ESG Investing in Private Equity: Benefits and Challenges

Maximising returns while making a difference. It's an easy sell, but there are still challenges and risks involved in this relatively new specialism. This article makes the case for private equity firms to use or continue to operate ESG investing funds when buying portfolio companies.

What is ESG investing?

ESG investing is about who and what you invest in. Specialist ESG funds will use ESG (environmental, social and governance) factors to identify a company and either qualify or disqualify it as a potential investment.

The case for ESG investing is that making a difference and maximising a return don’t need to be at cross purposes. There is ample opportunity to find good commercial opportunities in sectors or domains where you are driving an environmental or social good.

According to an ILPA survey, 93% of limited partners would walk away from an investment opportunity if it posed an ESG concern. And so, ESG has become core to creating value. The perception of ESG has sometimes been that it is a box-ticking exercise for compliance. But more and more, it is seen as a value creation lever.

ESG investing vs impact investing

How is ESG investing different from other kinds of sustainable investing? Impact investing is often used interchangeably with ESG investing, but there is a key difference.

ESG investing: More financially focused, this uses ESG as criteria for evaluating the suitability of an investment, on the understanding that businesses with good ESG practices are better performing and more sustainable, i.e. they have lower risk and more opportunity.

Impact investing: This puts financial return on a par with, if not lower than, a company's social impact. The purpose of this investment is to make an impact, whereas ESG investing is acknowledging that companies with good ESG tend to make more money for longer.

Key ESG factors

So what are these environmental, social and governance criteria investors use to identify good investments?

Environmental factors include all activities that help conserve the natural world, including energy efficiency, limiting pollution and promoting biodiversity. Social factors can include anything that considers the impact on people both inside and outside of the business. For example, employee diversity and customer data protection.

Governance is about how the company is run, which is arguably the most important, as it enables or disables its ability to effectively meet its environmental and social responsibilities.

Leadership is a key consideration for ESG investors. It's where company culture, the vision and its execution begins. Having the right leadership in place directly impacts a company's performance and the sustainability of its financial return. Good leadership is good governance.

Key governance factors include:

• Board composition

• Audit committee structure

• Bribery and corruption

• Executive compensation

• Political contributions

The benefits of ESG investing

The benefits of ESG investing span from the personal to the financial. Knowing that you are investing in something that is making a positive difference to the world at the same time as maximising your returns can be quite a feeling.

Competitive advantage for private equity firms

In the UK alone there are more than 600 private equity houses, with an average 2-3 funds in each. This is a competitive market, and investors are constantly trying to specialise so they can be more effective at deploying their capital. 

The classic buyout model is slowly losing ground to these kinds of innovative and sophisticated funds. In 2020, buyout funds held 41% of global private equity assets; in 2010 it was 62%.

Aligning private equity investors' personal goals

Gone are the early days of private equity, when they had a reputation for asset stripping. Today it's all about adding value, whether financial, environmental or social. Private equity fund managers can make a difference by choosing who they invest in, and with ESG investing, it doesn't have to exclude making a decent return.

Growing demand from limited partners

Public pension pots make up a large proportion of the limited partnerships for private equity firms, and they come with strings. For example the Ontario Teachers Pension Plan, one of the largest retirement funds in the world at C$ 241.6 billion, demands that all of their private portfolio companies where they have board representation designate an employee director as an ESG liaison.

First of all they need to be confident that they are going to receive a sustainable return, and those businesses with good ESG are more likely to achieve that.

Secondly, demand for responsible investing is growing among pre-retirees, whose personal values come into play. American public pensions applied ESG factors to at least $3 trillion in assets in 2018.

Challenges in ESG investing

This is a fast paced and evolving market, that has only emerged in the last 4 years. ESG investing trends and themes emerge dynamically and organically. So it comes with its risks.

That ESG investing is being viewed more as a value creation tool is only for the good, but it is not yet as established as classic models. The systems and infrastructures that surround classic buyout models have not yet been fully translated to these specialised funds.

How do I know which investments are ESG?

Measuring ESG impact can be fuzzy. Investors can find it hard to evaluate the non-financial successes of their investments, and that can make it hard to make a case for ESG investing in the first place.

Some of this is due to the interpretation of what can be classed as an ESG investment. Identifying what is and what isn’t ESG investing is an art not a science. A business doesn’t always directly impact an E, an S or a G, but if you invest in a business that helps other businesses achieve their impact, you could still class that investment as ESG. For example, a consulting firm that improves the way companies select their leaders so they can improve governance and remain a sustainable business.

However, the point at which a business is just that bit too far removed from the end-impact is open to interpretation and fund managers need to make their cases for why their portfolio company should be considered good for the environment or society.

Greenwashing

The lack of standardisation leaves the concept of ESG open to abuse, and companies can use misleading marketing to label themselves as a good ESG investment. 

For example, an airline that pollutes less than other airlines, even though they are still a major polluter. Or a utility company that uses only renewable energy, but is mismanaged to the extent it has to be bailed out by the government.

With no standardisation, investors have to find their own ways of confirming a responsible investment. Ontario Teachers Pension Plan have developed their own ESG assessment tool based on criteria they choose themselves.

Events, dear boy, events

Other challenges are more topical. Global events can make non-ESG investments more appealing. Investors need to take note of ESG investing trends that impact the success of their portfolio companies or pre-deal potential investments. 

For example, even though the trend towards green energy is still strong – in 2022, global investments in renewables, energy and heat storage, and electric vehicles matched fossil fuel investments for the first time at $1.1 trillion – Russia’s invasion of Ukraine boosted the profitability of energy and defence companies that would not qualify as ESG investments.

On the other hand, the desire to diversify from Russian gas has had a large impact on the growth of green energy in Europe and the UK. In 2021, EU countries depended on Russia for 40% of their natural gas. This dropped dramatically to 17% the next year. And the European Commission are planning for renewables to make up 45% of their energy mix by 2030.

We would argue that this challenge is more relevant to public equities investors, who are focused on short-term market changes. Private equity and venture capital investors have a much more committed and long-term outlook, focused on the end result.

So while listed companies like Meta are forced by shareholders to abandon risky ventures when the share price goes down, private equity backed companies can move two steps forward and one step back without anyone pulling the plug.

Fund volatility

ESG funds are open to risk. A study by George Mason University’s Business School in 2021 found that the average volatility of ESG funds was 15.46% annually over the past 20 years, versus 15.04% for the S&P 500. But again, this is an issue for public equities. Private equity investors have a long-term mindset, and unlike venture capital funds, they are putting their money into established businesses with proven income and value creation opportunities.

Leadership: the G in ESG

At Leadership Dynamics, we know from experience that governance is the cornerstone of ESG. And you cannot have good governance without good leadership. Good governance is manifested by a company’s leadership and is measured by its ability to maintain organisational effectiveness.

So, in order to maximise the value that comes with good ESG, private equity companies need to make sure they have the right leadership teams in place in their portfolio companies. (For more about how leadership impacts ESG, read our article on why succession planning is good governance.)

How do you make sure you have the right leadership team? First, understand the optimal mix of skills, experience and behaviours that make a high-performing team. Both diversity of background and cognitive diversity is key here. This will make sure you have a team that complements each other’s strengths at the same time as avoiding group-think. Different perspectives allow leaders to challenge one another.

The second step is to identify the gaps in your current team, so you can finally plug those gaps by developing high-potential employees or hiring in the ideal candidates.

But the first step is becoming aware of what's required from a behavioural standpoint. While personality can tell you what a person is like, knowing their behaviours will tell you how they will act in a given situation. Individuals and their colleagues can take our free PACE test to get a detailed behavioural profile.