Incorporating ESG
Considerations into
Private Equity

Private equity firms cannot afford to ignore the groundswell for Environmental, Social, and Corporate Governance (ESG) considerations. Investors’ demands for information about investments, combined with new regulations, are adding to the pressure on sponsors not only to be seen to do the right thing , but also to actually do, and to demonstrate that they do, the right thing. While sponsors are increasingly embracing the trend, many ESG policies and practices (both of investors and sponsors) remain a work in progress, as investors get to grips with the themes that really matter to them while continuing to seek ways of measuring relative impact and distinguishing ESG from adjacent themes such as a corporate social responsibility (CSR).

Over the last two years, firms and investors of all shapes and sizes have taken a greater interest in ESG. According to a 2019 survey by PwC, 91% of the limited partners (LPs) and general partners (GPs) polled had or were developing an ESG policy. Over one-third of private equity firms had dedicated in-house ESG teams,{{1}}{{{Private Equity Responsible Investment Survey 2019</br>Source: PwC}}} and investors have developed a standard Responsible Investment Due Diligence Questionnaire. As a result, even funds with little direct control over the businesses they are investing in – such as credit funds – are implementing ESG policies, and face exclusion from LPs’ portfolios if they fail to do so.

Investors and Regulators Push ESG Policies

While ESG policies are in demand, there is no off-the-shelf solution. Issues including environmental impact, social benefit and good governance are clearly important to investors. However, the expanding range of topics – from climate change to modern slavery – throws up different priorities for different LPs, which is reflected in the different standards they expect: it is a truism that ESG means something different to everyone.

Adding to the list of ESG considerations for GPs, new European regulations governing ESG disclosures for the financial sector are due to come into force in March 2021{{2}}{{{Regulation (EU) 2019/2088 of the European Parliament and of the Council of 27 November 2019 on sustainability‐related disclosures in the financial services sector </br>Source: European Parliment}}}. The aim is to promote greater transparency around how the finance industry addresses ESG topics in investment decisions. Requirements include providing information on how firms view the potential adverse impact of investment decisions on sustainability.

This is the first major piece of legislation of its kind worldwide and fits with the European Commission’s aim to keep Europe at the vanguard of ESG and climate change action. The good news for private equity firms that have taken an active approach to ESG is that they should already be well prepared. Many are signatories of the Principles for Responsible Investment (PRI) and, as a result of this and investor pressure of the past several years, have incorporated ESG factors into their decision-making and reporting. Nonetheless, there are many emerging issues for GPs to consider as they implement and refine their approaches.

Meeting and Measuring ESG Requirements

Whilst all sponsors are able to consider ESG matters as part of their due diligence and investment processes, put in place ESG oversight and governance structures and training amongst their own teams, buyout firms that take controlling stakes in companies will have the greatest ability to actually implement the ESG measures they see fit in their investee businesses, whereas firms that take minority stakes in businesses, and those providing loans or structured debt, will generally have fewer options for driving ESG policies and practices throughout their portfolio. Most investors’ requirements and industry standards are broad enough to give GPs the latitude to do their best without committing to a fixed result. For example, PRI requires signatories to demand “appropriate disclosure” from the entities in which they invest, while reporting on their activities and “progress towards” implementing the principles{{3}}{{{What are the Principles for Responsible Investment?</br>Source: PRI}}}.

Action on ESG increasingly goes hand in hand with measurement. While financial performance remains central, investors frequently want to be able to see positive social and environmental impact, which they can rate against other investments. According to PwC’s ESG study, 71% of those surveyed were using or developing KPIs to benchmark their performance on responsible investment topics.

Balancing Duties to Shareholders and the Planet

As ESG becomes more integrated in the fabric of private equity, it is raising new questions about the responsibilities of all stakeholders in a company. As a matter of UK company law, which has adopted a so-called “enlightened shareholder value” approach, it is clear that any director of a company (including a non-executive director nominated by a sponsor to sit on the board) should have regard to relevant ESG factors when seeking to fulfil their most fundamental duty to act in a way which would be most likely to promote the success of the company for the benefit of its shareholders as a whole. Company directors need to be mindful of ESG goals that may create a tension with purely financial returns in certain circumstances. To date, it is not an issue that many sponsors or investors have considered head on, but one of many topics that private equity will soon need to assess and address in practice.

One solution is a social purpose company (which takes various guises around the world, including community interest companies in the UK) that exists for a purpose other than, or in addition to, maximising profit. However, the implication that such businesses sacrifice profit for ESG, and the relative lack of understanding of how a for-profit motive should be balanced in social purpose companies, means that they have not yet been widely adopted.

More common is the drive to promote alignment between these apparently competing duties: a number of studies have pointed to the long-term financial benefits of investing in companies with a strong ESG track record, while sponsors and portfolio companies are also keen to avoid the reputational damage of working with businesses that don’t act responsibly.

In the long term, a principal thesis underpinning today’s ESG focus and efforts in the private equity industry is that businesses that have strong ESG credentials should be no less (if not more) successful and drive higher value creation with downside risk reduced in some areas. However, as ESG factors are fast becoming an inextricable part of undertaking any business, it remains critical to isolate and develop ESG measurement benchmarks and KPIs – preferably on a global, standardised basis – to allow the reliable tracking of performance and guide the future of the ESG landscape.

Michael J. Preston

T: +44 20 7614 2255

Gabriele Antonazzo

T: +44 20 7614 2353

Michael James

T: +44 20 7614 2219