Responsible investment: Seven key trends

The issues driving the ESG agenda at private equity firms.

There is a quiet environmental, social and governance revolution going on among general partners. That was apparent from a recent survey of GPs by Capital Dynamics, which found that 28 percent of GPs said the potential for high returns was one of the top three drivers for the adoption of a responsible investment or ESG approach.

The implication was clear. From being regarded as an optional extra for the more socially conscious funds, ESG has risen up the private equity agenda to the point where it is seen, arguably, as a fundamental driver of better returns. A value creator in its own right.

That is reflected at the UN-supported Principles for Responsible Investment, where private equity managers are the largest single group of asset managers among the more than 1,800 signatories: “GPs have historically looked at ESG risks in their investments, but they are responding to LP pressure to demonstrate how they are doing this in a systematic way and with accountability,” says Fiona Reynolds, managing director of PRI.

“New ESG issues continue to emerge all the time.”

So what are the key themes driving responsible investing strategy across the private equity industry? We canvassed the opinion of leading ESG experts and here are what they regard as the top seven trends in responsible investing.

1. Human rights has become an important consideration

Shami Nissan

Human rights have risen up the agenda for responsible investment professionals, says Actis’s Shami Nissan. “The PRI has done a lot of work on this over recent times, partly as a result of the UK’s Modern Slavery Act, but also similar initiatives in countries such as Australia,” she says.

The main area of focus is on risk in the supply chain, where firms and their portfolio companies have a legal responsibility to monitor the risk and remedy any issues that crop up. “This risk is particularly acute in emerging markets, where many supply chains end up,” adds Nissan.

Private equity firms are in a powerful position because of the amount of leverage they have over their portfolio companies, according to the PRI, which recently held a workshop to examine the implications that human rights have on due diligence at private equity firms.

2. Climate risk is paramount

New guidelines from the Financial Stability Board calling for private equity firms to disclose the risks portfolio companies face from climate change are a potential game-changer. “For the first time we are being asked to consider the impact on the company not the impact of the company,” says James Stacey, partner at environmental consultancy ERM, which carries out climate risk assessments for general partners. The FSB’s Task Force on Climate-related Financial Disclosures has said the financial risk that climate change poses to companies should be disclosed as part of annual financial filings.

The task force was set up nearly two years ago out of concern about the financial risks that climate change poses to global markets. The guidelines call for asset managers and asset owners to work on scenarios that consider how a two degrees Celsius rise in temperatures would affect earnings at their portfolio companies. PRI has begun work on a 10-year plan to look at climate change risk for investors after its signatory base identified the issue as their number one concern.

3. RI has become a core part of the value creation process

Adam Blumenthal

There are, says PRI’s Fiona Reynolds, “a growing number of GPs” that are vocal about the value-add that ESG can bring to their investments.

That’s reflected in the Capital Dynamics poll where 79 percent of GPs said they believe that the implementation of responsible investment or ESG can increase returns to investors.

Adam Blumenthal, founder and managing partner of Blue Wolf Capital, feels strongly that ESG principles have reached the point where they are seen as a fundamental part of the value creation process, rather than a mere box-ticking exercise. “A key trend is the recognition that ESG should represent a strategic initiative rather than a reporting requirement, and that ESG principles should be aligned with value creation rather than a tax on value creation,” he says.

Taking a more socially aware stance opens up business opportunities and “the openness to the idea that there are many, many more areas of alignment,” he says.

“Knowing your supply chain gives you a more reliable, lower cost, higher quality source of goods for your business. Aligning your business with regulatory initiatives creates the opportunity to grow. Solving the problems of recruiting, training and retaining qualified people gives you an advantage in a world in which the quality of education and training in society is declining.

“All of those are examples of alignment, and I think the trend is to look for alignment rather than to look for a report card.”

4. SDGs are being embraced by investors and corporations

The UN Sustainable Development Goals, adopted by all UN member states in 2015, have been embraced enthusiastically by the responsible investment community, says Fiona Reynolds of PRI. “They present a sustainability framework that finally has investors and corporates speaking the same language with clearly defined objectives.”

