Environmental, social, and governance (ESG) factors are more salient than ever. As more investors are demanding socially responsible investing (SRI), LPs and GPs have to research, plan, and measure their ESG-related strategies.
The picture is a complex one. LPs are always looking for more ESG and diversity and inclusion information on the GPs, who, in turn, need more information on portfolio companies and funds. The range of data points is vast and varied according to the sector the GPs operate in and requirements of the LPs. It could range from arms, fossil fuels, carbon polluters, to modern day slavery, ethnic diversity, gender diversity and social diversity.
However, it is notoriously hard to get information at every level - particularly on the portfolio companies. As a result, GPs and LPs are often strained as they try to collect the necessary information. One of the biggest challenges they face is knowing which data to collect and how to obtain a standard data set across businesses.
After all, there are so many interpretations of the data. With so many different frameworks, it can be challenging to agree on a data set that is comparable. Everyone does it differently. There is simply no consistent ESG data collection and reporting framework.
This article defines ESG and explains why there are many challenges when reporting on ESG data in private equity.
Why is ESG blowing up now?
While you might feel like the noise around ESG has picked up pace recently, ESG is not new. The Global Reporting Initiative (GRI) started all the way back in 2000, attempting to help organisations understand their environmental and social impacts. They began compiling sustainability frameworks that are still in use today.
In 2005, a cohort of some of the world's largest and most influential investors developed The United Nations Principles for Responsible Investment (UNPRI). Since then, many private equity groups have committed to these principles, which include:
- Being an active owner who integrates ESG issues into every policy
- Integrates ESG issues into all decisions and investment analyses
- Asks all entities for appropriate disclosures on ESG issues
- Promotes the implementation of ESG principles across the entire industry
- Details their attempts to implement ESG principles and progress and reports on their progress
ESG Standardization Challenges
As mentioned above, there is currently no single consistent ESG data collection and reporting framework. As a result, GPs struggle to research and meet their ESG goals and often find it difficult to investigate the link between ESG and financial performance. They then struggle to share this data with their LPs, who find it hard to benchmark their funds’ ESG performance.
That said, there are some organisations dedicated to ESG standardisation. These include the SBAI (Standards Board for Alternative Investments) and the PRI (Principles for Responsible Investing). In addition, The ESG Data Convergence Project brings together a group of LPs and GPs to agree on a standard set of ESG metrics for comparative reporting. As you can see, it is all very fragmented, and nothing is standardised.
There may be many different ESG ratings agencies and ESG data providers, but as an LP seeking meaningful information, who do you choose to work with?
Regional differences in ESG approaches
There are regional differences too. In the EU there are new ESG regulations affecting the finance sector. The EU Sustainable Finance Directive is a key piece of the European Union’s ambition to ensure that financial markets are central to the fight against climate change, and not part of the problem. The directive lays out a policy framework for how the EU can redirect finance towards sustainable investments that help mitigate and adapt to climate change.
The directive includes a number of measures to promote sustainable finance, such as:
- Encouraging financial institutions to disclose information on the climate-related risks they face and how they are managing those risks;
- Establishing a ‘green taxonomy’ that will provide common EU standards for what counts as a sustainable economic activity;
- Developing EU rules on low-carbon benchmarks and positive carbon impact investing;
- Creating an EU platform to exchange best practices on climate reporting by financial institutions.
In October 2018, the EU agreed on a new package of measures that set ambitious goals to reduce greenhouse gas emissions by 40% compared to 1990 levels, as well as increase energy efficiency and renewable energy use in the European Union by 2030.
It seems that the Securities and Exchange Commission (SEC), the US financial regulator, is following suit. They have some major proposals in the works that will mandate portfolio companies and funds to publish specific ESG data points. According to a recent press release, they may soon “require registrants to include certain climate-related disclosures in their registration statements and periodic reports, including information about climate-related risks that are reasonably likely to have a material impact on their business, results of operations, or financial condition, and certain climate-related financial statement metrics in a note to their audited financial statements.”
In addition, there's a lot of pressure from the public to standardise ESG data collection. The pressure is coming from all angles. That said, there are some other key ESG data challenges at play, detailed in the next section.
Additional ESG Data Collection Challenges
In addition to the standardization challenges detailed above, LPs and GPs face a number of challenges that affect their ability to buy into ESG investment and implementation. These include misunderstanding ESG goals, a lack of clear definitions, and concerns about funds appearing superficial or ‘greenwashed.’
- A misunderstanding of ESG Goals - Some investment managers misunderstand the purpose of ESG goals, and they mistakenly believe that spending time on these initiatives clashes with their fiduciary responsibility to their clients.
- No standardized definitions - When it comes to ESG strategy, a lack of standardised definitions prevents GPs and LPs from reaching a consensus.
- No consensus on ESG goals - A lack of consensus about which ESG goals are most important. Should funds focus on social responsibility, environmental stewardship, or diversity and inclusion?
- Worries about ‘Greenwashing’ – Investors are very savvy and can identify ‘greenwashing,’ or companies making superficial attempts to appear more environmentally sustainable than they actually are. Therefore, GPs and LPs are worried about committing to greenwashed funds.
It’s vital to overcome these challenges. Today, it is mostly LP behaviour that drives ESG in private equity, as many investors now include ESG considerations when making allocation decisions. However, some GPs are putting a lot of time, resource and money into driving their own ESG and responsible investment agendas, some with great success. They are showing that it doesn’t have to be a choice between maximizing returns, or making a positive impact on society.
Blackrock has invested heavily in ESG. In an interview, CEO Larry Fink said that sustainability is not a political issue, but an economic one. He argued that companies that are not considering how they will be impacted by climate change will be at a competitive disadvantage in the future.
Similarly, a recent study from MSCI shows that sustainable investments outperformed traditional investments over the long term. The study looked at data from 2,200 companies worldwide and found that companies with strong ESG scores had lower levels of volatility and better stock performance.
Should you be Striving for Improvement or Perfection?
This is not to say that all GPs that invest in portfolio companies with low ESG scores are bad investments – far from it.
Many LPs target investments in GPs and portfolio companies with low scores as they are planning long term investments and have the resources to invest in companies that may be lagging behind on sustainability, but that have the potential to make significant improvements. For many LPs the goal is improvement. Without a financial lever, it is impossible to have a positive impact on poorly performing businesses.
Using Technology to Overcome ESG Data Collection Challenges
Every LP and GP has their own preferences and requirements about what kind of ESG information they need to collect. But no matter what kind of information you need or want to collect, Dasseti facilitates the smooth, secure one to one transfer of ESG data from GPs to investors and from portfolio companies to GPs. Additional data room integration means that LPs can also automate data collection from the GP’s data room to the Dasseti platform and apply advanced analytics, flagging and scoring in custom ESG dashboards.
Get in touch to see a demo of Dasseti's ESG and diversity dashboards and find out how it could work for you.