A Perspective on ESG and Private Equity

Q. What is driving the increased interest in ESG at private equity firms?

There are a number of different factors. New regulations are important, especially in the European Union. For example, in early November of this year the U.K. announced that it will make it mandatory for companies to disclose climate risk within the next five years. This will be broad sweeping and include U.K. registered large private companies. Of course, there are also voluntary initiatives in place. In addition, increased investor demand is a key driver, as large asset owners are becoming more educated on ESG issues and are looking for additional reporting —not just on risks, but also on potential opportunities.

Q. What is the value to private equity firms of addressing ESG issues?

ESG analysis can be incorporated into due diligence and risk management practices, helping firms identify investment opportunities that can potentially translate into better returns. Asset owners are also asking more questions about general partners’ (GPs) ESG strategies in order to meet their own needs for disclosure, so being able to clearly articulate a position can help GPs with fundraising. This is happening at a time when the COVID-19 pandemic has magnified a range of problematic societal issues, making ESG considerations “the right thing to do” for many.

Q. What are some of the challenges for private equity firms?

There are definitely data challenges given the private nature of the business. Benchmarking is also an issue, since there is limited information available to do peer group analysis to help a firm understand how it is faring relative to others.

Q. How can private equity firms do more on ESG?

We suggest firms start by creating a baseline to understand a fund’s footprint today (i.e., its exposure or impact), which can be used as a point of reference to monitor progress year-over-year. This can also help identify potential companies of concern through a hotspot analysis, which can be followed by a deeper dive into a select number of companies for further evaluation. Customized questionnaires can also be created for portfolio companies to have data collected for future analysis.

While data availability may be a concern, there is often some data to be used that can then be supplemented with modeling techniques to fill in the gaps. Modeling at Trucost involves looking at a specific company and its different business activities and matching each activity with an environmental profile we have created. The profiles are then aggregated to create an overall picture for the company or a total fund. We recommend focusing on what is material to the company in question, what can be quantified and, then, what can help produce actionable insights. What is most valuable is how firms turn that information into something financially material that can help drive investment decisions.

Q. Are there other considerations?

In addition to setting a baseline, we recommend that our private equity clients take a forward look to help identify any hidden risks. For example, there may be transition risks for a company as we shift to a low-carbon economy, such as unpriced carbon risk that can affect a company’s valuation. There may also be physical risks based on where a company’s assets are located and how vulnerable those locations are to climate-related events, such as wildfires, hurricanes, droughts, floods and sea-level rise. In addition, we suggest that firms look at both sides of sustainability—exposure and impact. Exposure could be a risk associated with child labor laws in certain countries, for example, while impact could be an opportunity based on selling products to an area of high need.