Robeco Private Equity, a Dutch asset manager with €2 billion in private equity assets under management, is one of a “small but increasing number of GPs” using the SDGs as part of their investment criteria, Silva Deželan, its director of sustainability, told Private Equity International’s Responsible Investing Forum in Berlin last September.

The 17 goals include zero hunger, affordable and clean energy, gender equality and quality education. Individual investments can be screened against individual goals, Deželan said. For example, adopting the economic growth goal could be used to track jobs created, or the gender diversity goal could be used to encourage greater female participation in the workplace.

“SDGs are a paradigm shift for responsible investing,” said Mikkel Kallesoe, senior sustainability advisor at Dutch development bank FMO.

Runa Alam, co-founder of pan-African private equity firm Development Partners International, believes private equity has a key role to play in delivering the SDG objectives.

“Private sector investment holds a pivotal place in achieving current projections and analyses for the SDGs,” she says.

5. Cybersecurity is being regarded as an ESG issue

This may not sound much like a responsible investment item, but, says Actis’s Shami Nissan, it touches on the ESG issues of data privacy. Financial services and healthcare are  particularly at risk from breach of confidential information, together with fraud, corruption and the misuse of personal information, which are clearly linked to the G of ESG. This has come into particular focus as the European directive on data protection, the GDPR, is due to come into effect in May 2018. “Many firms are not yet well equipped to tackle this issue,” says Nissan, who has been working to develop a set of top 10 questions for boards to ask at their next board meeting to gauge how effective their cybersecurity measures are.

The reputational risk from a cyber-attack makes the issue a key part of ESG concerns, says Matt Hawley, director of cybersecurity at PwC. The question to ask, Hawley says, is “how well the board understands what its cyber-risk is”. Key indicators, according to Hawley, include whether the company has engaged an external third party to gauge risk, whether it has achieved ISO 27001 certification and whether it has a chief information security officer – a CISO – on the payroll.

6. Impact investment is at record levels

Amit Bouri

Long considered as operating on the margins, there’s growing evidence that the idea you can have a positive social and environmental impact alongside a financial return is entering the mainstream of responsible investing. TPG’s debut impact investment fund hit its $2 billion hard-cap at the beginning of October.

“We have representation from some of the TPG core institutional investors but we also brought in some new ones,” Maya Chorengel, Rise Fund senior partner and sector lead for financial services, told PEI.

“The super majority of these institutional investors never invested in an impact fund.”

High profile limited partners to commit to the TPG fund include Washington State Investment Board and Swedish pension fund Andra AP-Fonden.

Over $144 billion has been placed in impact strategies, according to the Global Impact Investing Network.

Challenges remain, most notably in scaling the market, says Amit Bouri, the co-founder and chief executive of the GIIN. Significant capital shortfalls persist in the very-high risk segment, as well as in secondaries markets, which could provide useful exit options for investors. But there are grounds for optimism. “We are seeing some promising early innovation here also, especially in the development of financial products designed to address the most critical social and environmental challenges of our time,” he says.

7. Diversity is emerging as a key concern

Gender diversity and anti-harassment has emerged as a key area of focus in responsible investing, says the PRI’s Fiona Reynolds. “New ESG issues continue to emerge all the time and other issues such as diversity are gaining in importance,” she says. “The push for greater diversity within private equity firms, and the investment case for supporting better diversity on portfolio company boards, continues to grow. We understand that the ILPA Principles 3.0 version, expected in 2018, will expressly tackle issues of diversity and anti-harassment, giving LPs a better understanding of what commitments they might expect from GPs on these issues.”

Some private equity firms such as Dutch firm Karmijn Kapitaal have a policy of only investing in companies run by gender diverse management teams. “We found there was really an opportunity there of all sorts of deals that are just not being done because women do not find the right companies to turn to when they want to do growth financing or a buyout,” the firm’s founder Désirée van Boxtel told delegates at the Women in Private Equity Forum in London. LPs say gender diversity at portfolio company level is something they are increasingly monitoring, and some GPs, such as Triton, now set diversity targets for themselves and their portfolio companies and their boards in an effort to drive change.