The Changing Reputation of Private Equity: A Renewed Duty of Care

Pre-pandemic, GPs were already feeling the pressure to make more meaningful investments and ESG issues were creeping up the agenda in boardrooms and LP meetings.

Then came along Covid-19, presenting the largest humanitarian crisis in modern history and the worst global economic downturn since The Great Depression. The nexus between business and society has become clearer than ever, as has the fiduciary responsibility of private equity managers to help rebuild economies and serve as a force for good.

The private equity ownership model – with its ability to invest with a long-term horizon, free of the shorter-term pressures of public markets – is conducive to driving such change. These managers can steer portfolio companies’ operations, strategy and governance, and have an obligation to do the right thing.

According to research from PwC, ESG private market assets could hit between €775.7bn and €1.2tn by 2025, up from €253bn in 2020, with regulatory developments and client demand set to be key drivers.

Talk the walk: Tell your sustainability story

Today, pressures are coming from all corners – not just sustainability-conscious investors, but also from increased regulatory requirements and societal expectations. This means heightened risk not only for GPs that fail to implement an ESG agenda, but also for those that do but fail to communicate it effectively.

Having pushed the industry into a virtual world, the Covid pandemic has been an accelerant to improving authenticity and transparency in communications. The past couple of years have provided renewed impetus to all stakeholders to better articulate how they are elevating ESG standards. In what has traditionally been an opaque industry, GPs are learning to be more overt to promote their ESG mission in internal and external communications, disclosures and reports. To gain market share, engage employees and raise funds, they must keep an open and ongoing dialogue about how they are embedding ESG throughout the investment life cycle, from the due diligence phase to ESG assessment and monitoring at the fund and portfolio company level.

Future-proof: Manage risk and create value

As we transition to a cleaner, more sustainable economy, investments in UN SDG- or EU Taxonomy-aligned goals are increasingly viewed as a way of future proofing; to mitigate the physical risks companies will have in 20-30 years, while boosting resilience so investees are well positioned to weather adverse conditions.

Then there is the opportunity for value creation – the growing realisation that you don’t have to sacrifice returns to create positive impact. Rather, the balancing act of pursuing financial and social returns actually involves managing these two goals in symbiosis to achieve both above their predefined thresholds, with a no trade-offs approach.

Over half of the private equity respondents to PwC’s EU Private Markets: ESG Reboot survey said incorporating ESG into the investment cycle boosted exit multiples by 6% to 10%; and 32.1% found that exit multiples were more than 11% higher.

A regulatory burden turned opportunity

New rules such as the EU’s sustainable finance disclosure regulations (SFDR), which sets mandatory ESG disclosure obligations for asset managers and other financial markets participants, are spurring the institutionalisation of ESG risk management, with GPs adapting accordingly.

PwC’s research found that about a third of the respondents it surveyed cited regulatory developments as one of their primary drivers for revamping their investment processes with respect to ESG.

The Institutional Limited Partners Association’s (ILPA) new ESG Assessment Framework helps LPs evaluate and benchmark GP responses to due diligence efforts, inform goal-setting conversations with GPs and measure ESG integration progress over time.

Still, definitions of what counts as sustainable vary and there is no global standard for ESG classification, measurement or reporting. This is why clear internal ESG principles and methodology – supported by comprehensive messaging and PR – is fundamental to how a company is perceived both internally and externally. A recent BDO survey highlighted clear room for improvement, with a third of private equity firms yet to publish their own set of ESG principles.

Data opening doors

With a plethora of ESG questionnaires from LPs these days, GPs are getting better at recording their initiatives and results, from sourcing and selection to the exit stage. LPs’ increasing focus on specific themes is helping to drive the ESG agenda forward and accelerate GPs' KPI synergies and measurement capabilities.

Growing regulatory pressures to enhance ESG transparency will further drive global efforts to standardise ESG metrics and taxonomies. Meanwhile, the emergence and adoption of cutting-edge technologies, offering automation of data collection and exchange processes, will revolutionise how both LPs and GPs report non-financial metrics to key stakeholders.

With so much capital set to be funnelled into ESG investment opportunities and potentially affecting valuations, GPs need to be thorough in their due diligence for a better grasp of return potential.

It is up to fund managers to integrate themselves into the ESG discussions to learn best practices and help shape how private capital can be a force for good for all stakeholders – this is a matter of survival. Those that additionally invest in technology to streamline ESG- and sustainability- related data processes, better assess risks and convert data into actionable insights will be the ones that thrive.

For more exclusive insights from industry experts, be sure to join us at SuperReturn International >>

With thanks to BackBay Communications for their contribution to this article.