Three ESG trends for Private Equity in 2016

Some private equity executives I spoke to the past year, both in my role at PGGM and ERM, mentioned that ESG (environmental, social and governance) integration is becoming less prevalent in the discussions they have with their investors. However, in discussions with their investors we, at ERM, noticed three ESG trends that will impact private equity firms in 2016 and beyond: Institutional investors are setting ESG ambitions, improving ESG monitoring and data availability, and shifting towards ESG value creation.

  1. Setting ESG ambitions: What we mean by ambitions is that institutional investors, such as pension funds, are increasingly setting sustainability targets for their investment portfolios. For instance, Dutch pension funds ABP and PFZW have both set CO2 reduction targets, and AP3 seeks to triple its green bond holdings. Although most of these targets have focused on the investors’ public equity and bonds portfolios, it is a matter of time before these will be applied to their alternative investment portfolio (ie those including private equity (PE) funds). Institutional investors will also look for other ambitions in line with their investment strategy and those of their stakeholders’. In the near future, we may see water scarcity targets and health and safety targets for instance. As these risks become more evident as an investment risk and opportunity, institutional investors will also want to measure them, which brings us to the second trend.
  2. Improving ESG monitoring and data availability: Institutional investors know a lot about their public portfolio due to ESG disclosures by listed companies and firms such as Bloomberg, MSCI and Sustainalytics who collect this ESG data. However, investors have little visibility on the overall ESG performance of their private equity portfolio. For instance, most institutional investors can’t calculate the CO2 footprint of their private equity portfolio. They just don’t have the data. However, some firms have been collecting sustainability data of private equity funds and their portfolio companies for years, such as private equity fund-of-fund managers Robeco and Adveq. Solutions they have developed are now rolled out to the broader market. Sustainalytics recently bought ESG Analytics, a spin-out from Adveq. eFront, a reporting solution for private equity firms, released FrontESG in partnership with a French fund of funds, Swen Capital. And then there is the PRI which is asking PRI signatories for more ESG data. Overall this will mean more scrutiny of ESG performance of portfolio companies and data requests for private equity firms.
  3. Continuing shift towards ESG value creation: At a recent seminar, the majority of investors voted risk reduction as the main driver for integrating sustainability in private equity. However, private equity is in the business of creating value. As a result, there is an ongoing shift from seeing sustainability as compliance-and legacy driven to a strategic advantage that is central to a company’s business model. For instance, manufacturing companies can reduce incidents with days/ time lost, leading to millions of dollars of margin enhancement. One manufacturing company ERM worked with reduced its safety performance by a 68% reduction in lost time incidents leading to EUR 8 million margin enhancement, as well as business interruption. The private equity community is realizing as well that sustainability does not need to be an add-on or compliance tick-in-the-box, but can enhance their existing investment model.

Private equity firms who think the ESG trend has passed will be in for a surprise in the coming years. However, private equity firms who are able to deal with investor requests for ESG disclosure intelligently and make it part of normal business, creating value for their investors, will probably see it become less prevalent in their discussions.

Responsible investment specialists should watch their language

When you put 100 portfolio managers in a room, very few want to be the odd one out saving the planet.

Responsible investment specialists must become better storytellers for mainstream investors and CFOs.

The use of words such as “externalities”, “extra-financial risks” and “socially responsible investments” often results in the perception that environmental, social and corporate governance (ESG) factors are extraneous to conventional investment decision-making, that they are extra work, and that they are only about ethics. This has turned the integration of ESG factors into a niche and has given mainstream investment managers an excuse not to be explicit about ESG factors in their investment processes.

The ESG community can borrow from general sustainability research. A recent report by advertising agency OgilvyEarth showed that the communication of sustainability in general should be rethought. “The great green middle, [79% of Americans], isn’t looking for things to set it apart from everyone else. It wants to fit in.”

Likewise, there is still a social stigma associated with ESG that links it with tree-huggers. When you put 100 portfolio managers in a room, very few want to be the odd one out saving the planet. The more we communicate ESG analysis as somehow different from regular investment analysis, the less it will be adopted.

The ESG community is comprised of many green leaders, but to be successful we must realise that the majority of investors are not motivated by ideals to save the planet: they want to know what’s in it for their investment thesis. It is our task to insert ESG into that and in doing so help investors to better value “green companies” without resorting to suspect language as sustainable investing or SRI.

How can the ESG community fix its communication error?

Speak portfolio manager language: less Greenpeace, more Goldman Sachs. To be heard and influence someone, you need to speak the language of the other. For instance, do not speak about water usage or carbon reduction, but show a financial analyst the risk of water scarcity on a company’s future cost of capital and balance sheet. Saving the planet may not be a manager’s fiduciary duty, but analysing material information is.

Show the upside. A lot of what ESG advisers do can be summarised as change management. Changing people works best when you show them the upside. So to have investment managers include ESG information speak in terms of how ESG information adds value. Show how solving environmental and social trends results in new value creation opportunities, instead of scaring people about global warming. For instance, according to McKinsey, a transition to a circular economy is an economic opportunity of $630bn.

If the ESG community is serious about saving the planet, we should first make ourselves understood and stop communicating that ESG analysis is exceptional. Undoubtedly, communication alone will not solve all environmental and social problems, but some form over substance may help to bring about a sustainable financial system.

Originally published at on August 21, 2013.