ESG has gained greater attention in the world of private markets. Specialist administrators are helping firms tell their ESG story, Angela Madden reports.
Sustainable investing and other elements of ESG have gained attention in private markets strategies, not just in the world of public companies.
“ESG-focused investments and practices have become unavoidable to general partners in the private equity space,” says Jacolene Otto, head of private equity and real estate at fund administrator Maitland Fund Services. She says limited partners (the underlying investors) no longer see ESG or impact investing as a ‘nice to have’, but rather as an integral part of asset-manager selection.
Otto adds that fund managers are either buying assets that meet ESG criteria or, depending on their focus, looking at purchasing assets where they can change an asset from ‘non-compliant’ to ‘compliant’ – in other words, gain an ESG-related uptick in longer-term performance.
Last October, research by the fund manager Schroders Capital found 90% of 750 institutional investors surveyed were aiming to increase their allocations in one or more private asset classes in the following 12 months. This means a reduction in listed assets.
Diversification was a key theme, but more than a third of investors also said that the impact of the pandemic had increased the importance of ESG considerations. Some 54% thought that ESG strategies which have a ‘benefit all stakeholders’ principle at the heart of their investment process were the most appealing.
Matt McManus, a managing associate in law firm Ogier’s funds team in Jersey, agrees. “ESG has, without a doubt, reached ‘mainstream’ status within PE,” he says.
Marie Fitzpatrick, senior director, fund services at JTC Group, adds: “The last 12 months has seen a staggering increase in the number of private equity managers publicly addressing ESG.”
Many firms in our Specialist Funds Administration Directory, which follows this article, mention an increased focus on ESG and related transparency, including with reference to the EU’s Sustainable Finance Reporting Directive (SFRD).
For example, Bruno Bagnouls, head of sales and relationship management, Europe, for fund administrator Alter Domus, tells Funds Europe: “The regulations around ESG reporting, such as the SFDR, are front of mind for us and our clients.” He says the firm is working to provide clients with the relevant templates for regulatory reporting due in 2023.
And Gregorio Pupino, head of fund services, Western Europe at Intertrust Group, says that as well as a growing trend for renewable energy infrastructure fund launches, the increasing need for asset managers to “start reporting disclosures on their business sustainability and to convey appropriate information to their stakeholders in an efficient manner is now a core discussion point for us”.
McManus, at Ogier, says there are several drivers for the mainstreaming of ESG in private markets investing. These include formal regulatory requirements, which he says have largely centred on reporting and disclosure; investors needing (and wanting) to translate their ESG commitments into investment decisions; and a growing understanding that factoring ESG into the investment process can contribute to rising value.
Otto says ESG factors are not looked at so much now as a “burden” or merely as a “tick box” exercise, but rather as “crucial elements of value creation”.
One of the difficulties for a private equity investment firm – and this is likely to be where specialist fund administrators see opportunities – involves communication. “One of the biggest challenges, but also the biggest opportunities, for a private equity firm is how to tell their ESG story,” explains Otto.
Fitzpatrick says: “With investors and stakeholders now asking each private equity manager where they are on their ESG journey, and with coverage across the media, private equity managers want to be able to communicate to their stakeholders and investors where they are on their ESG journey and report on the steps they are taking and the progress made.”
Sarmad Naim, associate director, regulatory at fund administrator IQ-EQ, says: “As investors have become more ESG-conscious, there is greater communication starting at the fundraising stage, particularly in terms of what ESG information is expected.
“Throughout the life of a fund, private equity firms need to meet those promises. The quality of information helps investors in turn measure their own compliance with their ESG goals. Firms that provide good-quality information firstly help the investors with their own compliance whilst indirectly helping the entire ecosystem. Such firms reap the rewards in the long run by enhancing their reputation and increasing demand for their subsequent funds.”
The Washington-based Institutional Limited Partner Association introduced an ESG framework in 2021, designed to help limited partners (LPs) evaluate general partners (GPs). But it is difficult for a private equity firm to tell its ESG story in any credible or meaningful way without data and “there is still no single scoring mechanism for private companies”, says Naim.
