This article was written by Robert G. Eccles, Vinay Shandal, David Young, and Benedicte Montogomery and originally published in Harvard Business Review in the July – August 2022 magazine.
Despite their reputation in the 1980s as corporate raiders, most private-equity firms attempt to improve the performance of their portfolio companies through better corporate governance. Historically their business model has been to create value by sharpening the focus and oversight of largely ignored business units inside conglomerates or poorly managed private companies, such as dysfunctional family-run businesses. But although the G in “environmental, social, and governance” has been important in the PE industry from the outset, the E and the S have been virtually nonexistent. The industry has been content to seek returns with little concern for the long-term sustainability of portfolio companies or their wider impact on society.
A huge opportunity for private equity—and for society—now exists. PE has moved far beyond its Wall Street niche to become a major player in the global economy. In 2021 the industry had $6.3 trillion in assets under management (compared with about $90 trillion for public equities) and close to $2 trillion in “dry powder” (funds raised but not yet invested). Those assets are projected to exceed $11 trillion by 2026. Roughly 10,000 PE firms worldwide oversee more than 20 million employees at about 40,000 portfolio companies. Some of the largest PE firms—Apollo, Blackstone, Carlyle, EQT Partners, KKR, and TPG—are now publicly listed themselves and therefore subject to the same pressures that all public companies face.
Because the industry is now so large, society won’t be able to tackle climate change and other major challenges without the active participation of private-equity firms and their portfolio companies. And unless those challenges are addressed, the PE industry, along with all other economic activity, will fail to thrive.
To better understand ESG’s impact on PE and the opportunities and challenges facing the industry, we interviewed 100 people across the globe. They included industry experts and individuals from 22 limited partners (LPs)—the pension funds, insurance companies, sovereign wealth funds, endowments, and wealthy families and individuals whose money firms use to make investments—and from 39 general partners (GPs), which manage and invest money for LPs. (Disclosures: One of us, Robert, serves as the chair of KKR’s Sustainability Expert Advisory Council. Vinay, David, and Benedicte are consultants to the industry, including to several firms at which we conducted interviews for this article.)
We found that members of the industry have been slow to realize the importance of ESG for its future relevance, profitability, and even license to operate. The immediate challenges that PE faces are numerous and substantial: job losses at portfolio companies, the location of funds in tax havens, investments in private prisons and other controversial industries, the purchase of oil and gas assets from publicly listed companies (especially without a credible plan to improve their sustainability performance), donations to far-right organizations, and substantial payouts—sometimes hundreds of millions of dollars—for senior partners and other employees at a time when income inequality is a major societal challenge. But we also learned why the industry is well-placed to take the lead in sustainable investing—and how it can accelerate an adoption of ESG principles.
Why PE Now
Private equity’s business model gives it clear advantages over investors in public equities when it comes to implementing a sustainability agenda. A PE firm has virtual control of its portfolio companies from an ownership and governance perspective, even when it doesn’t own 100% of a company: It has one or more representatives on the board and a strong influence on who else serves. It has access to any information it wants about both financial and sustainability performance—whereas investors in public companies see only what the company reports. Finally, the firm determines executive compensation and can fire a CEO who is not delivering. “Our investment model—whereby we are often in control ownership positions and have a long-term perspective—and our expertise can help our portfolio companies advance their ESG journeys,” says Elizabeth Lewis, the deputy head of ESG at Blackstone.
PE-owned companies operate on a longer time horizon than publicly traded companies do, further facilitating a focus on ESG. The average holding period for portfolio companies has increased from about two years in the industry’s early days to about five today, which gives a GP and its handpicked CEOs ample time to make investments without the glare of quarterly earnings calls.
Of course, private-equity firms aren’t likely to integrate ESG into their management unless they feel it’s in the interest of long-term profitability—which is why they’ve largely ignored it until recently. But signs suggest that this mindset is quickly changing. Principles for Responsible Investment (PRI) reports that the number of PE and venture capital managers among signatories to the network has quadrupled over the past five years, for a total of 1,090 today. Nine of the top 10 GPs globally are now members of PRI. Of the world’s 100 largest PE firms, 70 are based in the United States. Twenty-eight of those are PRI signatories, and 13 have signed on in the past two years—evidence of how quickly the industry is evolving.
Three forces are pushing ESG in the industry. First, ESG is becoming more important to limited partners and their beneficiaries. The largest asset owners—among them pension and sovereign wealth funds—are increasingly concerned about the system-level effects of climate change and inequality. A recent survey of LPs by INSEAD’s Global Private Equity Initiative found that 90% of them factor ESG into their investment decisions and 77% use it as a criterion in selecting general partners. Many LPs are developing more-sophisticated approaches to evaluating the ESG capabilities of their GPs, and some are helping them improve their ESG capabilities.
