“ESG is in our DNA” isn’t just a cliché: How PE firms can prepare for ESG scrutiny by communicating strategically

Private equity as an asset class continues to boom, but this has brought with it added scrutiny, particularly on how firms are incorporating ESG and sustainability into their investing process. It has become a cliché to say that “ESG is in our firm’s DNA” but the PE business model lends itself particularly well to sustainable investing in a number of ways and businesses can communicate this better. In the current absence of uniform disclosure rules, firms that are transparent about their approach to ESG can stand apart in an increasingly difficult fundraising environment while setting an example in an industry that is associated with opacity.

The scene today

Assets under management in the PE industry totaled $2.7 trillion according to Preqin data in 2010 globally. Despite a marked drop in fundraising over the past two years, that figure has still mushroomed to $13.1 trillion as of June 30, 2023, with Asia accounting for nearly a third of that total. As a result, the stakeholders are proliferating, with investors such as private wealth and family offices growing, and demands for greater transparency, and even action on better distribution of profits increasing. The head of Calstrs, a major pension fund and PE Limited Partner (LP) issued a call for PE firms to “share the wealth” with the workers and communities of companies that they invest in.

Among those stakeholders, ESG is of ever-increasing importance when selecting a manager. A recent INSEAD survey showed that 90% of PE investors consider ESG as part of their investment process, with 77% citing it as a gauge for picking a manager.

Transparency is improving, but firms, particularly mid-size and smaller ones that have been hit hardest by the recent fundraising squeeze, can do much more to communicate their strategy and approach to sustainable investing.

Regulation is on its way

ESG regulation regarding disclosure is being developed in Europe and the United States in response in part to demand from investors and media. Examples include the proposed U.S. Securities and Exchange Commission Scope 3 emissions disclosure rule and the Corporate Sustainability Reporting Directive (CSRD) from the EU, which came into force in January.

The CSRD affects PE firms in Asia as several of their portfolio companies will be in the value chain of the EU companies covered in the directive. They will have to prepare detailed reports covering carbon emissions, workers’ rights and a raft of other measures. They also cover the LPs themselves. Reporting will be released in 2025, but in the meantime, firms will have to move fast to put in place the means to measure the data correctly.

The issue that firms face, and one that affects sustainable investing globally, is the lack of a uniform reporting structure. While that is being developed there are ways for firms to inform their LPs, their stakeholders and the employees of their portfolio companies how they are applying ESG to their investment process, without being mistaken for an impact fund.

ESG really is in the DNA

Private equity as a strategy has several advantages for advancing sustainability due to its ownership structure allowing greater scope for activism at a board level, its focus on sustainability and its ability to offer scale.

Even if LPs don’t own 100% of the companies they are invested in, they will almost certainly have a strong presence on the board, meaning access to information around sustainable performance, can hire or reward executives for hitting sustainable targets and can scrutinize governance closer than investors in public markets and even regulators. They also have a longer investment horizon, meaning they have the time to implement and execute new strategies and see them through to completion.

Secondly, PE as a business model is focused on maximizing efficiency and profitability, initiatives that are clearly aligned with issues like reducing energy use. To maximize efficiency and performance, PE firms also have a rigorous system of collecting KPIs, which can be used to facilitate the collection of sustainability data while aligning it with financial goals.

Finally, PE firms offer scale. Small and medium enterprises (SMEs), which make up a huge amount of the wider economy and that PE firms often invest in, may struggle with making the changes necessary to pivot to lower or zero emissions as they don’t have the technical ability, knowhow or resources to change their business model in the desired manner. Having a PE firm as an investor or owner means that SMEs can apply all the resources at their disposal and the synergies of their portfolio companies to help businesses make those changes.

How to make it count

Uniformity among reporting regimes is still to come, but firms can demonstrate their actions through increasing transparency, employing strategic messaging, recognizing their extended universe of stakeholders and engaging with them in a clear and thoughtful way. Explaining a firm’s sustainability model transparently as well as the improvements it is making from an ESG-perspective will make sure it can stand out to asset allocators, regulators and the growing universe of stakeholders which PE firms now must address.