Archived insights remain available on the site. Please consider the publish date while reading these older insights.
publish

Seeing an end to the ESG blind spot in private equity

ESG’s role is coming into focus in the private market, says Hillary Flynn, director of ESG, Private Investments. She discusses governance, climate, and other key themes; the higher bar for newly IPO’d companies; and the evolving activist playbook.

The views expressed are those of the author at the time of writing. Other teams may hold different views and make different investment decisions. The value of your investment may become worth more or less than at the time of original investment. While any third-party data used is considered reliable, its accuracy is not guaranteed. For professional or institutional investors only.

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

Please refer to this important disclosure for more information.

Recommended for you

Vicious liquidity cycles, volatility, and the role of alternative investments
Dennis Kim and Lori Whiting, members of our Alternatives Team, consider the changing relationship between volatility and liquidity, and offer ideas on alternatives strategies for what they expect will be an enduring trend.
Archived insights remain available on the site. Please consider the publish date while reading these older insights.
publish
May 2021
Vicious liquidity cycles, volatility, and the role of alternative investments
,
publish
Central bank digital currencies: Debunking five common myths
We discuss how disruptive central bank digital currencies are likely to be and dispel some commonly held CBDC myths.
Archived insights remain available on the site. Please consider the publish date while reading these older insights.
publish
April 2021
Central bank digital currencies: Debunking five common myths
,
publish
<em>ESG insights for private companies —</em><br>Diversity, equity, and inclusion: FAQ
We answer some of our private portfolio companies’ most frequently asked questions on diversity, equity, and inclusion.
Archived insights remain available on the site. Please consider the publish date while reading these older insights.
publish
April 2021
ESG insights for private companies —
Diversity, equity, and inclusion: FAQ
,
publish
APAC Investment Forum 2021
Wellington specialists offer their views on the key themes transforming the investment opportunity set today.
Archived insights remain available on the site. Please consider the publish date while reading these older insights.
publish
March 2021
APAC Investment Forum 2021
,
publish
Bridging the gap in credit portfolios with a long/short strategy
Amid massive changes in the credit market and growing demand for fixed income diversification, the authors explain why long/short credit strategies could help round out a portfolio of traditional and private credit investments.
Archived insights remain available on the site. Please consider the publish date while reading these older insights.
publish
March 2021
Bridging the gap in credit portfolios with a long/short strategy
,
publish
Mission critical: The vital role of alternatives in pursuing investment success
Multi-Asset Strategist Cara Lafond considers three alternatives ideas for the current environment, including private equity vintages that coincide with market downturns; long/short directional strategies that may aid the pursuit of stability across the cycle; and long/short risk-mitigating strategies that complement other diversifiers.
Archived insights remain available on the site. Please consider the publish date while reading these older insights.
publish
February 2021
Mission critical: The vital role of alternatives in pursuing investment success
,
publish
Surviving the stress test: Companies adjusting to the new landscape
The pandemic has forced companies around the world to revisit their business plans and processes. Michael Carmen, co-head of Private Investments, moderates a discussion with three CEOs about how they have been navigating this time of crisis.
Archived insights remain available on the site. Please consider the publish date while reading these older insights.
publish
January 2021
Surviving the stress test: Companies adjusting to the new landscape
,
publish
Shorting stocks in China: The emerging opportunity
Two of our emerging market investors explain why shorting appears to be at an inflection point in the world's second largest equity market, where idiosyncratic conditions may offer a unique environment for generating alpha and diversifying risks.
Archived insights remain available on the site. Please consider the publish date while reading these older insights.
publish
January 2021
Shorting stocks in China: The emerging opportunity
,
publish