ESG has become a contentious subject. Political winds are fanning the flames of controversy, especially in the United States, where Congress voted in March to prevent pension fund managers from basing investment and shareholder rights decisions on environmental, social and governance factors, claiming they would hurt performance. Greenwashing incidents around the world are casting a further pall.
ESG funds were hit hard in 2022 by the fallout from the Ukraine war, inflation, market turbulence and the growing US political backlash. With fossil fuel shares soaring, ESG fund performance lagged non-ESG funds for the first time in five years.
ESG is snowballing
Despite the headlines though, ESG momentum is still building, with confidence in the sector boosted by the Biden administration’s $369 billion Inflation Reduction Act, according to Preqin’s latest ESG survey.
Investor interest in ESG capabilities continued to climb through 2022, the survey noted, with the proportion who believe ESG considerations are extremely important in investment decisions more than doubling to 13%, from 6% in 2021. Those who ascribed no importance to ESG dropped from 13% in 2021 to 10%.
The survey also found growing numbers of LPs are confident ESG funds deliver better returns, with 28% of respondents suggesting they offer superior performance, up from 23% the year before. Limited partners are increasingly willing to step away from investments or partnerships due to concerns over ESG standards as well. A separate survey reported that over half of investors believe GP compensation should be directly linked to ESG goals.
Interest in impact investing – which actively seeks businesses delivering social or environmental benefits, rather than simply screening out companies – has become particularly marked. Industry body the Global Impact Investing Network calculates the market is now worth almost $1.2 trillion. And it looks set to grow.
Two-thirds of investor respondents to the latest Cambridge Associates survey said they engage in sustainable and impact investing, a 29% increase from the 2018 survey, with more than a quarter allocating at least 25% of their portfolio to such investments. Among families and high-net-worth individuals, over half now engage in sustainable and impact investing. And 90% of the survey respondents plan to increase their allocations over the next five years.
ESG policies under scrutiny
With LPs ramping up their interest in ESG-oriented allocations, and scrutiny of who they invest with, private equity firms need to ensure they can meet expectations. Robust ESG policies that extend from the initial portfolio company due diligence through ongoing investment monitoring and engagement to investor reporting are now crucial.
Yet ESG data availability, transparency and quality remains a major challenge as GPs strive to analyse and measure the associated risks.
A recent KEY ESG report of general partners and portfolio companies around the world highlights the difficulties. It found 90% of portfolio companies are unsure how to report on ESG data. Many firms take up to 12 weeks to collect ESG data, which can lead to missing reporting deadlines, and stalling or failing deals at the point of sale.
Regulatory changes and geographic differences are complicating data collection, the report found, noting a fifth of GPs that have started measuring ESG in the last decade are struggling to align their in-house methodology with emerging industry and LP standards. GPs that collect granular data on material metrics and know what to report on will be better placed though to meet evolving ESG regulations and understand their portfolio companies, helping them raise funds and make improved investment decisions, it added.
Amid the focus on meeting investors’ and regulators’ heightened standards, private equity firms’ internal ESG policies should not be forgotten. Diversity – which allows for the amalgamation of a mix of ideas and experiences to improve decision-making – is a prime example. Progress on gender diversity, for instance, remains slow, with women accounting for only about a fifth of employees in the alternative assets industry. Just 14% hold senior roles. At the current rate of progress, Preqin estimates the alternatives industry won’t reach gender balance until 2065.
But with investors and regulators showing no let-up in their focus, private equity firms’ approach to such internal and investment-related ESG considerations will be ever more important.
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