- More private equity firms are incorporating ESG criteria into their investment strategies and improving how they manage related risks, say pension plans.
- Retirement funds PGGM, AP6 and Border to Coast explain how they assess their private market managers’ approaches to sustainable investment.
- There is some way to go for private equity firms to reach the level of ESG integration and transparency of their public-market fund manager peers.
Private equity managers have traditionally been seen as focused on returns to the exclusion of almost everything else. But there has been a growing push from their asset owner clients, or limited partners (LPs), for these managers to integrate sustainability criteria into their strategies.
This push appears to be yielding fruit. Private equity firms, or general partners (GPs), say they are taking ESG more seriously, and more are hiring senior sustainability executives and advisers or expanding their teams in this respect. KKR, for instance, announced the formation of a Sustainability Expert Advisory Council in December.
More to the point, GPs’ pension fund clients – in Europe at least – are reporting positive results. The Netherlands’ PGGM, Sweden’s AP6 and the UK’s Border to Coast Pensions Partnership have all told Capital Monitor about the progress they are seeing their external private market managers making on ESG integration.
This had been coming. As Capital Monitor reported in October, pressure is building on GPs to improve transparency over issues related to ESG factors and to improve stewardship of the companies they own, given their high level of access to and influence over management teams.
Half of European LPs surveyed from September to November last year by private equity secondaries manager Coller Capital said they had rejected committing to a private equity fund due to ESG-related concerns, according to its winter 'Barometer', published in December. That was up from a third who said the same in the 2016/2017 winter 'Barometer'.
Private markets are a steadily growing area of interest for LPs as they offer a diversification from listed assets, as well as the potential for an illiquidity premium. Fundraising has been steadily increasing since 2010, according to consultancy McKinsey, from $155bn to $643bn in 2019 – although the total fell in 2020 to $503bn as a result of the Covid pandemic. Not surprisingly perhaps: research from BlackRock shows that private equity outperformed the S&P 500 and MSCI World by 2.8 and 4 percentage points a year, respectively, between 2002 and 2020.
At the same time, the regulatory bar is rising. In Europe and the UK, the onus is on pension funds to set climate-aware investing policies, and to be – at the very least – cognisant of wider ESG risks across their portfolios. US regulators are further behind, but are upping their scrutiny of the private equity sector.
Without consistency of data and reporting from the private equity segment, it is hard for LPs to get a true handle on exposures. But progress is being made – not least through the Institutional Limited Partners Association’s (Ilpa) ESG Data Convergence Project – and a quiet revolution seem to be taking place.
Monitoring private equity
“Over the past [few] years we have seen considerable improvements in how our GPs manage ESG risks and opportunities,” says Eric-Jan Vink, head of PGGM’s €14bn ($16bn) private equity portfolio. This has led to a “continuous trend of higher performance” as measured by the €252bn fund’s internal assessment model.
The model uses a series of questions based on the UN Principles for Responsible Investments’ (PRI) due diligence guidance for LPs. PGGM then adds sector and country ESG risk data from companies including MSCI and Sustainalytics. GPs are assessed on their ability to manage these risks, receiving a score from one (the worst) to five (see chart below). PGGM reviews and engages annually with each manager and has published a dedicated annual private equity ESG report since 2018, with the latest in July 2021.
By the end of 2020 the pension fund had allocated around 80% of its private equity portfolio to GPs with ‘high’ or ‘very high’ scores, Vink says. During 2020, it had engaged with 46 managers, with 31 showing “significant improvement”, according to its 2020 report, published last year. PGGM also said it had experienced “a significant increase” in the number of GPs reporting ESG-related key performance indicators for portfolio companies.
Anna Follér, head of sustainability at AP6, one of five funds investing money for Sweden’s state pension system, agrees there have been improvements in the past few years. “Using the ESG lens as a perspective for identifying risks and value creation opportunities is becoming mainstream in private equity,” she says. Pressure from LPs and regulators have helped accelerate ESG integration among GPs, she adds.
AP6 allocates its SKr45.2bn ($4.96bn) portfolio solely to private equity via GPs. It assesses each private equity team’s ESG reporting and due diligence process, but does not currently assess the impact of portfolio company holdings due to a lack of comparable data. However, the fund regularly provides feedback and examples of best practice to its GPs.
In the UK, meanwhile, the asset pooling of local government pension schemes (LGPSs) in recent years has boosted their buying power and thereby also helped them drive greater transparency from their external managers.
Leeds-based Border to Coast, which manages £22bn ($29.8bn) on behalf of 11 LGPSs, last year developed and implemented an “in-depth ESG scorecard” for private equity managers. It is based on the organisation’s own ESG questionnaire with inputs from the PRI, Ilpa and investment consultancy Albourne Partners.
Border to Coast’s work with venture capital companies has helped with the development of ESG policies and reporting, alternatives portfolio manager Christian Dobson tells Capital Monitor. They now “better align ESG requirements with their business models, enabling investors to make effective comparisons and supporting decision-making”.
