ESG in private markets: the next frontier?

February 1, 2021

Reading Time: 5 min

Consultants and service providers believe that the mainstreaming of ESG in public markets will naturally spill over into private equity and other alternatives. Not just yet.

ESG in public markets: entering mainstream

Environmental, Social and Governance (ESG) risk management and reporting have by now largely become the mainstream. Last week, a group of business leaders gathered around the World Economic Forum issued a statement committing to Stakeholder Capitalism Metrics. Sure, that’s another confusing buzzword thrown into the mix but it doesn’t take away from the impression that such meetings, and such news releases, seem to be appearing on a daily basis by now. There’s critical mass behind ESG.

The practicalities of ESG reporting remain confusing but consolidation might be on the horizon, in particular following the SASB-IIRC merger. Soon, most public companies will have some sort of an ESG strategy and more or less know how to put it into practice.

The Altruist League serves institutions which have been grappling with issues of social and environmental sustainability for years, and have by now developed holistic approaches in which the ESG is just one component.

A natural question is: with so much progress, are the private markets next up?

ESG in private equity: the consultant pitch

At the first glance, we might be already there. For example, two thirds of UK PE firms now take ESG into consideration when making investments, whatever that means.

Rating providers, consultants and international networks such as the UNPRI have a horse in the race and are stretching themselves to portray ESG penetration as the ultimate juggernaut. They push their agenda with a two-pronged strategy, aiming at inspiring excitement as well as the fear of missing out. Managers should get on board, they warn, before their performance begins to suffer or their access to capital becomes constrained.

To support this narrative, there is no shortage of whitepapers and walkthroughs. So far, SASB’s Integrating ESG Holistically In Private Equity: A Strategic Approach is probably the best. But even that document ignores the measurement problem and showcases paper-thin case studies; it treats the ESG as the panacea that will solve all the sustainability-related issues the portfolio businesses are facing. The argument for ESG in PE appears still in its infancy.

ESG and private equity: regulatory pressure on the LPs?

Private equity funds will begin using ESG consistently when 1) it becomes a bit clearer how to do that in practice, and can be proven that it generates above-average returns or 2) when their investors, the limited partners (LPs) compel them to do so. The latter factor is, I feel, the more relevant one.

PE LPs have historically persisted in allocating to this asset class while not minding the industry’s (deserved or not) reputation for profit-seeking above all else. It is hard to see some of these same investors developing a soft spot for sustainability at the speed of public-market ones. Again, analysts are racing to prove that this is indeed happening, using opinion polls that I find unreliable – it’s easier to tell people what they want to hear than to put your money where your mouth is.

Other investors in PE, however, might soon have regulatory requirement to care about ESG. Here I’m thinking in the first place about institutional investors such as pension funds, which only allocate a small portion of their portfolios into alternatives, for diversification purposes, but which jointly comprise a sizeable LP segment.

If this indeed becomes the route by means of which ESG enters private equity, then it risks being slow, watered down and symbolic because the problem of measurement along a highly complex portfolio will always loom large.

ESG in private markets: the League’s experience

League members from the private equity and venture capital industry care about sustainability metrics in a way not necessarily limited to ESG considerations. They predominantly (85% in our latest survey) do so because they see these issues as a source of risk if not handled. Climate change affects investments as does social unrest. But all of them agree that returning a profit on the fund remains by far the number one objective. To say anything else is disingenuous.

Recently, a fund manager told me: “Getting the returns used to be 100% of what mattered to my LPs. Now, after all the sustainability talk, it is 99%.” I think the quote summarizes nicely the inroads which ESG thinking has made on the private markets. Profit remains king. So let’s not succumb to all the hype just yet.