Q: European fund managers and large US buyout groups have been quick to embrace ESG. But, many US mid-market and lower mid-market private equity groups seem to be lagging in this regard. Why?
A: Europeans LPs and GPs were among the first to emphasise ESG as an important investment principle. When I joined the PEGCC four years ago, I noticed this distinction from our European counterparts.
Today, most US private equity firms, both large and small, are tuned in to ESG. Many middle market firms have ESG policies in place but they don't publicise their efforts widely. Undoubtedly, smaller firms' main audience is their current investors and potential investors – they are who matters.
Q: Do smaller private equity sponsors need to make formal commitments to ESG in fundraising documentation?
A: Some of our smaller members have defined ESG policies that include reporting back to their LPs on relevant investment issues. Even if they don't have a separate ESG team or specialist, their focus on ESG-related matters is embedded in their investment practices.
There are also instances where firms don't have a full-time ESG specialist, but the firm's investor relations lead may have taken on this role and is considered the go-to source when it comes to managing responsible investment questions.
Generally speaking, if a private equity firm is conducting due diligence on a company, then they typically investigate if there is an environmental, governance, or social-related risk before deciding to invest. In this sense, most firms are already addressing ESG as part of their normal investment practice.
For many firms, it's just a matter of formalising and reporting their practices within an ESG framework.
Q: What practical steps would you suggest a general partner that may not have a responsible investment programme take if they're interested in implementing an ESG policy?
A: There are a few things they can do. General partners can talk with their counsel about general practices concerning ESG or seek the advice of advisory firms that provide guidance on responsible investing policies and procedures. I would also recommend that they talk with their peers and learn more about how other firms address ESG concerns. PEGCC members can also attend our seminars to help them gain a better understanding of key issues and best practices around ESG.
Q: Some larger GPs have been pretty active about marketing their ESG policies, while some other firms have gone about it more quietly. How far does a GP need to go in communicating their adherence to adopting a structured ESG?
A: The large, public firms tend to want to publicise their uniqueness, including their commitment to ESG, which becomes incorporated into their overall brand. A midmarket firm may not want to publicise its practices in the same way. For them, responsible investing practices are something they discuss with LPs as part of fund updates or when fundraising.
Q: What ESG issues are being formally addressed by limited partners in their quarterly or annual meetings?
A: The first priority has been and remains investment performance. Some of our members have said they have begun to field more questions from LPs about ESG policy, but really it's a mixed bag. I'd estimate that most of our members are taking a proactive role in addressing ESG-related questions with their LPs.
We continue to see more firms move towards more formalised ESG policies. This includes reporting back to LPs about changes implemented in portfolio companies to improve the companies' ESG profile. I expect this trend will continue and ultimately the majority of private equity firms will have some type of formalised policy in place.
I'd like to stress that responsible investing is more than just addressing environmental issues. For example, examining a company's adherence to the Foreign Corrupt Practices Act or making sure supply chains don't pose a third party risk are part of sound governance review.
Q: Is it possible to create an industry-accepted standard for measuring GPs' adherence to ESG?
A: It's great that a number of organisations are working to develop ESG metrics and standards. The challenge for GPs and investors is to identify the right standard. Right now, we still have many guidelines are currently in use, and the question is which one will private equity firms adopt.
One current challenge is that standards often change without advance warning, and private equity firms have to rework the data that they have accumulated to adapt. Adding to the complexity is that different industries have their own benchmarks and guidelines. Just compare manufacturing to the insurance industry. The major ESG issues in each industry are very different and would need a different type of review.