But there is still a lot of work to be done. The lack of standardisation is a key issue, says Dobson. “A standard set of data metrics or reporting requirements would ensure investors were more informed, supporting more effective decision-making and making measurement of progress more effective, supporting real-world change.”
In some cases, GPs' attitudes to need to change to reflect the shift in investor priorities. Liza McDonald, head of responsible investments at Aware Super, an Australian A$150bn ($108bn) retirement fund, told Capital Monitor in August about a survey it conducted to help it build a tool to assess the risks of modern slavery in its investment portfolio. “Some of our US private equity fund managers responded with: ‘We’re not completing your survey. We only invest in American companies; we don’t have any supply chain or modern slavery risks’,” McDonald said.
The GP perspective
Certainly, from a GP's point of view, ESG-focused requests for proposals and due diligence questions have become “extremely detailed”, reflecting “more sophisticated” LPs, says James Lindsay, head of institutional business at UK private markets investment firm Gresham House.
ESG-focused requests for proposals and due diligence questions have become extremely detailed, reflecting more sophisticated LPs. James Lindsay, Gresham House
Investors often now hold dedicated ESG sessions during due diligence periods, Lindsay tells Capital Monitor. The topics covered are many and varied, ranging from climate change and carbon emissions to the EU’s new sustainable fund definitions, to how Gresham House measures specific impacts and outcomes.
LP feedback is vital to enhancing a GP’s sustainable proposition, Lindsay says. In response to one request for proposal (RFP) process, Gresham House created a proprietary ‘forestry charter’ outlining its ESG commitments in this area – and reflecting the rise of investor interest in biodiversity. “Although this decision was made based on a specific process, we know that initiatives like this charter will be important to all clients,” he adds.
Despite their reported progress on ESG disclosure, private equity managers still seem reluctant to talk publicly about their ESG initiatives and processes. Capital Monitor approached seven GPs for comment for this article, but Gresham House – a £4bn manager specialising in sustainable investing strategies – was the only one to agree to comment on the record.
Aligning with investors’ ESG demands presents challenges for GPs, says Matthew Harold, global sustainability lead at strategy consultancy EY-Parthenon. “While funds are being touted as delivering ESG impact, it’s getting harder to do this credibly, with accusations of greenwashing presenting a real risk."
Signing up to industry collaborations or standards “can help provide evidence, but also exacerbate data, measurement and reporting challenges”, Harold adds. “Those who get it right will have a competitive advantage during fundraising.”
Collaborating on data
To this point, a key feature of the progress on sustainability in private equity has been collaborations between LPs and GPs.
One of the most successful to date is Ilpa’s ESG Data Convergence Project. AP6 is signed up to the initiative, and the PGGM is on the steering committee. The initiative is working “to streamline the industry’s historically fragmented approach to collecting and reporting ESG data, enabling greater transparency and more comparable portfolio information for LPs”.
Many GPs have been proactive in using third-party consultants with a sustainability focus, adopting ESG policies and committing to industry standards. Christian Dobson, Border to Coast Pensions Partnership
Launched in September 2021, the project has attracted the commitment of 104 GPs and LPs as of the end of January, representing around $8.7trn assets and 1,400 underlying portfolio companies.
The collaboration has led to a rising number of GPs reporting ESG data in more detail, Vink says. The first reporting deadline for GPs is 30 April 2022, after which Ilpa aims to publish its first data benchmark. It will incorporate measurements of greenhouse gas emissions, renewable energy exposure, work-related injuries, board diversity, net new hires, and employee engagement. Boston Consulting Group is compiling and analysing the data.
The project’s steering committee will meet annually to review the prior year’s data, and build on the initial metrics, Ilpa said in a statement on 28 January. It also has plans to expand to cover other asset classes such as private credit.
There is still a long way for private equity – and private markets more broadly – to achieve the same level of consistency in reporting as public equity. While there has been significant progress in improving disclosure, many GPs still seem unwilling or unable to provide data to the level that LPs require, as AP6’s annual sustainability report shows.
Bright outlook for private equity ESG
Still, LPs suggest the future is looking brighter for sustainable private markets investing.
As well as making improvements in transparency and recruiting more ESG specialists, many GPs have been proactive in using third-party consultants with a sustainability focus, adopting ESG policies and committing to industry standards such as the UN’s PRI, says Border to Coast’s Dobson.
AP6’s Follér, meanwhile, says venture capital firms have demonstrated increased engagement around ESG issues. She also welcomes moves by some private equity companies to set and commit to science-based targets in order to align portfolios with the Paris Agreement.
In November 2021, Science-Based Targets initiative (SBTi) – which promotes best practice for emissions reduction and net-zero goals – said six private equity GPs had received validation for their targets, while a further five committed to achieving validation within two years.
While the six firms validated by the SBTi represent roughly 2% of the private equity industry’s assets under management, it marks a small but significant step forward for the sector. Many more should be expected – and ultimately social goals may also become more common.