Environmental, social, and governance (ESG) investing has gained a lot of traction in private equity, and for good reason: it can prove to be a game changer in sustainable investing. For example, the Preqin Special Report: The Future of Alternatives in 2027, forecasts that natural resources will return +8.1% to investors between 2021 and 2027 on an annualized basis, compared with +9.0% over the preceding five years. As a result, private equity investors are increasingly looking for more information about the ESG impact of assets in their portfolios.
In this blog post, we will explore how an increased emphasis on ESG aligns with the industry-wide trends of ESG compliance, sustainable investing, and greenwashing, and we will examine the challenges private equity firms face in order to stay at the forefront of the ESG wave.
The Global Private Equity Responsible Investment Survey 2021 shows how PE firms are currently adopting sustainable investing. Here are three key takeaways: 89% are concerned about compliance with ESG regulations, 36% consider climate risk at the due diligence stage to understand and/or mitigate the exposure of portfolios, and 66% rank “value creation” as a top-three driver of ESG investing in Private Markets.
In other words, ESG has evolved from a risk management tool to a driver of value creation. This recent shift shows that PE firms indeed acknowledge ESG as a lever of transformation. Major sustainability trends bear this out, as the circular economy, net zero, inclusive recruitment, climate technology, and nature-based solutions are disrupting the status quo and creating significant investment opportunities (Source). At the same time, new businesses with more sustainable products are reshaping consumer tastes and creating even more opportunities for PE firms to pursue sustainable investment and acquisition.
Measuring the effectiveness of ESG activities remains challenging
In order to take advantage of emerging ESG opportunities, PE firms need a reliable way to evaluate and assess various ESG activities. But the current data environment makes this more challenging than expected. For example, disparate criteria for qualitative and quantitative ESG metrics have contributed to a fragmented market, making it complicated to evaluate the investment impact on portfolios. The inability to manage or analyze ESG data consistently has impeded risk management at the individual investment level as well as the portfolio level.
In addition, some corporations and banks provide misleading information about ESG efforts in order to make them appear more sustainable than they actually are, a phenomenon called “greenwashing.” Greenwashing occurs when firms have investments or operations with significant negative ESG impacts but the marketing materials do not adequately reflect this. It can cause investors to unknowingly invest in operations that do not align with their ESG expectations. It also makes it very hard for PE fund managers to stay aware of risks that violate internal ESG policies, especially because this work is usually done manually.
How technology can help you ride the ESG wave
Gaining clarity in ESG investing will likely require new technology for managing ESG data. Because it measures how a company influences the environment, ESG data is obviously an increasingly important factor in investing, providing critical information to CFOs and CLO managers about how a company is performing compared to others in the same industry, region, or sector. With easy access to this information, PE portfolio managers can identify which investments are currently outperforming their peers and merit further analysis by the firm’s monitoring teams.
The challenge is finding and integrating technology specifically designed to monitor ESG data. Ideally, an ESG management application would offer a centralized repository for all relevant ESG data, so PE funds can quickly identify risks and receive alerts about ESG-driven exposures. ESG metrics could then be mapped to KPIs on a dashboard for performance benchmarking and reporting purposes.
How IVP can help
With its configurable data management capabilities, IVP for Private Funds is well-positioned to help PE firms address the challenge of ESG data. Specifically, the ESG Management module of this platform can configure deal-specific ESG metrics across the entire deal lifecycle. It also helps PE firms incorporate ESG considerations with the ability to track every asset class. Other important features of the ESG Management module include:
- Fully customizable data collection forms and questionnaires
- Custom ESG workflows for deal sourcing, screening, and ongoing monitoring
- Custom calculations to derive an ESG Score for portfolio companies
- Inbuilt support for standard international frameworks, including UNPRI and SASB
- Definition of materiality for each question at the industry level and improvement plan tracking
- Portal to access ESG-related data points directly from the borrower
- Out-of-the-box, industry-specific ESG analytical dashboards, and deal and portfolio reports
- Adaptors to a wide range of third-party data providers
- Deal-specific KPI tracking and management
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