ADVEQ Applied Research Series: ESG moving out of the Compliance Room and into the Heart of the Investment Process

Executive Summary:

Environmental, social, and governance (ESG) concerns are increasingly being factored into the valuation and management of financial assets. Issues such as climate change, sustainability, consumer protection, social responsibility and employee engagement are no longer viewed solely as components of risk management, but have also gained recognition in recent years as important drivers of firm value, particularly in the long term.

We present results from one of the first comprehensive surveys covering the role of ESG in the investment practices of the private equity industry. This is the first phase of a deeper academic investigation of the topic. Based on responses from 42 private equity firms, representing a broad geographic and sector focus and a cumulative total of over US$640 billion in assets under management, the findings indicate that ESG policy – far from being a peripheral consideration – emerges as a core value-creation strategy at private equity funds for portfolio companies.

We find that this trend appears to be led by LP demand, and that the integration of ESG permeates down from the highest board levels, throughout the organization and all the way through to the individual private equity fund level, with core investment professionals often tasked with ESG policy implementation. Moreover, ESG policy appears to be rather sophisticated in that consideration of such issues takes place at the origination stage as well as during the period of asset ownership, although adherence to ESG policies is not uniform and is often implemented through guidelines rather than investment rules. We also find that ESG policies encompass not only environmental, social, and governance matters but also ethical issues, with companies actively monitoring their activities, gathering data and reporting along these dimensions.

In our sample, the emphasis on ESG policy as a core private equity value creation strategy is particularly prominent in the largest of the private equity funds (i.e., AUM >US$10 billion), where investor pressure is reported to be most acute. However, despite this focus, some barriers are reported in quantifying and monitoring the implementation of ESG policy. Importantly, we also discover fascinating heterogeneity across firms, in terms of how ESG policies are implemented and the processes by which ESG is integrated in decision-making. We speculate that such heterogeneity will likely have important implications for the variation in capability across private equity firms to generate value through ESG.