ESG REPORT | Part I: Incentive Never Higher For ESG In Private Equity

April 19, 2018     |     Darien Group

ESG in the Modern Private Equity Landscape

The movement toward “responsible investing” has gained considerable traction among private equity firms over the past two decades. In years before that, questions of irresponsible investing implied decisions involving undue risk. Today, investments are labeled conscientious and responsible when they consider investors’ expectations for the protection of humanity and society. Although this principle may seem universally appealing, a large segment of U.S. investment managers have been slow to accept the idea that environmental, social, and corporate governance (“ESG”) matters can coexist peacefully with, or even provide further support to, profitability.

To firms that remain unconcerned with social and political issues, concerted efforts to integrate ESG into existing business practices may feel like a weak attempt to assimilate with competitors. Specifically, many firms struggle to see how ESG will positively impact the bottom line for them and their investors. Likewise, a 2017 survey by RBC Global Asset Management demonstrated that the leading two reasons institutional investors neglect ESG are that there is a lack of demand from board members, and that the value proposition of ESG is unclear.

The numbers, however, suggest that there is, in fact, a positive correlation at play. A meta-analysis published in the Journal of Sustainable Finance & Investment (Friede et al. 2015) reviewed over 2,000 studies and found that 90% show a positive association between ESG-conscious investing and corporate financial performance. More importantly, these benefits have proven to be sustainable in the long term.


Differing Philosophies

European firms are ahead of the curve in this respect, leading the U.S. 85% to 49% on investors who report contemplating ESG principles in day-to-day business decisions. Furthermore, U.S. and European private equity companies hold such differing opinions on yet another critical component of ESG: risk. Over 70% of European equity firms reportedly believe that ESG is a risk mitigator, whereas just under 30% of U.S. firms see it the same. Likewise, over 40% of U.S. firms believe that ESG has no value as a risk mitigator, whereas just under 20% of European companies maintain that perspective.


Europe Sets Stage For Global ESG Integration

Europe has remained at the forefront of ESG integration throughout the last decade, with multinational organizations within the continent changing the legal landscape of responsible business practices.

These mandates soon turned ESG practices into hallmarks of quality in business and indicators of smart investments for asset managers.

European firms give credence to ESG’s influence on financial returns. A team of quantitative analysts looked at the histories of a sample of European firms and found that those with a lackluster ESG framework are more likely to underperform. In another instance, a leading consultancy showed that 41% of a sample of 111 leading private equity firms have either demanded a devaluation or refused a deal because of undesirable corporate ESG performance. These findings all point to the evolving perception of ESG standards as symbols of sound business practices and risk mitigators.


Embracing Conscientious Investing

Responsible investment is a two way street for GPs and LPs. Private equity firms are quickly becoming well-acquainted with LP demands for increased ESG processes and reporting. Public pensions and select endowments are driving this charge, seeking transparency and governance throughout their portfolios. As public pension funds continue to ramp up their investments in the private sector, private equity firms can improve their chances of securing investment from ESG-conscious LPs by embracing ESG policies and procedures.

This concludes the first report in a four-part series on the significance of ESG in investment management. To view our work on ESG materials for clients, click here.

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