Private Equity Firms and ESG Due Diligence

ESG Due Diligence Challenges and Possible Solutions for Private Equity

Today’s investing environment is more challenging than ever for private equity (PE) firms. It’s not just greater regulatory scrutiny and increased market volatility standing in the way of better returns. Both investors and stakeholders are now increasingly focused on investing in alignment with environmental, social and governance (ESG) principles.

A 2019 Schroders Global Investor Study found that over 60% of respondents believe that investment funds should consider sustainability factors.¹ In addition, a 2020 poll by sustainability consultancy ERM found that 93% of PE firms agreed that a focus on ESG helps generate good investment opportunities.²

In Asia, more investors and regulators have joined the ESG movement juggernaut. (We’ve gone into more detail in this article: Why ESG is On the Rise in Asia). The trend towards greater adoption in China will only increase in the next decade, as climate change becomes a key concern in the Chinese government’s upcoming Five-Year Plan (FYP).³ A massive shift of investment to ESG-managed assets may occur if the next FYP links sustainability to corporate policy. In addition, limited partners (LPs) will look at managers’ ESG credentials, focusing both on how they impact and drive investment strategy, as well as their integration into managers’ internal policies and procedures, before committing capital to their funds.

ESG’s Benefits for Private Equity Firms 

Fund managers and LPs should consider adopting ESG-based principles of investment for the following reasons:

Better Management of Risk and Enhanced Performance

A recent Fidelity International study found a “remarkably strong linear relationship” between ESG ratings and performance. As the COVID-19 pandemic caused the S&P 500 index to fall by 26.9%, high-ESG companies performed 3.8 percentage points better by comparison, while low-rated companies performed 7.4 percentage points worse.⁴

As non-ESG compliant businesses are now perceived as riskier investments, more investors are insisting that ESG factors are included in the due diligence process. Some have even proposed instituting ESG teams with the authority to veto transactions that fail to meet predetermined ESG standards.⁵

Alignment of Investor and Manager Interests

Aligning general partner (GP) asset management practices with the interests of the PE firm’s LPs is a constant source of tension on both sides. A 2019 survey found that 85% of LPs considered ESG issues when conducting fund due diligence, being a “major consideration” for 40% of these LPs.⁶

In ESG management principles, both sides can find a starting point for consensus. As more LPs recognize ESG’s role in achieving optimum risk-adjusted returns, more GPs also find ESG management as a way to align interests across funds’ investors. 

Boosting Internal Culture

Today’s professionals prefer to work for companies whose values align with their own. Millennial workers, for example, are more likely to choose to work for companies with a “strong environmental agenda,” and are even willing to accept accepting a smaller salary in turn.⁷

Creating and implementing a corporate ESG policy can boost a PE firm’s corporate culture and sends a strong signal to employees who are drawn to companies that “walk the talk” on sustainability.

Structuring ESG Due Diligence Efforts

All these points make a solid case: asset managers should incorporate ESG principles into their operations, beginning with an ESG policy that guides decision making and helps formulate key performance indicators.

Some fund managers have difficulty integrating ESG considerations into their due diligence process because they lack frameworks to guide implementation. LPs also need quantitative methodologies to help assess their GPs’ ESG due diligence efforts. To help guide their ESG due diligence, GPs and LPs can consider the following frameworks

Integrating ESG in Private Equity

This guide, released by the Principles for Responsible Investment (PRI), a United Nations-supported network of investors, is intended to help GPs develop a framework for integrating ESG factors into their investment cycle.⁸

Sustainability Reporting Standards

There are two separate but complementary standards that provide standardized quantitative and qualitative metrics to help measure  overall ESG impact: The Global Reporting Initiative (GRI).

Sustainability Reporting Standard that takes after generally accepted accounting principles (GAAP);⁹  and the PRI ESG Reporting Framework.¹⁰

Both are intended to be executed by different parties in the investment ecosystem: organizations use GRI to report their ESG performance to investors, while investors use the PRI framework to self-report their portfolio level responsible investment activities.

GRI is in wide use in China, with conglomerates like China Mobile and BMW Brilliance Automotive Ltd using the GRI standards’ Simplified Chinese translation.¹¹

Other ESG Toolkits for PE Firms

The variety of ESG toolkits and frameworks reflect the multiplicity of responsible investment approaches and the different business sectors covered by PE firms. This list is by no means exhaustive, but reflects a series of different approaches to ESG reporting:

• IFC Environmental and Social Management Toolkit for Private Equity: useful for GPs who need an extensive overview of ESG-related templates and tools during due diligence
• ILPA Portfolio Company Metrics Template: framework for GPs’ reporting portfolio company metrics to LPs and includes a voluntary ESG reporting section¹²
• CDC Toolkit: a reporting framework designed for GPs investing in emerging markets

Considerations for PE Firm in Relation to ESG Due Diligence

GPs and Relevant LPs Should Approach ESG From a Common Starting Point

When forming and participating in a fund, both parties should agree on a common ESG strategy, policy and execution.

The Institutional Limited Partners Association (ILPA) recommends that asset managers maintain and update an ESG policy that explicitly addresses how ESG factors into due diligence and performance reporting.  Tools like the PRI Limited Partners’ Responsible Investment Due Diligence Questionnaire can help LPs and GPs establish consensus on ESG principles.¹³

There is No ESG One-size-fits-all 

ESG standards vary widely from sector to sector. For example, GPs cannot expect an agricultural company to have the same environmental impact as a software startup. ESG standards should be set and measured on a sector-by-sector basis, tailored to individual industry sectors, geographical regions and business models.

ESG due diligence for an industrial manufacturer, for instance, might report in greater detail on their environmental impacts, while ESG covering a bank might emphasize its social and governance factors. GPs can use the industry toolkits listed above to help identify relevant ESG regulations, standards, risks and opportunities specific to their target’s geographical region and industry sector.

Consider Hiring an External and Independent ESG Due Diligence Advisor

ESG expertise may be hard to come by in-house within smaller PE firms. Resource constraints may also prevent GPs from setting up a dedicated ESG team.

Both problems can be solved by hiring an external advisor to handle ESG due diligence.

As private equity firms continue to navigate a shifting regulatory landscape governing ESG compliance, the need to investigate their target investments’ ESG-related risks and returns will be more pressing than ever.

As ESG concerns become more mainstream, GPs will need to integrate ESG due diligence into their investment process to better meet the global appetite for responsible investments and the value they create for investors.