ESG in private equity: how investors can minimise risk with AI

ESG is now an important driver of value creation that firms making investment decisions of all sizes need to assess holistically.

In May, the S&P 500 removed Tesla from its Environmental, Social, and Governance (ESG) index. It said the electric vehicle maker lacked “a low-carbon strategy” and “codes of business conduct,” and was host to racism and poor working conditions at its California gigafactory. In response, Tesla CEO Elon Musk said ESG has been “weaponised by phoney social justice warriors” and uses metrics that are “a scam”.

Musk is no stranger to controversial, widely published outbursts. As the S&P 500’s ESG Index is used to rank and essentially recommend companies to investors, he has a vested interest in discrediting anything that would dissuade investment in Tesla. But a more nuanced impact report Tesla later released highlights some of the key issues with current ESG reporting:

“Current environmental, social and governance (ESG) reporting does not measure the scope of positive impact on the world. Instead, it focuses on measuring the dollar value of risk / return.”

ESG reporting is flawed. It is inconsistent, often unregulated, and driven by data, rather than a whole, holistic picture. But that’s no reason to ditch it, as Musk appears to be keen to do. Instead, it needs to get better. A lot of that is going to come down to the methods and tools adopted by private equity as they gatekeep which companies receive funding.

The many reasons ESG must improve

Last year, private equity had $6.3 trillion in assets under management and oversight of more than 20 million employees at about 40,000 portfolio companies. By 2026, the industry’s assets are expected to hit $11 trillion. The private equity industry now controls such a huge stake in the global economy that its ESG decisions, priorities and methodologies will be major determinants in society’s ability to tackle climate change and address other social issues.

As the private equity industry has grown, the consumer zeitgeist has turned concurrently towards ESG issues, from the system-level effects of inequality, to companies’ stances on decarbonisation, waste reduction, sustainable sourcing, diversity and inclusion. Limited partners increasingly consider it a priority too, no longer looking for financial returns-only but seeking out investments that do good. Around the world, regulations are tightening. And finally, companies with strong ESG ratings are frequently generating better returns than their non-ESG driven competitors.

Across private equity’s asset classes, ESG reporting is no longer a check-the-box, risk-mitigation exercise for generating good press and satisfying socially conscious employees. It is now an important part of value creation that private equity firms making investment decisions of all sizes need to implement carefully, using the right tools.

ESG claims don’t always add up

With these new concerns and priorities, it is unsurprising that around 42 per cent of global private capital ($4.73tn) is now held in funds with ESG commitments, according to Preqin. Sustainability, or at the least the appearance of sustainability, is now considered good business sense.

However, when ESG metrics in private markets are disclosed the data is rarely transparent or standardised. There is no uniform way of knowing whether these funds really will reduce pollution in line with the principles of the Paris Agreement, fulfil sustainable development goals, or represent more than token female and non-binary board appointments.

What’s more, thematic and complex risks such as climate change that are not quantifiable can be measured based only on the numbers the company seeking investment has supplied.

As a result, consumers and investors find it difficult to ascertain how private equity firms and their investments are assessing and integrating ESG principles – if at all. More and more frequently, this is leading to allegations of greenwashing or social washing.

One Limited Partnership company (LP) told Institutional Limited Partners Association and Bain & Company in a February 2022 survey that LPs are increasingly attuned to what makes ESG initiatives legitimate, and they can tell “the difference between meaningful action and greenwashing.”

Last April, the US Securities and Exchange Commission issued a Risk Alert that highlighted weak internal controls, compliance issues and misleading marketing among funds that promote impact investing and sustainability.

New regulations

Regulators and authorities from both sides of the Atlantic are now stepping in to force better ESG reporting.

In February, the European Commission adopted a proposal for a directive on corporate sustainability due diligence. It will require companies with significant operations in the European Union to identify ESG risks, and measure and report the strategies they put in place to mitigate them. Both EU and non-EU multinational businesses will need to build environmental and human rights due diligence into their business practices under the directive.

Also in the EU, the Sustainable Finance Disclosure Regulation, requires financial institutions within the EU, as well as those marketing to EU investors, to make principles-based disclosures on ESG-related activity. This must be visible on their websites and be included in any marketing materials. Even more in depth sustainability reporting will be required from 2023.

In the US, the Securities and Exchange Commission is considering introducing ESG rules for investment funds, including private equity firms. As he announced the review, Gary Gensler, chairman of the SEC, said he was concerned about the rise in ‘impact washing’ and ‘greenwashing’.

This comes as the Task Force on Climate-related Financial Disclosures is developing recommendations on disclosure standards that are expected to become mandatory for UNPRI signatories from 2024 or 2025.

During COP26, the IFRS Foundation, a not-for-profit, public interest organisation established to develop accounting and sustainability disclosure standards, announced the formation of the International Sustainability Standards Board. It will create global sustainability disclosure standards to help investors assess “sustainability-related risks and opportunities” to make informed decisions.

Responsible investing

Regulators aren’t alone in driving better ESG practices. Funds and private equity firms are playing a part too. Industry experts and investors are working to standardise metrics. A single standard is expected to be agreed upon within a year.

The world’s largest private equity firms and giant pension funds have joined forces to establish ESG disclosure standards. Over 140 private equity firms and pension funds have signed up, including the influential Dutch pension provider PGGM, Canada’s CPP Investments and California’s Calpers.

Some 3,000 large investors, including UBS, have now signed the United Nations’ Principles for Responsible Investment. This voluntary set of investment principles for incorporating ESG issues into investment practices includes a commitment to incorporate ESG and promote corporate sustainability disclosures.

Limited partners want better ESG

These new regulations and practices make good business sense for private equity firms. Multiple surveys show LPs view ESG factors as important performance metrics in addition to investment performance. INSEAD’s Global Private Equity Initiative recently found that 90% of LPs consider ESG when making investment decisions, while 77% use it as a factor in selecting general partners.

One LP told Institutional Limited Partners Association and Bain & Company that the holistic incorporation of ESG standards by a firm was the deciding factor in a close competition between fund managers with similar performance records.

Younger clients are particularly concerned about ESG issues, suggesting the demand for reporting and compliance will continue to grow.

Investment-related benefits of ESG

Many LPs and GPs are certain that better ESG must become industry standard if private equity is to continue delivering high returns.

A recent Fidelity International study found a clear relationship between high ESG ratings and strong portfolio performance. Companies with good ESG ratings are outperforming their non-ESG focused competitors. There is a clear financial mandate for identifying companies that have strong ESG credentials.

Weak ESG due diligence can result in:

• Reputational harm from not meeting the expectations of LPs and consumer
• Legal and regulatory penalties for breaking ESG-related rules
• Financial losses stemming from reputational and legal risks

The problem with existing ESG tools

ESG risk management within private equity is now receiving plenty of investment. New jobs that translate ESG policies into concrete, data-driven processes and actions are rapidly being created.

But the tools on offer are delaying progress. They are constrained to metrics, lists and databases. Investment research firms are often not unreliable, offering opaque sources for the data they base their results upon.

Public markets have a far greater array of standardised metrics from firms such as Sustainalytics and MSCI – but there are no equivalent systems for private investments yet.

Unlike typical risks that businesses face, such as fraud or criminal activity, ESG risks, particularly the environmental ones, are thematic and poorly defined, making them hard to spot. They are often based on a company’s self-declared ratings, which is likely to be biased. Often, they are subjective.

If private equity firms want to attract investors, meet regulatory requirements, and invest in companies with legitimate ESG credentials, this will need to change.