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Seeing an end to the ESG blind spot in private equity

Hillary Flynn, Director of ESG, Private Investments
2022-01-31
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Earlier this year, we wrote about the growing role of ESG research in the private market. Having just completed a six-month industry listening tour, I can say this with confidence: ESG isn’t coming to private equity — it’s here. Following are six key takeaways on the growing role of ESG, both pre- and post-IPO.

  • Private equity firms are investing in ESG While the private market has historically lagged the public market in ESG adoption, general partners (GPs) of all sizes are integrating ESG into their due diligence processes, building out dedicated teams, collecting ESG data from portfolio companies, and reporting to limited partners on progress. According to a 2020 Pitchbook survey, 55% of GPs report that they’ve integrated sustainability throughout their investment process and 11% have a dedicated sustainable investing team.1
  • Primary focus areas are governance, diversity, and climate Multiple examples of unsuccessful public offerings over the past few years underscore the importance of effective governance, including in areas such as shareholder rights, leadership, and incentives. Amid studies linking diversity to innovation and financial results, many GPs now track diversity stats at the board and management team level, with an increasing number setting explicit diversity targets. Climate is another dominant theme, driven by the rise in global climate-related regulation, the standardization of disclosure (e.g., by CDP Disclosure Insight Action and the Task Force on Climate-related Financial Disclosures [TCFD]), and the intensifying public investor focus on climate. 
  • ESG provides an opportunity to partner with portfolio companies — Private companies are looking to GPs for guidance on ESG, especially as they plan a path toward an IPO. Some GPs are actively advising portfolio companies on ESG topics, while many outsource to third-party consultants. We think companies can benefit from guidance on board composition and shareholder rights best practices, compensation analysis and benchmarking, and ESG “materiality” assessments and prioritization.
  • The bar has been raised for newly IPO’d companies — Proxy advisors, ESG ratings agencies, asset owners, and asset managers are taking harder stances, particularly on governance. Some proxy advisors recommend that shareholders vote against the entire board of directors at companies that go public with multiple-class share structures and unequal voting rights (without a reasonable sunset provision). And the new Sustainable Finance Disclosure Regulation (SFDR) in Europe makes asset managers explicitly define “good governance” without differentiating between (newly) public and private companies. Meanwhile, climate disclosure has become an expectation. In some major markets, including the US, UK, Singapore, and Hong Kong, TCFD reporting (climate reporting) will become a regulatory requirement in the next 12 – 24 months.
  • Stronger ESG profiles may translate into broader access to capital — In 2019, 80% of asset owners were integrating sustainable investing into their investment process (up from 70% in 2017), with an additional 15% saying they were seriously considering adoption.2 Both asset owners and managers are paying attention to companies’ ESG practices and ratings. A company being labeled an ESG laggard is a distraction and reputational risk at best, and at worst could reduce the company's access to capital post-IPO — especially as some ESG-focused asset owners choose to screen out companies that rate poorly from an ESG perspective.
  • ESG is now part of the activist playbook — We're increasingly seeing activists use lagging ESG and corporate governance practices as part of their pitch during proxy contests, in order to win seats on the board. We're also hearing anecdotally that companies’ environmental and social practices may be targeted in coming years. Stronger governance profiles and leading ESG practices may offer companies protection from minority shareholders looking to gain control and effect change. 

Taking these market dynamics into account, we believe that the earlier boards and management teams address ESG issues and understand how they stack up to public company peers, the better. In our view, the process should begin with an “ESG road map” that outlines plans for improvements in areas such as board composition (e.g., diversity of thought in the boardroom), executive compensation (e.g., transparency and alignment with the interests of long-term shareholders), and ESG strategy (e.g. materiality assessments of environmental and social impacts and communication to relevant stakeholders).

1Pitchbook Sustainable Investment Survey, October 2020

2Morgan Stanley Institute for Sustainable Investing, Sustainable Signals report, May 2020

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