Responsible Investing: Why ESG matters to investors

 High pricing has been a significant concern for both the GP and the LP community for a good while now.

According to data from private equity firm Argos Soditic and Epsilon Research, the average price paid for a business in the eurozone in the third quarter of 2016 was 9.2x earnings, rising above the 9.1x high watermark set in 2006.

In this high price environment, LPs are calling on GPs to boost the value of their companies through ESG initiatives.

“Competition is high, pricing is high,” says Mirja Lehmler-Brown, a senior investment manager at Aberdeen Asset Management.

“If you don’t build as good a company as you can, then in my view you’re not going to get a premium when you try and sell it. For me, the ESG measure is not instead of returns, it makes your return solid and in fact you should be able to enhance your returns.”

A focus on sustainability is key to preparing businesses for the longer-term, and private equity is just the sort of capital that can effect such drastic change. “Private equity is about the transformative power of investment and serves a key role backing new businesses and upgrading old businesses in order to successfully future proof organisations and, with that, returns for its investors,” Lehmler-Brown says.

“The private equity governance (longer term and active) model puts it in prime position for effectively incorporating environmental, social and governance issues in value creation.”

Large northern European asset managers, particularly from the Nordics and the Netherlands, led the charge on bringing ESG issues onto the agenda at private equity general partners, and industry insiders agree they’re still ahead of the pack today.

For the First Swedish National Pension Fund (AP1), ESG issues are becoming “increasingly important”, says Jan Radberg, the fund’s head of private equity.

“We have been working with companies on ESG-related topics on the public equity side for a long time. We are now trying to increase awareness among our private equity managers,” he says.

“The topic is important to us and we must be comfortable with a manager’s approach to ESG. It is our experience that many managers are already paying attention to these issues but some have formulated their ESG approach more explicitly than others, their methodology varies depending on the industry, size and location of the manager and so forth.”

Speaking on a panel at the seventh annual PEI Responsible Investment Forum in London last May, Anders Stromblad, head of external managers at AP2, said the fund would not be doing its fiduciary duty if it were to fail to take ESG into consideration when evaluating managers.

“We put a lot of effort [into] manager selection. In fact, we will not invest in a manager if they don’t take ESG into consideration,” Stromblad told delegates.

Kathleen Bacon, managing director at HarbourVest Partners, who was speaking on the same panel as Stromblad, agreed. “It is definitely part of our manager selection,” she said. “If we thought that somebody was not, in principle, practising good governance or looking at the social impact of their businesses, we would not invest.”

A focus on ESG is embedded into the DNA of Dutch pension administrator APG Asset Management, largely thanks to its client base, says Marta Jankovic, its senior sustainability specialist and head of ESG integration for alternatives.

“Our clients, who are public pension funds, believe that responsible investment is important from a risk-return perspective as well as a way of demonstrating social responsibility,” she says.

“As a long-term investor, which is tasked with generating sustainable returns for many years to come, you have to think about the effect that you and your investments have on the ability of economies and socie-ties to continue to exist and to be better, more resilient, more sustainable. It’s in our interest, both from a risk-return perspective, from a social responsibility perspective, and from a long-term investment perspective to focus on responsible investing.”

However, in PEI’s straw poll of which elements carry the heaviest weight for LPs during the due diligence process, a formal approach to ESG floundered at the bottom of the list, well behind other factors such as track record, team stability and succession planning, and demonstration of a clear, differentiated strategy.

Mounir Guen, CEO and founder of placement agent and advisory firm MVision, says the problem with approaching the issue in this way is that it doesn’t take into account that investors’ first filter always has to be performance.

“The first thing you’ve got to ask is, ‘Does [the manager] perform?’” he says. “The second filter is ‘will you continue to perform’? So, what’s your infrastructure, who are your people, where’s your talent, how do you source, how do you own companies, what do you do in problem situations?”

After ascertaining that a manager has strong performance numbers and a demonstrable ability to continue to produce those numbers, “then I go inside your company and I see how you report, I see what your ESG looks like”.

That is not to say that the lack of an ESG policy – or at least the commitment to work toward implementing one – is not a deal breaker for some investors.

According to Coller Capital’s Global Private Equity Barometer Winter 2016-17, which polled 110 private equity investors globally, for more than a third of European LPs ESG considerations have played a major or primary role in their decision to refuse to commit to a private equity fund. A fifth of North American LPs and 36 percent of Asian-Pacific LPs have also turned funds down for this reason.

Aberdeen is not a “negative screener but a constructive partner”, Lehmler-Brown says, adding that as long as firms are moving in the right direction “we’re happy to help them”.

“The only thing that would be a completely red flag [for a European fund manager] would be if they don’t do anything and they’re absolutely not interested in doing anything,” she says. “That then, even if they’re producing a good financial return, could lead us to actually say, ‘This is not a house we would like to work with as there is no cultural fit.’”

Coller’s Barometer also found that two-thirds of European and Asian-Pacific LPs, and a third of North American LPs, are either taking climate change into account in their private equity decision-making or intend to do so within two to three years.

However, this is one area Jankovic highlights as in need of dramatic improvement among the fund manager community.

“The majority of managers are still not well prepared to answer specific questions on climate change topics in a way that indicates there has been a strategic discussion about this topic, which is a concern for us as investors,” she says.

While APG acknowledges that GPs have different sector and geographical focuses, and the priorities will be different, for example, for financial services or software investments compared to those in the industrial sector, those managers who think climate change isn’t relevant to them are mistaken.

“It’s really important not to forget that every single society and every single business and every single country in this world is potentially affected by climate change. To think that it doesn’t apply to you because you’re not investing in a specific sector or geography is not a good way to go forward, and a really important climate risk issue can be missed as a result, for example.”

While industry insiders agree that US investors and fund managers are a step behind their European counterparts on ESG, there has been some significant progress on the other side of the pond in the last year.

The board of administration at public pension giant the California Public Employees’ Retirement System adopted its first-ever ESG policy last year.

The five-year strategic plan names six initiatives to support the fund’s efforts in sustainable investing, including addressing private equity fee and profit-sharing transparency, conducting research to better understand ESG factors, setting expectations for external managers across asset classes, data and corporate reporting standards, diversity and inclusion, and climate risk and opportunity management.

In 2016, CalPERS’ investment committee focused on finalising key performance indicators surrounding topics such as climate change, human capital and alignment of interest with internal and external investment managers, and the board offered final guidance on the five-year strategic plan in July.

Thought of by many as a bellwether for the industry, where CalPERS leads, other US pension plans are sure to follow.