Environmental, social and governance (ESG) factors have moved from the investment fringes to a priority topic. More recently, ESG has become vitally important to investors and fund managers in private markets.
In 2018, IHS Markit explored the impact of ESG across private market investments and fund types, including multi-strategy groups, institutional advisers and fund of funds.
By conducting interviews, meetings and roundtables with global investors and international organisations such as the United Nations-backed Principles for Responsible Investing (PRI), we assessed how private market participants view the challenges and opportunities in ESG.
The LP Footprint Project found that 63% of limited partners (LPs) researched have public ESG policies, 59% have self-selected to be signatories with PRI and 40% publicly publish annual ESG reports, with the number rapidly growing.
A recent report by Private Equity International, based on a global study of 101 institutional investors, corroborates the IHS Markit research. It found that ESG is a consideration for 85% of LPs throughout due diligence on private equity funds, but only 19% agreed that general partner (GP) investments strongly reflect their ESG policies.
IHS Markit research found a growing number of GPs are beginning to close that gap by choosing to track and report ESG metrics on their portfolio companies’ operations. At the IHS Markit 2018 client conference in London, 67% of attendees confirmed that they collect ESG data.
ESG reporting is seen as a way for firms to differentiate themselves from other GPs with similar investment theses pre-investment and to increase transparency to investors post-investment.
Of the 2018 London conference attendees, 28% reported the drive to collect ESG data was a responsible investor initiative, 10% in preparation for a fund raise and 57% for both, paired with existing investor requests.
As a result, portfolio companies face increasingly requests from GPs to provide ESG metrics during the due diligence process and throughout the investment period.
Through roundtable discussions in 2018 with 17 private market firms, IHS Markit confirmed that LPs and GPs, alike, derive three major benefits from ESG reporting, in risk management, value creation and differentiation.
As materiality concerns go beyond financial data, ESG metrics enable a more in-depth assessment of risk. Assessing ESG factors during due diligence flags potential risks to monitor throughout the investment period.
The practice of ESG reporting can be an indicator of strong corporate oversight, controls and a commitment to transparency, which combined with assessment of ESG metrics themselves have been correlated in many studies with potential for excess return.
As LPs prioritise ESG, GPs tracking and reporting on portfolio company ESG metrics can produce reports to demonstrate to investors their commitment to driving better financial performance as well as supporting social or environmental improvement benchmarks.
Here again, other research corroborates IHS Markit findings. A Morgan Stanley survey of 118 large institutions showed that 78% of investors identified risk management as an important application for ESG data and 77% of investors identified return potential as an important factor in ESG-driven investing.
In recent years, the private markets have made great strides in improving transparency and reporting capabilities, but more is needed to support ESG objectives for investors and investment managers alike. IHS Markit research shows that new tools and guidelines are two areas where leadership is most required:
Guidelines on ESG metrics will help LPs and GPs determine the data that needs to be requested and reported on throughout the investment lifecycle. GPs and LPs reported there are multiple consortiums and organisations aspiring to outline standard processes and metrics. Nevertheless, no set reporting standard for portfolio companies has come to the forefront globally for private capital markets.
Tools for collecting and analysing ESG data are needed to help GPs be efficient in collecting and integrating these additional data into their existing portfolio monitoring and reporting processes.
Interest in ESG continues to grow in the private markets and IHS Markit research indicates that all market participants, including LPs, GPs and portfolio companies, are looking for more direction and support that enables them to integrate ESG metrics into their existing workflows.
– Sarah Broderick is associate director of iLEVEL, a division of IHS Markit