Responsible Investing: Justifying ESG

General partners without a responsible investment policy and staff to implement it are an endangered species, for good reason. Fund managers recognise that introducing environmental, social and governance best practice at portfolio companies is the “right thing to do”, steered by limited partners that require their commitment. GPs can also see that progress on ESG drives value.

UK-based Palatine Private Equity outlines seven ‘business benefits’ of integrating ESG policies at their portfolio companies. These are: attracting and retaining the best talent; increasing staff engagement and productivity; building customer loyalty and market share; improving supply chain resilience and risk management; innovating on products, services and markets; reducing operational costs; and strengthening brand and reputation.

But GPs are less good at measuring the effect of ESG initiatives in financial terms. GPs “do not, as a whole, have systematic processes in place for assessing and monitoring the impact of ESG issues on company value”, according to a UN Principles of Responsible Investment report. They are, however, “doing well” in policies, fund raising and pre-investment practices.

Only 14 percent of the GPs polled by PRI measure the impact of ESG on financial performance. “We measure EBITDA but breaking that down into ESG contributions is difficult to pinpoint,” says Palatine Private Equity partner Beth Houghton.

“Conceptually, ESG has been separate from value creation and has been treated separately,” says Paris-based Apax Partners’ Bertrand Pivin, who oversees the firm’s responsible investment policy. “We believe ESG improvements really impact value creation. If you don’t have the capability to link ESG with financial performance, it will remain a nice-to-have and when the going gets tough it will be put on the backburner.”

Data on policies’ financial benefit would help justify the expense of implementing the programme, he notes. “Some investors in the US still ask why ESG is a good thing and say, ‘We don’t pay you to do that!’”

However, linking ESG key performance indicators to financial metrics is difficult. “ESG topics are changing very fast and there is no golden rule for managing them,” says Paris-based PAI Partners’ Caterina Romanelli, who is in charge of the firm’s responsible investment and ESG strategy. The firm gathers a range of ESG performance data using qualitative and quantitative approaches based on more than 100 indicators, as well as narrative reports.

When making assessments, using reliable data and picking the right indicators are vital. “If you want to link financial ratios to ESG KPIs you must adapt an entrepreneurial mind set and test to see if the indicators are appropriate,” says Romanelli. Otherwise there is a risk the analysis will be “shallow” and not focus on the correct performance levers, including sector-specific factors, she says.

“The KPIs have to make sense so that people on the [portfolio company] board see the performance. You have to be material,” Romanelli says.

Firms are wary of reporting changes they perceive will be viewed negatively, such as job cuts, notes one London-based GP. “A lot depends on the firm’s investment strategy. Everyone has their own interpretation of ESG. Some think the most meaningful statistic is job creation.”

To collect data effectively, GPs need internal support for their ESG programme, someone responsible for implementation and backing from the portfolio company’s chief executive, says the source.

And some elements are easier to quantify than others. “Not everything that can be counted counts, and not everything that counts can be counted,” says co-head of responsible investment at UK pension scheme USS, David Russell, quoting Albert Einstein. “For example, spending on health and safety might not generate direct income, but by reducing accidents it protects staff, reduces regulatory scrutiny and stops business interruption, all of which are positive for company performance.”

More easily measured impacts on the bottom line include environmental policies, such as reducing carbon emissions and water use. Head of ESG and sustainability at secondaries investor Coller Capital, Adam Black, points to KKR’s Green Solutions Platform, which tracks both environmental and financial impacts, as an example of an approach that successfully demonstrates financial savings.

“And even on the social side you can look at safety and employee turnover and attribute financial benefits,” Black says. “The vast majority [of ESG focus] is on risk mitigation, cost avoidance and protecting brand and reputation.” The latter is critical and hard to measure. “It is difficult to put a figure on an improvement in reputation, but companies need to do it for that reason.”

He also stresses the importance of communicating business changes with a direct commercial effect. “If there is something that is going to impact business operations, for example a factory closure, significant costs or negative press, we want to know about it,” Black says. “We steer our GPs to think about materiality.”

However, collecting financial performance data from teams focused on operations can be difficult. Typically, for instance, a portfolio company environmental and safety manager does not think purely in financial terms, Black notes. “They are thinking about accident prevention and avoiding harm to the environment or employees.”

The absence of data demonstrating the link between ESG-led change and value creation is also a feature of timing and where funds are in their investment cycle.

“Many in the sector are still at the early stages of implementation of their ESG policies and strategies,” says Russell. “During the early phase, appropriate systems are usually being established, and monitoring programmes are beginning to collect data. It is therefore not surprising that GPs are finding it difficult to quantify the positives from better managing ESG issues. We expect this to be more possible in the future.” 

Pivin believes LPs, which already want to see progress on ESG, will begin ask about its impact on financial performance in the near future.

GPs are already trying to demonstrate ESG progress at exit to potential buyers. It is more and more common to include this information in the data room, vendor due diligence and the investment memo, says Romanelli.

When fund managers can prove the link between ESG improvements and financial gain, then the true commercial value of investing responsibly will be indisputable.


USS co-head of responsible investment David Russell describes the UK-based pension schemes’ approach to ESG as an LP and direct investor

As an LP, what information do you require from GPs about their ESG performance?
We have, to date, not expected our GPs to provide us with reams of data as to how they are managing ESG issues. We usually monitor our GPs and direct assets through face-to-face meetings where we request information on how they have managed specific issues. That said, the world is moving on. We are, for example, going to be requesting our GPs to provide data so that we can undertake carbon footprinting of our private equity funds.

USS has undertaken a carbon footprint for our public equity portfolios, and would expect to be able to do this for other asset classes including PE. Beyond that, there are increasing expectations for pension funds to be overseeing ESG issues across all asset classes and to do this we require information: as a result, we believe there will be growing expectations on GPs to provide ESG data to their LPs.

As a direct investor, how does USS quantify the impact of its ESG policies on value creation?
Many of our assets have certified environmental management systems such as ISO14001, which include targets for reduction in, for example, energy use or waste production, which have positive financial benefits. Some publically report the environmental and social performance.

USS has a process for monitoring the ESG activities of its direct investments whereby a member of the USS Responsible Investment team visits our assets to discuss how ESG issues are being managed. The fund has also recently undertaken carbon footprinting of its major directly held assets. In addition, the fund is establishing a system for collection of data from our direct assets, including ESG data, so that we can have better oversight of how these issues are being managed.

Firms have already begun to experiment with linking ESG to value creation. Paris-based PAI Partners is working with a portfolio company currently in a sale process to demonstrate the material impact of better governance thanks to improved processes, business ethics and professionalisation, as well as social benefits linked to a stronger brand and better talent retention.

Another GP in the French capital actively linking ESG to financial metrics is Apax Partners. Working with a consultant, the firm has undertaken a pilot project at portfolio company Group Inseec to examine the cost and benefits of its changes at the education provider. “The list of ESG initiatives is clear,” says Apax’s Bertrand Pivin, “the cost measurements are simple in terms of capex and time. Measuring the benefits is a little more subjective.”

The firm has tried to gauge how many more students Group Inseec has attracted due to its policies by analysing page views on the company’s website. In its results, the firm found that for every $1 invested in ESG the benefit was two-and-a-half to three times.

Pivin says: “At the end of the day, if management is convinced ESG is useful, we just have to give the impulse and they will run with it. If you enforce it as a majority shareholder, it doesn’t last.”