LPs Increasingly Consider ESG in Investing Due Diligence

Will 2018 the year of ESG for limited partnership investing? And what might that mean for private equity firms?

As Lexology notes: “Asset owners are increasingly expecting the managers with whom they invest – across a large number of asset classes – to take ESG factors and risks into account, and mainstream managers are increasingly viewing a focus on ESG as integral to the exercise of their fiduciary duties. Over the last few years, there has been a growing body of research asserting that companies that are strong on ESG factors have stronger financial performance over time and/or exhibit less financial risk. In addition, as discussed further below, the rise of index funds, which now represent more than 30% of global fund AUM according to Nasdaq, is changing how large asset managers view corporate engagement.”

ESGOr, as the post states differently: “In the years to come, 2018 is likely to be viewed as the tipping point when corporate social responsibility definitively became a mainstream investor consideration. (Note that, in this section and the next, we generally use the terms “ESG” or “E&S,” rather than CSR, since those terms are more commonly used in the investment community.)”

According to the Financial Times: “ESG (environmental, social and governance) is a generic term used in capital markets and used by investors to evaluate corporate behaviour and to determine the future financial performance of companies.”

Further, “ESG factors are a subset of non-financial performance indicators which include sustainable, ethical and corporate governance issues such as managing the company’s carbon footprint and ensuring there are systems in place to ensure accountability.”

But interest is ESG is not new. So what is pushing it higher on the list of LP priorities?

Role for Private Equity

Financier Worldwide reports that “At the fund manager level, investment teams are realising that ESG and sensible, sustainable investment should increase returns in the long term. Indeed, ethical investing strategies can, for example, lower overall portfolio risk by mitigating at least one set of risks, while lowering the probability of incidents which cause reputational damage.”

The piece adds: “PE is ideally suited to ESG and responsible investing, given the long-term investment horizons common to the industry – in 2015 the average holding period of a portfolio company by a PE firm was around five and a half years, according to Preqin. While negative ESG effects can be felt in that time, the long horizon also allows ESG performance to be comprehensively analysed.”

But these expectation shifts advance, actions from PE firms also must necessarily evolve.

Financier Worldwide adds: “At the fund manager level, many larger PE houses are appointing dedicated ESG professionals, further indicating the focus on responsible investment. Though to date it is has been LPs driving the ESG push, attitudes are changing.”

Indeed, the United Nations-supported Principles of Responsible Investment has outlined “a voluntary and aspirational set of investment principles that offer a menu of possible actions for incorporating ESG issues into investment practice.”

“The Principles were developed by investors, for investors. In implementing them, signatories contribute to developing a more sustainable global financial system. They have attracted a global signatory base representing a majority of the world’s professionally managed investments.”

The Six Principles include:

  • Principle 1: We will incorporate ESG issues into investment analysis and decision-making processes.
  • Principle 2: We will be active owners and incorporate ESG issues into our ownership policies and practices.
  • Principle 3: We will seek appropriate disclosure on ESG issues by the entities in which we invest.
  • Principle 4: We will promote acceptance and implementation of the Principles within the investment industry.
  • Principle 5: We will work together to enhance our effectiveness in implementing the Principles.
  • Principle 6: We will each report on our activities and progress towards implementing the Principles.

As Financier Worldwide notes: “As investors become more fixated on responsible investing and ESG, GPs must respond. The due diligence stage is where GPs must pick up the mantle.”