The fast-growing private equity (PE) industry has gained a reputation for being brutal and focused on maximising financial returns for investors, no matter what. Moreover, it is still largely ‘male and pale’. Yet, over the past few years the sector has shifted toward more sustainable practices, driven primarily by investor demand, as well as regulation.
PE has an immense amount of capital at its disposal: $5.8tn in 2019, and rising as high as $8.3tn by 2025, according to PwC analysis. Thanks to its long-term investment horizon and stewardship-based style, it is well positioned to use its strengths, market position and capabilities to generate positive impact for society and the environment, alongside the returns it generates for investors.
Indeed, PE’s edge has always been to create value by driving transformation, more quickly and deeply than other owners can, as PE firms typically have a significant majority in their underlying investments.
In the industry’s first decades, that meant reducing costs and repositioning assets, and good governance practices have long been linked to better financial outcomes. Going forward, creating value can mean turning its power to drive meaningful environmental and societal change.
General Partners (GPs) are increasingly acknowledging environmental, social and governance (ESG) as a driver of value creation. Two-thirds of PE firms rank value creation as one of their top three drivers of ESG activity, according to this year’s PWC’s private equity survey (see Fig 1).
“In the private equity space, historically the focus has been on the G, on the governance side of things, in terms of creating good corporate structures and solid management teams, and making sure there are risk controls within the organisation,” says Duncan Storey, director, investment research at the London-based multi-family office Capital Generation Partners (CapGen).
“That’s an important part of sustainability but it doesn’t get the same emotional traction, it is quite dry compared to environmental or societal concerns.”
Certainly, especially post the global financial crisis, highly leveraged transactions have unraveled with considerably detrimental impact on employees and the local communities involved.
As unfair as it may be, “it only takes a few bad apples and a few prominent failures for everyone in the industry to be tarnished,” adds Mr Storey.
In the past few years there has been a “pretty stellar improvement” around embracing sustainability and reporting on it. “Five years ago, if you asked a GP to show you their sustainability strategy you would be getting a lot of blank stares. Today, even mid-size or small managers can address the topic and show you case studies,” says Mr Storey.
Rather than signing up to new ESG initiatives or presenting glossy ESG reports, what really matters to fund selectors is substance. “Often, the most interesting conversations with managers are those on deals they have passed on, for sustainability reasons. For me, that’s the real asset test.”
“Large private equity companies have put a lot of effort into integrating sustainability into their strategies,” notes Cristina Alcaide, managing director, private funds group at New-York headquartered PineBridge Investments. “You can see resources dripping into their portfolio companies and have been much efficient in reporting back to investors.”
On the other hand, smaller companies have struggled to keep pace with regulation and with ESG reporting, and have been slower in acknowledging the value of ESG integration. “Small or founder-led firms which may have gone well over the past 20 years are kind of resistant to change, and cultural biases have made the shift to ESG a little bit slower,” she adds.
But it is only a question of time, as both institutional and retail investors are much more demanding today, putting PE firms “under pressure” to embrace ESG issues and reporting.
PineBridge’s GPs’ annual ESG survey, recently released, shows that an increasing number of PE firms (94 per cent) have an established ESG approach, up from 78 per cent last year.
Firms incorporating ESG into their reporting went up substantially, to nearly 70 per cent, versus 57 per cent last year, with another 15 per cent planning to incorporate such reporting within the next 12 months.
Nearly half are adopting local and international ESG standards. However, there are clear geographical differences. In North America, only 39 per cent of respondents have committed to some international standards that promote responsible investment practices, versus 78 per cent in Europe and 63 per cent in Asia. And only 11 per cent of North American respondents have committed to the UN Principles for Responsible Investment (PRI), versus 67 per cent in Europe and 50 per cent in Asia.
