European private equity firms push ahead on ESG agenda

For the majority of private equity firms, ESG is no longer a fringe concern. The industry is now integrating environmental, social and corporate-governance issues into its business model, and 2021 has brought many important developments.

Through signatories’ annual reporting to the PRI, we have identified progress at both fund and portfolio company level. While regulators and investors are both applying pressure, PE firms are concluding that ESG can drive value creation too.

Climate change and human rights are two particular areas of action, but the lack of robust data on ESG metrics remains a difficulty. We address each of these areas in more detail below.

The story so far

PE firms are signing up to the PRI in increasing numbers. In 2021, the number of investment manager signatories with at least 10% of their assets invested in private equity expanded by about 250, to 975.

Interest is particularly visible in Europe, where about two-thirds of our PE signatories are based, according to 2020 reporting data.

Within this space, there has been an uptick in the number of venture capital investors joining the PRI in Europe and beyond and so the PRI is increasing its support for this part of the industry. We will shortly publish a discussion paper on VC, and a series of case studies is planned for the end of Q1 2022.

PRI is particularly keen to support the dialogue between Limited Partners (investors) and General Partners (private equity firms) on ESG integration. We are delighted that the Institutional Limited Partners Association (ILPA) has once again included the new PRI LP Due Diligence Questionnaire as the ESG section within its own DDQ. This forms part of a suite of tailored guidance from our Private Equity team.

The three big challenges ahead

Responsible investment is a broad agenda, but three priorities have come to the fore in PE. They are climate change, human rights, and the challenge of data.

Many European PE firms are now working on assessing the implications of climate change. The PRI is supporting the Initiative Climat International (iCI), an investors’ initiative that brings together 129 private market firms committed to engaging with portfolio companies to reduce their GHG emissions. It has active chapters in France and the UK, and a Scandinavian launch is imminent. The iCI and the PRI have also collaborated with the Science Based Targets Initiative on guidance for private equity firms to set near term emissions reductions targets.

The transition to a low-carbon economy can present a conflict for firms that are investing in oil and gas-related assets. These will likely attract scrutiny from LPs implementing a climate strategy.

Diversity, Equity and Inclusion (DEI) is another high priority. Women continue to be underrepresented within PE investment teams, as well as within the leadership of investee companies^[1], despite the established benefits of greater diversity – better investment decision making, deal sourcing and higher returns^[2].

ILPA has recently updated its diversity metrics template to help PE firms tackle this issue. Local associations such as France Invest are actively promoting DEI amongst their members. In addition, dedicated initiatives such as Level 20 have set an objective for women to hold 20% of senior positions in the industry.

However, it is vital the industry’s diversity efforts go beyond gender quotas, and address the practical barriers that prevent women and other underrepresented groups (for example, characteristics such as disability, age, race, culture and educational background) from achieving leadership positions.

PE firms are also well-placed to encourage financial inclusion and diversity in entrepreneurship in a broader sense^[3], through initiatives such as the Investing in Women Code in the UK, for example.

Considering human rights more broadly, the PRI has published a series of case studies and organised a roundtable for private markets investors on this topic. Human rights, as discussed at the Responsible Investment Forum in London, are relevant to every investor – and subject to increasing regulatory pressure in Europe^[4]. Complex supply chains may make due diligence difficult, but PE firms should engage with affected groups – local communities, the workforce, and any others – to identify problems. We recommend that investors start with a policy based on the United Nations Guiding Principles on Business and Human Rights (UNGPs) and OECD Guidelines.

The final challenge is one of data. The PRI continues to advocate for accessible, reliable, comparable and integrated company disclosures on ESG topics, and supports the European Commission’s proposal for a new Corporate Sustainability Reporting Directive (CSRD). We argue it should be extended to include non-listed SMEs from ‘high-risk sectors’. Once material ESG data is identified, PE firms still have to make use of this data through capacity building and staff training to deliver sustainable value creation.

Emerging practices

The PRI’s role in the industry allows us to identify and encourage advanced practices, which could be considered ‘the next frontier’ of ESG investing in private equity.

A growing number of European firms are setting up climate strategies and measurable goals, including on supply chain emissions. Some are leading the way with validated SBTs. They are also increasingly tying their investment decisions and teams’ incentives to ESG considerations and empowering investees’ management from the outset with a 100-day ESG plan. More firms are undertaking ESG due diligence at exit – both on the value they have generated, and on future buyers’ sustainability credentials. Some are also sharing capital gains with the portfolio companies’ employees.

Although challenging to structure, the future of the industry will likely include a direct link between the attainment of sustainability goals and a part of the private equity firms’ compensation (carried interest). As well as adding long-term financial value, PE players will be increasingly expected to demonstrate to investors that they can create positive impacts in the real world. This will confirm the validity of their business models, and successfully enhance their license to operate.

 

 

 

 

This blog is written by PRI staff members and guest contributors. Our goal is to contribute to the broader debate around topical issues and to help showcase some of our research and other work that we undertake in support of our signatories.Please note that although you can expect to find some posts here that broadly accord with the PRI’s official views, the blog authors write in their individual capacity and there is no “house view”. Nor do the views and opinions expressed on this blog constitute financial or other professional advice.If you have any questions, please contact us at [email protected].