The data challenge
As in public markets, the private markets face a data challenge. Achieving consistency across information is perhaps one of the biggest difficulties for the industry as it pushes on with ESG investing.
Otto says: “There is an increasing demand for transparency by LP’s around ESG matters. The ESG reporting is becoming just as, if not more important than the financial figures.”
The problem is well identified in the listed equity area, suggesting opportunities for existing data suppliers who focus on these markets and asset managers. However, as Fitzpatrick points out, “we’ve seen traditional data ratings agencies exploring the private sector using progressive modelling based on assumptions, but this can carry increased resource burden to the private firm during the data-gathering stage”.
McManus adds: “One of the key challenges to date has been around data: finding ways of measuring the performance of an investment from an ESG perspective so that impact can be tracked over time – or compared against other assets – in much the same way as you would for financial data.
“Involving a third-party service provider with this process enables managers to access expertise, technology and manpower from firms who are focusing on this new service line, and also adds a degree of independence to the process.”
This is becoming critical, according to McManus, who says that investors will have their own reporting requirements and will need to negotiate reporting rights from their fund managers – something that private equity funds will have to be able to respond to.
Fitzpatrick at JTC says additional information is “creeping into quarterly investor reports, pre-empting questions from investors and featuring on the investment synopsis page”.
Part of the problem with ESG ‘storytelling’ is knowing exactly what to measure or benchmark.
“The biggest challenge for GPs still remains how many of the ESG factors should they focus on and how do we then actually report on what we are doing to our investors,” says Otto.
It is important to emphasise that “each ESG journey is different”, Fitzpatrick notes, and that with many of the underlying portfolio companies not in the same sector, there may be different ESG frameworks to follow.
According to Naim, some private equity firms have developed their own internal scoring mechanism. In addition, many use key performance indicators for their portfolio companies to report on before providing feedback.
Fitzpatrick says: “We’ve seen various approaches, depending on the business sector of the private firm, the operating location, and which ESG frameworks are available or relevant. For example, some PE firms work with private firms using their own proprietary [due diligence questionnaires], checklists and progress reports focusing on what the private firm already does and has committed to do, then expecting regular updates to map progress against set targets.
“They may manage this themselves, with some external support for independence or expertise.”
The approach used and extent to which PE firms rate private firms appears to be based on proportionality, relevance and risk, Fitzpatrick adds.
The opportunity for specialist fund administrators is similarly in the development of tools such as ”cohesive dashboards that help them tell their ESG story and report back to investors”, says Otto.
Fitzpatrick says JTC helped portfolio teams conduct initial ESG health checks on portfolio companies and reviewed them annually.
Naim at IQ-EQ says specialist fund administrators helped portfolio managers with their data requirements by helping them create definitions for each datapoint and gathering information from various reporting sources. “It also means standardising and checking the data when it comes in and reporting it periodically.”
Technology, not surprisingly, has a key role to play, Naim says. “At times there is approximation required for many data points, but advanced technologies will make this easier. Technology will also help determine short-term and long-term qualitative and quantitative impacts of ESG, which in turn will help determine how it impacts a firm’s benefits and costs, ultimately allowing them to target higher valuations at exit by meeting specific ESG targets.”
There is plenty of work to be done.
Naim describes the private equity industry as having initially launched ESG efforts at the “minimum possible level”, but says they are slowly stepping up their internal procedures and resources. “They’re also asking for more information from the portfolio companies in time for various periodic reporting. Progress has been made, but there is still a long way to go for many.”
There may have been a slow start to ESG investing among private-markets specialists. It was public equity that led the way. But as processes become stronger, and proof becomes easier, beyond the best practices and the technology, leading clients will want to see their private equity providers become ESG to the core.
Says Otto: “We are also seeing that the most successful managers in this space are the ones that fully embrace ESG as core values – not just for the firm, but by the people that they employ, people that truly believe in what they are trying to achieve.”
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