ESG comes of age

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After several years in which the pressure on private equity managers to step up their efforts on ESG seemed only to be intensifying, Private Debt Investor’s LP Perspectives 2023 Study appears to suggest investors are getting more comfortable with the response coming from GPs.

On the issue of climate change, for example, only 12 percent of LPs today feel that their GPs are failing to take the risks seriously enough in their own investment policies and practices, compared with 29 percent last year. Around half of investors are now comfortable their GPs are taking climate change seriously, with the proportion that strongly agree they are doing so rising from 6 percent to 10 percent. “The pandemic, together with societal issues front and centre, has accelerated the pace of change over the past two years around ESG. It is hard to imagine investing in a company without putting an ESG lens on all aspects of the business,” Glenn Mincey, global and US head of private equity at KPMG, told affiliate title Private Equity International earlier this year. “This has become business as usual with all sides aligned – LPs, GPs and talent – around the acknowledgement that this is the way forward.”

With around three in 10 LPs now saying they always consider UN Sustainable Development Goals in their investment decisions, and only 21 percent saying they never do so, it seems managers and investors are increasingly pulling in the same direction.

TPG closed its inaugural climate fund on $7.3 billion in April, highlighting the volume of private capital now mobilising around identifying climate solutions.

“Even though we were showing up with a first-of-its-kind fund, investors were really receptive and prepared to figure out how to fit the fund into their programmes,” Jonathan Garfinkel, partner at TPG Rise Climate, told PEI in November.

“We were met with terrific demand from many of the world’s most sophisticated institutional investors and leading multinational corporates, who recognised this as something every company on the planet and every individual on the planet is going to have to focus on, which creates an extraordinary investment opportunity and an extraordinary impact opportunity.”

Beyond risk mitigation

Nearly seven out of 10 LPs now believe that adopting a strong ESG policy will lead to better long-term returns in their private markets portfolios. That is in part because in the last few years we have seen private equity firms’ approaches to ESG evolving from a risk mitigation focus to one that puts responsible investing at the heart of value creation.

As Stephan Forschle, co-head of Triton’s business services team, told PEI in October: “There is now a much greater appreciation of ESG considerations as a force for value creation throughout the investment process, in addition to being a risk mitigation tool. We have long believed in the power of ESG factors in building better businesses, and we are seeing more and more GPs following suit in building in-house teams to help implement, track and measure sustainable value creation.”

Coller Capital’s Global Private Equity Barometer: Summer 2022 found that 65 percent of LPs believe ESG adds value by excluding high-risk investments and business practices, and by making proactive, positive changes to portfolio companies.

Still, there are signs that this focus on ESG by LPs may be starting to cool in the face of macroeconomic challenges. Perspectives data shows that the number of LPs that do not believe in ESG as a driver of better long-term returns has increased from 26 percent last year to 31 percent in the 2023 study.

The proportion of LPs that have asked to avoid investments made by a fund for ESG reasons has dropped from close to 50 percent a year ago to 40 percent, while the proportion refusing to fund an opportunity based on a lack of diversity and inclusion at the GP level has also fallen from 20 percent to 13 percent in the last 12 months.

Very few investors are yet to classify their GPs’ ESG performance as excellent, with only 1 percent fully satisfied with diversity and inclusion efforts at their GP and 5 percent rating reporting efforts as top-class. However, the market has witnessed significant improvements in ESG reporting in the last year, in part driven by regulatory scrutiny: 60 percent of LPs now rate the frequency and quality of ESG reporting as good or excellent compared with around 40 percent a year ago.