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The three Levels of ESG Engagement in Private Equity

As ESG continues to become a key strategic priority for private equity firms, we look at the three levels of engagement ESG leaders are pursuing in this space.

Part 2 of a 3-part special series on ESG in private equity.

By Tom Eagar, Head of ESG Search at Sheffield Haworth 

In part two of our series on PE leaders in Private Equity, informed by a panel discussion we hosted with the AESC, we discuss what existing PE firms are currently doing with respect to ESG.

As ESG has become more of a priority for the private equity industry, there are three stages of development. This development can be tackled in parallel, but most firms tend to do them sequentially, in part, because each stage informs the next.

Level 1: Getting ESG reporting right

How do Portfolio Managers know what the impact of their portfolio is without the right data? This is clearly the first priority for the PE business, and the regulator understands this too. With increasingly onerous reporting requirement deadlines coming every year, as well as client demand for better understanding of how their investments are performing on a non-financial basis, getting the reporting right is extremely important. According to Alison Collins, Head of ESG at Pollen Street Capital, about 35% of the time she spends on ESG is specifically focused on investor reporting, “because everybody cares about this now. ESG is going to be part of the reporting suite and the annual report, covering both financial and non-financial metrics”.

Nor is it a simple operation. “We collect 50 data points or so when thinking about ESG. The S, that’s largely thinking about diversity and inclusion, health and safety, employee engagement, charity and community, and from a G perspective, it is looking at policy coverage and board composition.”

This is a big challenge for ESG leaders, as working with a diverse set of corporates to report on brand-new metrics is not easy. They must have the relevant stakeholder management skills to work with the portfolio companies to get the right information flow and reporting.

Level 2: Working with portfolio companies to improve their externalities

Armed with this data and measurable metrics, PE firms can then work with the portfolio companies to improve the externalities over the course of ownership.

“With the data we collect, we can help them understand different potential business strategies, help guide them into what path they need to take – whether they need to recruit a head of ESG or hire a consultant to help them with certain aspects of their ESG agenda, or simply to remind them they can use us as a resource,” Alison says.

ESG leaders can guide their portfolio companies by:

  • Sharing ESG best practice
  • Introducing them to other portfolio companies who are doing well on ESG and can offer advice on ESG-compliant vendors and suppliers

“It’s helping them understand they’re part of a broader network and ecosystem and they don’t necessarily need to invest a huge amount of time and resource.”

Level 3: Incorporating ESG into portfolio investment strategy

Finally, the ESG leader has to work with the PE investors themselves to incorporate ESG and impact/sustainability considerations into the investment decision making process. While this was previously a relatively niche consideration with specialist impact firms leading in this regard, we expect this to become a staple of all PE investing in the future, mirroring the path public markets investors have taken.

In part one we already established how critical ESG factors are going to transform entire industries. The transition will affect all investments and while that poses a risk for many investments, it’s also a clear opportunity for many more.

Through our experience of hiring public markets ESG leaders, persuading investors to genuinely integrate ESG and impact factors into their investment process is the hardest and the most part important of the role.

Investment firms are built on their investment track record and process, and having someone, often a non-investor, change how they run their money is incredibly difficult. Over and over again we have seen highly qualified ESG leaders in public markets asset management companies fall at this hurdle, whether it is because of cultural reasons or just an inability to shift the mindset of the fund manager.

What can the ESG PE leader learn from this? If they are entering a business in this role, they must interrogate the firm’s fundamental understanding of what ESG & sustainability means for their commercial activities and make sure they are aligned to them. They must also understand what the cultural and political levers are within the organisation to enact change in this direction, and whether they feel they are appropriate for the scope in question.

We have heard over and over from experienced leaders that this part of the role is as much about the art of compromise as much else. While in many instances the fiduciary and sustainability responsibilities align, the ESG leader much be vigiliant in making sure they absolutely do so, in an empirically demonstrable way.