Sustainable investing in private equity

Private equity (PE) funds may often be the first to identify a promising new business, but when it comes to embracing responsible investing, they have been behind the pack.

One reason why progress so far has been slow is that private markets are notoriously opaque, with unlisted companies not required to make the same levels of disclosure as their listed peers. Many such firms are small, without the resources to provide detailed reporting. This has been a key barrier to PE funds incorporating environmental, social and governance (ESG) factors into their decision making. While many have, for years, routinely factored in governance considerations and taken into account the societal and environmental impact of potential investment candidates, until recently there was no formal way of accounting for this.

That is now changing as ESG has become a priority for asset owners and companies, and as regulation increases the risks of non-compliance. In Europe, the Green Taxonomy and Sustainable Finance Disclosure Regulation have set standards for what counts as sustainable investing, which include private equity.https://www.engage.hoganlovells.com/knowledgeservices/news/private-equity-harnessing-esg-opportunities The UK is working on its own versions of both regulations while in the US the Securities and Exchanges Commission (SEC) is also stepping up ESG reporting requirements.https://www.sec.gov/news/press-release/2022-92

The emphasis on greater transparency is in part a response to the increased might of the unlisted sector – where the asset base has grown significantly in recent years – as well as to the growing clamour to democratise private markets. If the doors are to be opened to retail investors, disclosure must be much more rigorous than it has been.

A new initiative has stepped into the breach. An increasing number of general partners (GPs) within the PE industry have started to measure the ESG performance of their portfolio companies as part of a recently established open partnership of stakeholders called the ESG Data Convergence Initiative (EDCI). Its central aim is to increase transparency and facilitate the comparability of data between companies and sectors.  

ESG data collected during EDCI’s inaugural year (2021 reporting cycle) provides useful guidance on the state of sustainability in PE portfolio companies, as well as areas of opportunity for improvement and development.

As of September 2023, EDCI already comprises more than 350 members, who together account for over USD28 trillion in assets under management. Assets under management (AUM) across all asset classes not only private equityPictet Group was one of the initiative’s first members, having joined shortly after its inception as a member of the Steering Committee.

EDCI’s GP members commit to report data across a core set of ESG metrics within six pre-defined categories – greenhouse gas emissions, renewable energy use, diversity of board members, work-related injuries, net new hires and employee engagement. The data was then aggregated into a benchmark by The Boston Consulting Group (BCG).

Using this information, we were able to analyse data on over 300 private companies included in our own PE portfolios and to compare them both with a general private firm benchmark (also from EDCI) and with a benchmark of publicly-listed companies based on Refinitiv data that uses around 3,800 companies from across the world’s largest stock exchanges.

The data showed that private companies owned by PE firms currently lag their public peers in several key environmental and social metrics like the use of renewable energy (Fig. 1) or board gender diversity. In our view, this is unsurprising given the higher regulatory requirements – such as sustainability disclosures – that public companies face versus their privately owned peers. 

Unique opportunity

The industry's embrace of ESG has the potential to enhance the risk-return profile of private equity investments in an number of ways. To begin with, by encouraging investee companies to improve their performance in areas such as their use of renewable energy, PE managers can build portfolios that are fit for a world where regulation and taxation are increasingly penalising  businesses which don’t follow ESG principles.

Second, private investors are arguably better placed to lead the green transition than bondholders or shareholders of public companies. This is because they exert direct control over their investments and therefore greater influence on corporate behaviour and capital allocation decisions. Their time horizon is also often longer than that of investors in listed assets, giving them more time to act.

Analysis from BCG of the EDCI benchmark data in the two years to 2021 showed that revenue at private firms with at least one female board member grew at a faster rate than companies without female directors. Although we feel it is too early to draw conclusions on the relationship between board diversity and financial performance, PE firms appear to lag public firms on board gender diversity (Fig. 2). This presents an opportunity for improvement that we intend to closely monitor in future.

We believe that private markets are uniquely positioned to promote sustainable practices, to the benefit of the planet, society and portfolio performance. That's not least because PE plays a crucial role in the global economy – it accounts for some USD7 trillion of assets under management, projected to reach almost USD12 trillion by 2027, according to Preqin.Preqin, 2023

Our analysis also unveiled areas where private firms had the upper hand. Contrary to the widely held perception that PE firms seek to maximise value creation through aggressive tactics – private firms created more jobs on a per FTE basis than their public peers in 2021 (Fig. 3). This was consistent across geographies and sectors.

Because EDCI has only been in existence since 2021, it is too early to conduct a rigorous analysis on the relationship between ESG factors and financial performance. Indeed, identifying a direct link between financial returns and ESG performance has historically proved challenging. Establishing causation between the two is difficult for various reasons, including the use of inconsistent terminologies, limited data and a lack of standardised ESG performance measures. As EDCI’s membership and dataset grow, we believe this will become easier.

Obtaining ESG data at portfolio company level will not only help us to make better investment decisions but also to focus our engagements on those GPs where we can have the greatest impact. For example, 15 per cent of the companies from which we obtained greenhouse gas emissions data (Scope 1 and 2) accounted for 80 per cent of total emissions; this clearly shows us where to concentrate our engagement efforts.

In a recent survey by the consultant PWC, GPs highlighted corporate values and regulatory developments as two main reasons for incorporating ESG into their investment process, while problems with data were identified as one of the key challenges.https://www.pwc.lu/en/sustainable-finance/docs/pwc-eu-private-markets-esg-reboot.pdf With EDCI helping to address the data challenge, we believe private equity has firmly turned a corner on responsible investment.