In the lead up to the Conference of the Parties of the United Nations Framework Convention on Climate Change (COP26) in November 2021, this report is the latest in a long line of news and announcements on the extraordinary impact of climate change
over the remainder of this century. It is clear that governments, regulators, the finance sector, businesses and households – essentially every sector of the economy – need to take radical and immediate action to fulfil the goals of the Paris Agreement and the United Nation’s Sustainable Development Goals.
Trillions of dollars need to be channelled annually into this effort, far greater sums of money than can be supplied by governments or governmental entities alone. Private finance, including private equity, must therefore scale up its involvement in channelling flows of private capital into sustainable investments and projects.
Despite the title of this article, applying ESG (environmental, social and governance) criteria to investments is far from a new approach for private equity firms. Many firms have been signatories for years to the Principles for Responsible Investment (PRI), have responsible investing policies and sustainability teams and apply ESG screening criteria to their investments, both at due diligence stage and as a form of ongoing assessment to improve the value of investments. For forward looking private equity firms, ESG is not only about being ‘the right thing to do’ but also vital for value creation in their portfolios.
Private equity is able to take a much longer term view than the public markets, usually having five to seven years to create value in their portfolio companies before exit. They are protected from the short term approach of the public markets which can tend toward decisions directed to more immediate profit. Private equity is therefore able to mitigate to some extent against what Mark Carney as the Governor of the Bank of England described as ‘the tragedy of the horizons’. Carney was referring to the fact that the impact of climate change and other irreversible damage to the earth’s planetary boundaries is well beyond the horizon of most governments, banks, businesses and individuals, therefore making it difficult to create the impetus for immediate concerted action.
Private equity has one of the longer investment timeframes, alongside strategic opportunities and infrastructure funds, so it can take the longer view. Indeed, private equity firms need to take the longer view because it is not sufficient to create value only in the investment period of their own funds. The investment must be attractive to buyers at the point of a disposal and appear a sufficiently attractive proposition where the buyer themselves in turn can create value and achieve a profitable exit another five to seven years down the track. For that reason, private equity firms are probably looking at least 10 years into the future and a private equity firm which fails to address and mitigate climate change and other ESG risks to its portfolio may well struggle to make a successful exit.
While scanning for ESG issues is an essential risk management tool, ESG is not only about risk but is also about opportunities and private equity firms are very alive to that. There are many investments where taking a business from bad to good or good to better on the ESG front will be a key driver of value and therefore deliver a better return to investors. Digital technology is also a key area creating risks and opportunities for the private equity sector and ESG and digital technology can overlap, for example, in the area of sustainable technology, which is likely also to prove an interesting hunting ground for private equity investment.
Even if a private equity firm was inclined to do the minimum on ESG, their investor base might not let them do so. More and more investors are asking questions on the integration of ESG into a firm’s operating model as part of their due diligence before committing to a firm’s latest fund. ESG is treated less and less as a box ticking exercise and more as an area on which investors expect to receive thoughtful and detailed responses. Some larger investors are submitting dedicated ESG audits when conducting their due diligence before committing to a fund, asking for evidence of screening of investments for ESG issues at due diligence stage and of ongoing interaction with portfolio companies on ESG issues. European (particularly Nordic) investors have shown a keen interest for a number of years and US investors, particularly US pension plans with a long term investment horizon, have been taking an increasing interest in the social and environmental aspects of ESG over recent years. It only takes a handful of key or larger investors to require this level of ESG information and a private equity firm will need to align their models and due diligence with those expectations.
Effective and accurate data collection and adoption of the appropriate benchmarks and reporting standards is key for integration of ESG into a firm’s operating model, due diligence and ongoing portfolio assessment and investor reporting.
Real progress is being made in this area with the Task Force on Climate Related Financial Disclosures (TCFD) (applied by Generation Investment Management, for example, who were used as a case study in the TCFD’s 2020 status report), the EU Taxonomy, Sustainability Accounting Standards Board (used by KKR for example who apply its sector specific industry standards for its portfolio companies) and others. The challenge is for the private equity industry (preferably, the funds sector more generally) to settle on agreed standards for benchmarking and analysing data and for reporting standards or process for ESG disclosures to be integrated into financial reporting so that useful comparisons can be made by investors.
How does Jersey fit into this? Jersey is already home to a number of private equity firms who are PRI signatories, with their own Responsible Investing Policies and taking an active approach to applying ESG criteria to their portfolios, some of them for more than a decade. Similarly, Jersey is home to a significant number of fund administration businesses, many of whom are investing into reporting systems for ESG reporting on portfolios and for reporting on ESG to investors, in support of the private equity firms to whom they provide services.
Jersey Finance has launched Jersey’s sustainable finance strategy with a detailed pathway to support its implementation over the next two years and will be working with Jersey’s finance sector to build capacity and skill in this area. Determined joint action to accelerate transformation of the finance sector and to channel capital flows to meet the coming ESG challenges is essential over the next decade and private equity firms, including the many Jersey based private equity fund managers, are already well on this journey.
The title to this article is the increasing case for ESG in private equity but, in reality, this is no longer the conversation in the PE industry. It is not whether a case can be made for increasing ESG in PE but whether PE firms who are not applying ESG criteria can credibly make a case for choosing not to integrate ESG into their businesses. Many PE firms are at the leading edge in this space and are continuing to invest their time and people into how they can most effectively drive sustainable value creation in their portfolio companies and through them, for wider stakeholders in the economies and communities that support them.