The future of ESG

Good environmental, social and corporate governance is essential, but the operating models to support those practices still have room to mature.

Over three-quarters of private fund leaders believe a stronger ESG vision and culture will ultimately drive value in their businesses, according to affiliate title Private Funds CFO’s Private Funds Leaders Survey 2021, conducted in partnership with MUFG Investor Services.

“It is very clear to us that responsible corporate behaviour and the consideration of ESG factors have a positive influence on long-term financial performance,” says Jeff Pentland, managing director at Northleaf Capital Partners.

However, LP pressure is still the main driver of greater ESG monitoring and reporting, with 86 percent of respondents saying LP questions on ESG had become more detailed over the previous 12 months. This was followed by a firm’s own social responsibility goals, competitive forces and valuation-creation objectives as reasons for enhancing ESG practices. Regulation was seen as the least significant.

ESG considerations play an equal role in due diligence and value creation. Just under half of respondents described ESG as critical or very important when assessing potential transactions. The same proportion said ESG was critical or very important for adding value in the businesses they buy.

Positive correlation

“We have already seen positive correlation between ESG progress and the performance of our companies across a number of different metrics, such as improved costs, efficiencies and an improved, more engaged workforce,” says Ruth Lane, head of investor relations and ESG officer at ATL Partners.

“We believe that robust ESG programmes at our portfolio companies inherently lead to better outcomes in the form of safe, healthy and motivated employees,” adds Brian Ramsay, president of Littlejohn & Co.

But while private markets leaders recognise the importance of getting ESG right, the operating models to support those practices remain immature. Almost three-quarters of respondents exclusively receive their ESG data from their portfolio companies, but close to 90 percent describe their ability to do so as at least slightly challenging. This is unsurprising when 64 percent employ a fully manual process.

Even where some degree of automation has been achieved, a lack of industry-wide uniformity remains a problem. “Metrics that are easily quantifiable are automated and those that are more qualitative are tracked via ongoing dialogue with our portfolio companies,” says Ramsay. “But the lack of standardisation around reporting metrics and ratings make it challenging for GPs to benchmark themselves against their industry, as well as for LPs to compare ESG programmes across their portfolios.”

Although close to two-thirds of respondents rely on an internal ESG team entirely, 34 percent expect to move towards an outsourced model over the next three years. Northleaf is one firm that believes in leveraging external expertise.

“We have sought to enhance our ESG risk assessment capabilities across our due diligence and portfolio management processes through a partnership with RepRisk,” explains Pentland.

“RepRisk provides a software platform that allows us to systematically identify and assess material ESG risks. The system also allows us to set up watchlists on a mandate-by-mandate basis and then to track how every individual investment is performing from an ESG perspective.”

In the expectation that climate considerations will become more important, Northleaf has also entered into a partnership with Climanomics, the Climate Service’s SaaS platform, to enable climate risk reporting aligned with the Task Force on Climate-related Financial Disclosures framework.

Which metrics to monitor?

The most commonly monitored metric is diversity, followed by board and management composition. The least-tracked are waste, then carbon. “We track a number of ESG metrics, both as a firm and across our portfolio companies,” says Lane. “Some metrics are consistent across our companies and some are company-specific. For example, as a sector-focused fund manager targeting aerospace and logistics, we try to lead by example and track the environmental impact we make due to our travel.”

“We track a variety of health and safety metrics, diversity statistics and some environmental metrics,” says Ramsay. “Each portfolio company is different and so we tailor our programme to fit their needs.”

And yet, despite a clear increase in focus on ESG, less than half of respondents are able to prove a positive correlation between ESG and investment performance at a portfolio company level. This is, in part, a question of maturity. Longer and deeper track records will be required to provide empirical evidence of ESG’s impact on value creation.

But Gareth Whiley, managing partner at Silverfleet Capital, believes equating ESG with returns misses the point: “We don’t look for a correlation between returns and ESG and continue to argue that this is a slightly odd way of looking at things. We believe we need to be responsible investors, not ignoring the financial costs, but certainly not only because we can justify that there is a financial benefit.”