Entrepreneurs below 55 allocate 16 per cent of their portfolio to private equity, while for those above 55, private equity represents 13 per cent of their portfolio, according to BNP Paribas’ Global Entrepreneur and Family report 2021
Regulatory differences between the US and Europe are a key factor behind these findings, believes Ms Alcaide. For instance, in the US, the legal framework is less clear in defining what is ‘green’, and many firms fear of damaging their reputation by ‘green washing’. This had led PE firms, especially smaller ones, to be less active in the ESG space.
Moreover, while in Europe the focus has been much more on carbon reduction and the environment, driven by the regulatory agenda, in the US the S factor has been predominant, possibly bolstered by events such as the Black Lives Matter movement.
Many PE managers have focused on improving their diversity and inclusion (D&I) practices because some D&I metrics are easier to gather, show and manage, compared to environmental metrics, observes Ms Alcaide.
Diversity and inclusion
“The low hanging fruit is in the S, and then moving to the E, as more historical data comes out and technology keeps advancing,” she says.
Yet, even if D&I initiatives are gaining traction, there is still a lot to do in an industry where professionals tend to follow a similar career path, in male-dominated sectors from banking, management consulting, M&A, capital markets and into private equity.
Women remain a minority of investment teams. Only 15 per cent of PineBridge’s survey respondents reported that women account for a quarter or more of their investment teams.
The key issue is not hiring but retaining and promoting diverse talent, adds Ms Alcaide.
Many PE firms have put in place mentoring programmes, yet one-third of respondents have taken no formal actions to support and advance women and employees from traditionally underrepresented groups.
Encouragingly, many PE firms acknowledge that diverse teams generate business benefits, notably in the field of innovation. In the UK, more than 80 firms have supported the Level 20 non-profit initiative to improve diversity and inclusion across PE. All PE firms with a French presence have signed on to France Invest’s diversity charter promoting gender equality.
Fund selectors are increasingly wary of managing risks deriving from skewed cultures, where people all have the same education and professional trajectory, and tend to think in a similar way.
“Diversity and inclusion is an area where there is a lot to do within private equity, as within the broader financial industry,” says William Benjamin, CIO alternatives, HSBC Asset Management. HSBC measures D&I metrics across all the funds in which it invests, taking them into account for each investment it makes, and engages with fund managers around these issues to drive improvements.
Data issues
Perhaps contrary to public perception, ESG and impact investing have been a feature of PE investing for many years, says Mr Benjamin. HSBC’s first investment into private equity funds targeting ESG factors or impact outcomes goes back to 2002.
However, the availability and consistency of ESG data is a greater issue in private equity, when compared to public markets. “In private equity, there are data sources available but they are not as comprehensive as in public markets. Therefore, it is a more people intensive exercise to collect, verify, analyse, report and act upon data across private equity,” says Mr Benjamin.
Signatories to the United Nations’ Principles for Responsible Investment (PRI) jumped 28 per cent last year and now number more than 3,000 institutional investors and PE firms, representing a staggering $103tn of assets under management
Another issue is the lack of global standards against which private equity managers can invest and report. The many different reporting frameworks used by different investors have made it difficult for PE managers to find consensus around what investors are looking to achieve, says Richard Clarke-Jervoise, global head of private equity and private debt for BNP Paribas Wealth Management.
Many PE managers have however started taking “the bull by the horns”, with many making public declarations around carbon reduction or diversity and inclusion. “Private equity managers themselves are taking ownership of ESG, which is a good thing, because it allows them to have a much more coherent view of what ESG really means for them,” he says.
However, the challenge is to provide that information consistently across the industry. In Europe, SFDR regulation and its EU taxonomy is aimed at channelling private capital into sustainable assets. In the US, similar regulation is also being considered, driving investors’ expectations that the North American PE industry will catch up with their European counterparts over time.
Regardless of regulation, there is increasing understanding among private equity firms that playing for short-term gains and profits, at the expenses of stakeholders, will negatively impact returns, observes Mr Clarke-Jervoise. This is reinforced by the “very strong” alignment between PE firms’ employees and businesses’ overall returns, with several PE firms promoting employee ownership of the companies they invest in.
