Environmental, social, and governance (ESG) factors are becoming more and more important in today’s society for both private equity firms as well as their investors. Recent norms are driving ESG policies away from simple compliance, and more towards a value-creating component able to enhance fund performance. In fact, research shows a growing appreciation among investors for non-financial factors and their impact on the long-term performance of firms and the overall well-being of society.
As investors increase their level of scrutiny on ESG compliance and reporting, business operations such as deal sourcing, due diligence, and ownership strategies will be heavily affected. As a consequence, it becomes increasingly crucial for the private equity market to recruit in-house ESG expertise, enabling them to monitor current strategies and identify new investment opportunities that stay in line with modern mandates.
Aside from making positive contributions to societal and environmental issues, successful integration of ESG considerations also provides additional benefits for the firm itself. The first advantage is the competitive edge gained by firms by simply having structured ESG policies in place, as investors attribute more weight to ESG factors than ever before. As a matter of fact, many investors will actually turn down a good investment opportunity if a lack of ESG compliance is present.
In addition, research highlights the effectiveness of ESG factors for a firm’s overall performance and risk management strategies. Due to the nature of rising ESG concerns, investments in non-ESG funds are now considered riskier investments in the eyes of Limited Partners (LP). Moreover, recent ESG funds are now outperforming traditional funds as sustainable investing becomes widely adopted in this generation.
Despite the positive effects that can be seen when incorporating ESG factors in your business model, there are certain challenges to be aware of. First, within the private equity industry, a clear way of measuring the impact of ESG related initiatives is yet to be identified. Because of this, an effective communication plan of ESG targets is necessary in order to track progress and allow fund managers to illustrate the initiatives taken to achieve these targets.
Also, it is crucial to know and understand the concept of greenwashing. An illegal and unethical practice used by many firms, as they convey false or misleading information about the sustainability of their operations, in an attempt to appeal to sustainability-conscious LPs. Ultimately, this leads to an increase in investor skepticism and is sometimes followed by greenwashing accusations, that could indefinitely harm the image and growth of a firm. Only once reporting standards and regulations are put in place, will we be able to get more transparency for ESG practices in the private equity market.
All in all, instead of seeing ESG compliance as an additional cost, it is time to take advantage of its value creation capabilities and risk mitigation opportunities, all while preparing your firm for inevitable compliance regulations in the near future.