For example, the Dutch pension investor APG has about $36 billion invested with 75 GPs across the globe. Starting in 2016, APG put processes in place to draw greater attention to sustainability from its GPs. Every year it scores each GP on a scale of 0 to 100 using a framework of 30 questions. No minimum score is required of a new GP, but all must report annually on what they are doing and show progress. Failure to do so will put future fund allocations at risk, however attractive a GP’s financial returns may be. APG also gets yearly reports on the key performance indicators for ESG issues that are material to each of the GP’s portfolio companies.
Another Dutch pension fund, PGGM, publishes an annual report on PE responsible investment. It uses a 1-to-5 scale to evaluate GPs. The fund won’t allocate capital to those getting a 1 rating but will do so for those getting a 2 if it has reason to think they’ll improve. Throughout the year PGGM monitors the approaches of its GPs and engages with them on ESG issues. The distribution of scores vividly illustrates how PGGM’s general partners have improved on ESG: In 2016, 13% were rated very low or low, and 16% were rated high. In 2020 those percentages were 3% and 37%, respectively.
The rise of coinvesting, whereby an LP makes a direct investment in a portfolio company alongside the GP, is increasing pressure on GPs to focus on ESG. Coinvesting gives the LP direct access to the ESG performance data of portfolio companies. The Institutional Limited Partners Association has published an ESG assessment framework to help LPs evaluate and build the capabilities of their GPs.
The second force pushing ESG in the industry derives from the belief of many LPs and GPs that it will be essential if private equity is to continue delivering its historically high returns. The work of Harvard Business School’s George Serafeim and others has shown that attention to ESG can lead to outperformance in public markets. LPs such as CalPERS, the largest U.S. pension fund, and Nuveen, a subsidiary of TIAA, believe that ESG is as relevant to private equity as it is to public equities. “ESG is important for all asset classes,” says Amy O’Brien, the global head of responsible investing at Nuveen. “ESG is agnostic to ownership structure.”
Despite their reputation in the 1980s as corporate raiders, most private-equity firms attempt to improve the performance of their portfolio companies through better corporate governance. Historically their business model has been to create value by sharpening the focus and oversight of largely ignored business units inside conglomerates or poorly managed private companies, such as dysfunctional family-run businesses. But although the G in “environmental, social, and governance” has been important in the PE industry from the outset, the E and the S have been virtually nonexistent. The industry has been content to seek returns with little concern for the long-term sustainability of portfolio companies or their wider impact on society.
A huge opportunity for private equity—and for society—now exists. PE has moved far beyond its Wall Street niche to become a major player in the global economy. In 2021 the industry had $6.3 trillion in assets under management (compared with about $90 trillion for public equities) and close to $2 trillion in “dry powder” (funds raised but not yet invested). Those assets are projected to exceed $11 trillion by 2026. Roughly 10,000 PE firms worldwide oversee more than 20 million employees at about 40,000 portfolio companies. Some of the largest PE firms—Apollo, Blackstone, Carlyle, EQT Partners, KKR, and TPG—are now publicly listed themselves and therefore subject to the same pressures that all public companies face.
Because the industry is now so large, society won’t be able to tackle climate change and other major challenges without the active participation of private-equity firms and their portfolio companies. And unless those challenges are addressed, the PE industry, along with all other economic activity, will fail to thrive.
To better understand ESG’s impact on PE and the opportunities and challenges facing the industry, we interviewed 100 people across the globe. They included industry experts and individuals from 22 limited partners (LPs)—the pension funds, insurance companies, sovereign wealth funds, endowments, and wealthy families and individuals whose money firms use to make investments—and from 39 general partners (GPs), which manage and invest money for LPs. (Disclosures: One of us, Robert, serves as the chair of KKR’s Sustainability Expert Advisory Council. Vinay, David, and Benedicte are consultants to the industry, including to several firms at which we conducted interviews for this article.)
We found that members of the industry have been slow to realize the importance of ESG for its future relevance, profitability, and even license to operate. The immediate challenges that PE faces are numerous and substantial: job losses at portfolio companies, the location of funds in tax havens, investments in private prisons and other controversial industries, the purchase of oil and gas assets from publicly listed companies (especially without a credible plan to improve their sustainability performance), donations to far-right organizations, and substantial payouts—sometimes hundreds of millions of dollars—for senior partners and other employees at a time when income inequality is a major societal challenge. But we also learned why the industry is well-placed to take the lead in sustainable investing—and how it can accelerate an adoption of ESG principles.