Even if there is no consistent data yet establishing a positive link between ESG investing and financial returns, PE managers are realising that they will get a good exit when they have looked after their investee companies. On the contrary, it is getting more challenging to sell firms which they have not helped to improve in their sustainability metrics, says CapGen’s Mr Storey. This realisation will lead to a greater adoption of ESG factors into their investment processes.
PE natives
Younger generations are another key growth driver of sustainability in private equity. They not only have a greater appetite for private equity than older investors, having a greater affinity with investing in firms with a longer-term horizon, but they are also driving the shift towards sustainability. “In the same way that the younger generations are digital natives, they are private equity natives as well, as they were brought up at a time when private equity was already a significant industry,” says BNP Paribas’ Mr Clarke-Jervoise.
Especially in multi-generational families, private equity is one of the few asset classes where the younger cohorts are very keen to become involved with the management of their wealth, he says. As wealth gets transferred to the next generation, the growth in private equity allocation will only increase over time, as will the drive towards sustainability.
Generating impact
Several private equity firms have segregated their ESG efforts into discrete funds wholly devoted to impact investing. Seventeen per cent of PE firms have a dedicated impact fund or plan to launch one in the next year, according to this year’s PwC PE survey. Forty-five per cent do not have an impact fund but consider the impact of their investments.
Impact investing in the private equity space is quite a young trend, observes Andrea Bergamini, product manager, LGT Private Banking and Asset Management, explaining that LGT started operating in this space in 2006.
The trend has accelerated rapidly in the past five years. “We see a lot of providers trying to join the fray, but some just do it because they recognise an opportunity, which is mainly regulatory driven, to get the necessary funding to develop the business. On the other hand, there are providers, like LGT, who believe impact funds generate value for investors but also for society and the environment.”
In May, LGT Private Banking launched its first impact fund for private clients, the Lightrock Evergreen Fund. The fund invests in the Lightrock Growth Fund, which has raised $1bn in total and is advised by Lightrock, LGT’s affiliate London-headquartered company focused on impact investing. The fund invests in a concentrated number of “rapidly growing, innovative and sustainable businesses” in Europe, Latin America and India, together with LGT and the Princely Family.
The reason there are few sustainable or impact private equity products on the market is because PE firms invest in companies that are typically relatively small and young, who do not have the resources to deliver ESG data, which is not compulsory yet, says Mario Baude, head products and services management at LGT Private Banking. In a few years from now, though, it will be difficult for a company to be part of a major index, if it does not comply with ESG regulation.
Distributors often complain about the lack of scale of impact funds, defined as those vehicles incorporating the intention of generating positive social and environmental impact in their investment strategy, offering a spectrum of financial returns.
“The universe of impact investing you can work with is small, but is growing and over time it will develop to be a very significant industry,” says BNP Paribas’ Mr Clarke-Jervoise. He says there is only “a limited number” of €1bn ($1.17bn) plus funds, which is the minimum size required by the bank to meet its global distribution needs.
Andrew Lee, global head of sustainable and impact investing at UBS Global Wealth Management, sees a “wealth of opportunities” emerging for private market investors across a range of different strategies dedicated to driving impact.
Themes related to climate change, like renewables, the circular economy, energy efficiency and smart mobility increasingly appeal to clients and represent interesting investment opportunities. Equally compelling are investment opportunities in natural resources, including water, food and agriculture. Healthcare has also been of interest, where UBS finds value as well as opportunities to fill the funding gap.
Due to the majority stake firms have in their investments, PE lends itself very well to work with underlying companies in not only defining impact objectives, working with them to help them achieve those objectives and drive change, but also helping them measure and manage those achievements, adds Mr Lee.
UBS works with funds across the size spectrum, ranging from the more thematically diversified to the more targeted and earlier stage venture vehicles.
“GPs across the spectrum are increasingly focused on sustainability and impact,” says Mr Lee. “There is widespread recognition that ESG factors are important both from a risk management perspective but also for value creation across portfolios.”
