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Supplements » ESG Report Winter 2020

ESG in private markets – ‘nice-to-have niche’ or ‘must-have mainstream’?

Andrew_Pitts-TuckerPrivate funds and ESG have long been considered by some as incongruous, if not outright incompatible. However, under growing pressure from institutional investors and regulators, and as evidence for the link between financial performance and ESG factors grows, private markets are taking notice. 2020 is the year that ESG moved beyond just a ‘box-ticking’ exercise for private markets, with 2021 set to be a pivotal year in its growth trajectory. In this piece, Apex’s Managing Director of ESG Ratings & Advisory examines the factors in which have helped ESG transition from a nice-to-have niche to must-have mainstream for private asset managers.

The clue is in the name: private funds, both debt and equity, have traditionally remained ‘private’ and have been somewhat reluctant to report to the market on non-financial (including ESG) metrics. But 2020 marked a sea change in the way private asset managers regard ESG, realising that private markets and ESG are not in opposition to one another: in many cases, ESG is compatible and indeed synonymous with operational best practice, something which private equity looks to implement during the period of time they hold a portfolio company. This year, we have seen growing evidence of this – that companies which are perceived to have strong ESG credentials appear to enjoy enhanced valuation compared to their peers.

A sign of the mainstreaming of ESG in private markets is captured by The Principles for Responsible Investment (PRI). This initiative is to promote responsible investment across various asset classes, including private markets, and now has over 500 private equity funds as signatories.

What is driving ESG in private markets?
Various stakeholders are demanding greater non-financial disclosure and ESG reporting, ‘pushing’ asset managers towards ESG. Firstly, LPs such as pension funds are now considering the ESG criteria of the funds they invest in, as part of their fiduciary responsibilities to their investors. Now, we have a situation where the demands being made on private asset managers are closer to those asked of public companies by institutional and retail investors. ESG has now become an essential part of their due diligence.

Many of the largest and most prominent private equity firms have responded to increasing investor scrutiny with dedicated impact-focused funds and incorporation of ESG considerations into their investment processes.

We anticipate that soon GPs will be required to pass an ESG screening as part of their vetting process as LPs demand more transparency into the funds’ ESG policies, procedures as well as the non-financial performance of the underlying portfolio assets.

Secondly, national and supranational bodies and economic unions are regulating across markets. Most notably, we are now less than six months from the introduction of the EU Sustainable Finance Disclosure Regulation in March 2021. This legislation introduces the regulatory directive for funds to better understand the ESG status of their portfolio investments and will require asset managers to report on the sustainability characteristics of their investments. Both LPs and GPs want to show market-leading credentials and compliance voluntarily before they are forced to change by the implementation of regulation.

And finally, an often overlooked inexorable ‘pull’ factor toward ESG is that private funds are facing employee pressure, seeking action from the inside out to make changes which will benefit people and planet, as well as profitability. We have all experienced, especially during the Covid-19 pandemic (more of which later), that people want to work for purpose-driven and ethical organisations, that stand for their employees and the environments and societies they operate in.

The pandemic impact
Some anticipated, incorrectly, that Covid-19 would fuel a single-minded focus on value preservation which would dampen the private markets’ commitment to and interest in ESG, but this is far from the reality we are seeing. From a pragmatic perspective, funds must honour the commitments they made to their investors when raising their funds and must avoid the potentially expensive and long-term reputational damage this could incur.

From what we have seen so far, there will be increased pressure from the LPs to ensure that non-financial risk-mitigation plans are developed and implemented and a rigorous ESG analysis of their portfolio companies will be an obvious starting point. In addition, the above drivers of the growth of ESG remain unabated.

Once the pandemic begins to wane, private asset investors and their portfolio companies are in a unique position to act as change agents to build back stronger, and ESG considerations must play an integral part in this.

Tailored solutions for private markets
It is easy to be critical of the private markets’ slow uptake of ESG monitoring and reporting with the task of accessing and analysing meaningful ESG data from private portfolio companies and underlying assets deemed ‘too difficult’.

With the growing appetite, and pressure to meaningfully engage with ESG, there remain several primary questions facing private asset managers:

  • What is the most reputable methodology to use, and robust data to capture to avoid accusations of ‘greenwashing’?
  • How can private markets source the data in a time-efficient, logical, accurate manner?
  • Who should they measure performance against including international standards and sector peers?

One of the key challenges for private asset managers is answering these questions in a way which addresses the inconsistency in how ESG is reflected in investment choices, and the absence of an accepted industry or international standard on data formats. The listed space already has a multitude of data-collection solutions, providers and indices, yet there still remain few reputable independent, global ESG providers for the private markets.

Private markets have been seeking an independent, end-to-end offering not only to ensure relevance, consistency and longevity surrounding ESG, but also to simply create better, more resilient, profitable and valuable companies.

We have welcomed a number of funds, from start-ups to established players willing to add their voices to the ESG conversation, and are excited by the proposition of solutions which will enable them to collect and analyse the right data. Greenwashing remains an ongoing LP concern and to demonstrate credibility, managers are going to need to make a concerted push to embed ESG metrics into their methodologies and throughout the investment lifecycle.

Andy Pitts-Tucker is Managing Director, Apex Group ESG Ratings & Advisory, Founder of PT Conversation and Development Board Member of Tusk Trust

This is an advance article from our upcoming ESG Report Winter 2020. Register now to download the *Early Access Edition* of the report.

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