While the world’s largest pension funds and financial services providers have been allocating capital toward tackling environmental, social, and governance (ESG) issues, private equity (PE) firms have largely lagged behind. However, ESG has gained more traction within the PE industry in recent years as it has become a core demand from limited partners (LPs) amid changing consumer patterns and the ascending class of socially responsible millennial investors. As a result, ESG considerations are being woven into contracts more frequently, and LPs can exert their leverage and “walk away” if their terms are not met. With dedicated and active management, ESG investing can help PE firms increase return rates and outperform the market.
Different ESG Strokes for Different Folks?
There are several ways to incorporate ESG considerations into contracts. For example, in June 2020, the Sweden-based private equity firm EQT AB announced an up to EUR 5 billion ESG-linked fund level bridge facility, which stipulates that portfolio companies will receive better financing terms as their ESG performance progresses and improves. This ESG-linked bridge facility is the first of its size in global fund financial markets to incentivize portfolio companies to improve their performance in terms of gender equality, renewable energy adoption, and sustainability governance policies. In Japan – the country with the fastest growth for sustainable investments and now the largest ESG center outside of Europe and the United States – an investor will typically take a different approach by including a stipulation that it can terminate a contract if a partner engages in practices that are against its ESG principles.
Investors in different regions often have different priorities for ESG investments and employ distinct strategies for influencing the behavior of portfolio companies. In Europe and the United States, social and environmental concerns may be paramount, while in Japan, corporate governance and diversity is at the top of the list. And while negative screening and ESG integration are the most widely adopted approaches in Europe and the United States, corporate engagement and shareholder action is the dominant ESG strategy in Japan.
While Japan currently leads the ESG drive in Asia, China has also experienced a sea change toward ESG due to the internationalization of its equity markets. With the United States, Europe, and the two major powers in Asia eyeing ESG, it is clear that no major market can ignore the demands of investors, governments, and consumers calling for focus on ESG in finance.
In order to efficiently unlock value from the growing ESG opportunities in Asia, it is critical for European and US-based investors to understand the non-financial ESG insights specific to each region that are often only discoverable through the local language. It is equally critical for Asia-based investors who want the support of foreign development finance institutions (DFIs) to understand the common pre-existing ESG practices in Europe and the United States. PE investors seeking to invest in Asian companies should adapt their ESG risk mitigation strategies to different countries’ practices and focus on employing their existing ESG guidelines as a first step rather than as a panacea in those jurisdictions.
ESG Investing Success: A Focus on Materiality
PE firms are jumping on board the ESG bandwagon as long-held concerns of trade-offs between maximized returns and ESG investing have been challenged. Over the years, compelling evidence has emerged showing that the return value of an investment can be enhanced by incorporating material ESG factors into the decision making process. ESG factors broadly include issues such as GHG emissions, fuel and water consumption, human rights and community relations, and business ethics and transparency. However, many investors and businesses make the mistake of casting their ESG net too wide instead of focusing only on the factors that affect their operations and performance in a financially material way. For example, a professional services company need not focus on improving its energy management as much as a manufacturing company should, and should instead prioritize ESG factors such as data security, client confidentiality, and employee engagement and welfare. One Harvard Business School study found that funds focused on material sustainability issues outperformed competitors significantly.
Shrewd investors go even further. An activist approach to management, coupled with a nuanced understanding of – and savvy participation in – the local business community, has paid off for some investors. The Carlyle Group’s investment in rebuilding the reputation of Guangdong Yashili Group (Yashili), one of China’s largest infant formula manufacturers, enabled the PE firm to generate 2.3x returns on its five-year investment. Carlyle first acquired a stake in Yashili in 2009, just one year after the company’s melamine milk scandal in China tainted public sentiment toward the industry. Carlyle worked with Yashili’s management to recruit experienced talent, led Yashili to switch from local raw ingredients to 100% imported raw milk powder, and established the first corporate food quality and safety advisory committee in the Chinese dairy industry to re-instill consumer confidence.
Partners Group and Quadriga Capital Eigenkapitalberatung made a significant return on investment with AHT Cooling Systems (AHT), which manufactures commercial cooling and freezing equipment for the food retail industry. AHT’s equipment is more energy efficient than its competitors’ products, which enables customers to lower their life-time operating costs. Partners Group supported AHT’s global expansion efforts and product innovation, which led to AHT’s revenues increasing by 50% during the PE firms’ investment period from 2007 to 2013. Partners Group exited AHT having achieved an internal rate of return of around 25%. Elsewhere, KKR released its ninth annual ESG impact and citizenship report in September 2019, stating that it expects to save USD 11 million annually by implementing energy and water efficiency projects in 11 of its portfolio companies.
Unlocking Local Advantage
As demand for ESG investing increases, PE firms often turn to the United Nations-supported Principles for Responsible Investment as a starting point on developing ESG policies. The 17 United Nations Sustainable Development Goals, including clean energy, water and sanitation, and gender equality, adopted by UN member states in 2015 have also become an increasingly important yardstick. However, those are not enough for investors who want to bring an ESG-conscious approach to their internal processes. Instead, in order to meaningfully tackle ESG issues, investors must be committed to being a long-term shareholder to make it possible and worthwhile to focus on ESG related issues.
To facilitate building robust ESG policies, BNP Paribas Securities Services’ ESG Global Survey 2019 surveyed 347 institutions including general partners and LPs. The survey lays out essential tools to help with identifying investments, executing ESG plans, and providing ongoing monitoring and reports on investments. The survey shows that there is a need to adopt technology to help aggregate and analyze ESG data for more accurate assessments of key performance indicators. There is also recognition among the industry of a need to invest in teams with ESG expertise.
Hiring ESG consultants who are well-versed in specific regions to assess local regulations, risks, and investment norms is one key component in achieving ESG goals. For example, qualitative information regarding ESG risks depends in large part on non-financial information that cannot be found on balance sheets or profit and loss statements, and instead is found through investigative research often in the local language. Some regions may not require companies to report their ESG risks in public disclosures, in which case on-the-ground reporting and surveillance may be the most effective methods to assess risks. These insights are particularly valuable given that ESG ratings – while a good starting point – often fail to provide the in-depth information about companies’ performance and internal environments that investors need to outperform the market.
ESG engagement is on the rise among PE firms, and those in Asia have shown an improvement in their quality of engagement. Firms that continue to view ESG as a “tick the box” exercise will be left behind.