What it doesn’t mean, however, is just putting an ESG policy in place: unless the policy is actually meaningful, LPs can now see right through it, according to Mistry. In fact, some of those in Mercer’s third category had a policy in place; it just didn’t amount to much in practice.

There is a potential issue, though. In response to a poll at the same panel discussion, 51 percent of those present said that ESG did not have a positive effect on investment performance. Over a third said they didn’t have a clear understanding of ‘what ESG stands for’. And 37 percent of GPs said they didn’t have an active ESG approach. In Mercer’s report, 42 percent of private equity strategies received the lowest rating of ESG4. Based on these poll results, it seems there is still plenty of work to do in persuading GPs that achieving best practice in this area is a sensible and worthwhile goal…