Over three-quarters of private fund leaders believe a stronger ESG vision and culture will ultimately drive value in their business.

“It is very clear to us that responsible corporate behaviour and the consideration of ESG factors have a positive influence on long-term financial performance,” says Jeff Pentland, managing director at Northleaf Capital Partners.

However, LP pressure remains the most significant driver behind greater ESG monitoring and reporting. An overwhelming 86 percent of respondents to the Private Funds Leaders Survey 2021 said LP questions on ESG had become more detailed over the previous 12 months. Meanwhile, ESG considerations play an equal role in due diligence and value creation. Just under half of respondents described ESG as either critical or very important when assessing potential transactions.

“This year we have spent much more time with our portfolio companies during the investment phase talking about ESG, but historically due diligence was really the key for private debt players like us,” says Coralie De Maesschalck, head of CSR and ESG at Kartesia. “It is really during the due diligence phase that we can ask companies for changes in this area. We often have fairly limited access to management and little or no direct influence on the company during the investment phase, so during due diligence we have more negotiation levers and can request changes in approach.

“That said, now we find that our portfolio companies are increasingly more open to discussing ESG, so I’m spending more time with management covering it. Several of our portfolio companies started last year to launch ESG reviews of their companies and some of them are already implementing the actions they decided to take as a result of those.”

Just under half said ESG was critical or very important for adding value in the businesses they buy. Ruth Lane, head of investor relations and ESG officer at ATL Partners, says: “We have already seen positive correlation between ESG progress and the performance of our companies across a number of different metrics, such as improved costs, efficiencies and an improved, more engaged workforce.”

Brian Ramsay, president of Littlejohn & Co, adds: “We believe that robust ESG programmes at our portfolio companies inherently lead to better outcomes in the form of safe, healthy and motivated employees.”

Uniformity problem

Yet although private markets leaders recognise the importance of getting ESG right, the operating models to support those practices remain immature. Almost three-quarters of respondents exclusively receive their ESG data from their portfolio companies, but close to 90 percent describe their ability to do so as at least slightly challenging. This is unsurprising when 64 percent employ a fully manual process.

And even where some degree of automation has been achieved, a lack of industry-wide uniformity remains a problem. “Metrics that are easily quantifiable are automated and those that are more qualitative are tracked via ongoing dialogue with our portfolio companies,” says Ramsay. “But the lack of standardisation around reporting metrics and ratings make it challenging for GPs to benchmark themselves against their industry, as well as for LPs to compare ESG programmes across their portfolios.”

Meanwhile, although close to two-thirds of respondents rely on an internal ESG team entirely, 34 percent expect to move towards an outsourced model over the next three years.

Northleaf is one firm that believes in leveraging external expertise. “We have sought to enhance our ESG risk assessment capabilities across our due diligence and portfolio management processes through a partnership with RepRisk,” explains Pentland.

“RepRisk provides a software platform that allows us to systematically identify and assess material ESG risks. The system also allows us to set up watchlists on a mandate-by-mandate basis and then to track how every individual investment is performing from an ESG perspective.”

Investment performance

In the expectation that climate considerations will become more important, Northleaf has also entered into a partnership with Climanomics, the Climate Service’s SaaS platform to enable climate risk reporting aligned with the Task Force on Climate-related Financial Disclosures framework.

And yet, despite a clear increase in focus on ESG at all levels, less than half of respondents are able to definitively prove a positive correlation between ESG and investment performance at a portfolio company level. This is, in part, a question of maturity. Longer and deeper track records will be required to provide empirical evidence of ESG’s impact on value creation.

But Gareth Whiley, managing partner at Silverfleet Capital, believes that equating ESG with returns misses the point. “We don’t look for a correlation between returns and ESG and continue to argue that this is a slightly odd way of looking at things,” he says. “We believe we need to be responsible investors, not ignoring the financial costs, but certainly not only because we can justify that there is a financial benefit.”