Why PE Now
Private equity’s business model gives it clear advantages over investors in public equities when it comes to implementing a sustainability agenda. A PE firm has virtual control of its portfolio companies from an ownership and governance perspective, even when it doesn’t own 100% of a company: It has one or more representatives on the board and a strong influence on who else serves. It has access to any information it wants about both financial and sustainability performance—whereas investors in public companies see only what the company reports. Finally, the firm determines executive compensation and can fire a CEO who is not delivering. “Our investment model—whereby we are often in control ownership positions and have a long-term perspective—and our expertise can help our portfolio companies advance their ESG journeys,” says Elizabeth Lewis, the deputy head of ESG at Blackstone.
PE-owned companies operate on a longer time horizon than publicly traded companies do, further facilitating a focus on ESG. The average holding period for portfolio companies has increased from about two years in the industry’s early days to about five today, which gives a GP and its handpicked CEOs ample time to make investments without the glare of quarterly earnings calls.
Of course, private-equity firms aren’t likely to integrate ESG into their management unless they feel it’s in the interest of long-term profitability—which is why they’ve largely ignored it until recently. But signs suggest that this mindset is quickly changing. Principles for Responsible Investment (PRI) reports that the number of PE and venture capital managers among signatories to the network has quadrupled over the past five years, for a total of 1,090 today. Nine of the top 10 GPs globally are now members of PRI. Of the world’s 100 largest PE firms, 70 are based in the United States. Twenty-eight of those are PRI signatories, and 13 have signed on in the past two years—evidence of how quickly the industry is evolving.
Three forces are pushing ESG in the industry. First, ESG is becoming more important to limited partners and their beneficiaries. The largest asset owners—among them pension and sovereign wealth funds—are increasingly concerned about the system-level effects of climate change and inequality. A recent survey of LPs by INSEAD’s Global Private Equity Initiative found that 90% of them factor ESG into their investment decisions and 77% use it as a criterion in selecting general partners. Many LPs are developing more-sophisticated approaches to evaluating the ESG capabilities of their GPs, and some are helping them improve their ESG capabilities.
For example, the Dutch pension investor APG has about $36 billion invested with 75 GPs across the globe. Starting in 2016, APG put processes in place to draw greater attention to sustainability from its GPs. Every year it scores each GP on a scale of 0 to 100 using a framework of 30 questions. No minimum score is required of a new GP, but all must report annually on what they are doing and show progress. Failure to do so will put future fund allocations at risk, however attractive a GP’s financial returns may be. APG also gets yearly reports on the key performance indicators for ESG issues that are material to each of the GP’s portfolio companies.
Another Dutch pension fund, PGGM, publishes an annual report on PE responsible investment. It uses a 1-to-5 scale to evaluate GPs. The fund won’t allocate capital to those getting a 1 rating but will do so for those getting a 2 if it has reason to think they’ll improve. Throughout the year PGGM monitors the approaches of its GPs and engages with them on ESG issues. The distribution of scores vividly illustrates how PGGM’s general partners have improved on ESG: In 2016, 13% were rated very low or low, and 16% were rated high. In 2020 those percentages were 3% and 37%, respectively.
The rise of coinvesting, whereby an LP makes a direct investment in a portfolio company alongside the GP, is increasing pressure on GPs to focus on ESG. Coinvesting gives the LP direct access to the ESG performance data of portfolio companies. The Institutional Limited Partners Association has published an ESG assessment framework to help LPs evaluate and build the capabilities of their GPs.
The second force pushing ESG in the industry derives from the belief of many LPs and GPs that it will be essential if private equity is to continue delivering its historically high returns. The work of Harvard Business School’s George Serafeim and others has shown that attention to ESG can lead to outperformance in public markets. LPs such as CalPERS, the largest U.S. pension fund, and Nuveen, a subsidiary of TIAA, believe that ESG is as relevant to private equity as it is to public equities. “ESG is important for all asset classes,” says Amy O’Brien, the global head of responsible investing at Nuveen. “ESG is agnostic to ownership structure.”
PE-owned companies operate on a longer time horizon than publicly traded companies do, giving them ample time to make investments without the glare of quarterly earnings calls.
The third force is portfolio companies’ increasing recognition of the importance of ESG issues. The reasons are unsurprising: a changing zeitgeist reflected in the preferences of employees and customers; growing awareness of the significance of climate change; social expectations regarding diversity, equity, and inclusion; pressure from large public companies to which the portfolio companies are suppliers; awareness of the sustainability focus in publicly listed companies; opportunities to boost their own value through sustainability; and increasing regulation.
The confluence of those three forces has had a powerful, albeit somewhat counterintuitive, effect. Many of the GP representatives we talked to, especially those who were sophisticated about ESG, said that a commitment to sustainability was a selling point and a differentiator in their negotiations with potential portfolio companies that are being targeted by multiple GPs.
What Distinguishes the Leaders in ESG?
Until recently, ESG in private equity was a box-ticking exercise at best. LPs would give GPs a form—called an ESG due-diligence questionnaire—to fill out when a new fund was being raised. The form was unique to each GP and often long, and it rarely had any effect on whether the LP invested in the fund. It was simply filed away, and everyone got on with the business of investing and making money.
This approach still exists among less-sophisticated GPs and LPs. But according to Giovanni Orsi, the head managing director of relationships and partnerships and private equity at the Canadian pension fund PSP Investments, “Five years ago there were clear leaders, with laggards significantly behind. Today the gap is narrowing.”
What are the leaders in ESG doing differently? They are becoming more sophisticated in three ways: (1) integrating ESG factors in due diligence, onboarding, holding periods, and exit strategies; (2) increasing transparency in the reporting of sustainability performance; and (3) assessing and improving the ESG capabilities of portfolio companies.
Integrating ESG.
Each target or portfolio company’s performance is assessed on the critical ESG issues that will affect value creation. That means moving from a short “risk and compliance” checklist in the due diligence phase (to screen out any obvious problems that could have financial consequences) to a sophisticated analysis of how well a portfolio company understands and is managing the ESG issues material to its business. That analysis is followed by collaboration with the company’s board (on which the GP always has a seat) and with management to improve its performance (often with substantial help from the GP).
Leading GPs are continually improving the integration of ESG considerations into portfolio-company management. For example, in addition to monitoring and managing ESG risks during the holding period, Apollo Global Management is experimenting with a post-exit analysis of investments to determine how ESG issues affected performance and how the firm might apply that knowledge to future investments. “We are developing a template to help us assess ESG performance over the lifetime of an investment, and we will continue to evolve our approach,” says Laurie Medley, Apollo’s global head of ESG.
Until recently the separation in PE between those making investment decisions, those overseeing an asset once the deal was done, and those responsible for sustainability was clear. At some firms it is becoming less pronounced as deal teams undertake training in ESG. For example, Investindustrial, a firm with $12 billion in assets under management, sends its deal teams and portfolio-company managers to a sustainability certification course at New York University. They are supported by in-house experts in environmental and social issues. Apollo, Ares Capital, Bain Capital, Carlyle, EQT, Generation Investment Management, IG4 Capital, Investindustrial, KKR, PAI Partners, TowerBrook, and Verdane all told us that they are creating a process to make deal teams more knowledgeable about ESG.
Increasing transparency.
With the growing recognition that ESG performance contributes to financial performance, GPs have become much more disciplined about gathering ESG data. They often collect a standard set of key performance indicators from their portfolio companies on an annual or even a quarterly basis. In some cases the number of KPIs ranges from 50 to 100. KPI reporting now almost always includes the ESG issues that are material to a company’s financial performance. (For example, water usage is more relevant to a food and beverage company than to a bank or a tech company.) Triton, with $15.6 billion in assets under management, has since 2014 had a reporting system based on “three Ps”: policy (what it is doing on the ESG front), program (its plan to implement the policy), and performance (how well the program is being implemented at the portfolio-company level). It uses various resources, including the Sustainability Accounting Standards Board, to identify material ESG issues when screening for investments and when managing them.
ransparency between GPs and their LPs is also increasing. Apollo has been reporting on ESG to LPs for 12 years, and in recent years its annual ESG report has been publicly available on its website—a practice some other GPs have now adopted. Some LPs are requesting ESG data, such as for carbon, at the portfolio-company level.
Improving ESG performance.
The private-equity business model puts general partners in a good position to help portfolio companies improve their ESG integration and reporting practices in a number of ways. These include identifying relevant issues and best practices for dealing with them, providing measurement and reporting tools, benchmarking against other portfolio companies, offering access to internal and external experts, and monitoring regulatory developments.
Some GPs have developed methodologies for assessing the degree of ESG sophistication in potential portfolio companies and helping them improve practice. Carlyle’s process for evaluating targets starts with risk (basic compliance on environmental, safety, and health issues), moves to value (captured from the company’s current business model and capabilities), and ends with growth (how to enter new areas). Its resources can enable portfolio companies to improve on sustainability faster than they could on their own.
Graeme Ardus, the head of ESG at Triton, told us that “deal teams and portfolio companies can see how each business is doing in comparison to the ‘Triton benchmark.’” The firm holds monthly calls to share good practices with its portfolio companies and hosts events where CEOs and other senior executives present what they are doing on ESG. Triton also has a formal annual ESG gathering at which companies can network with and learn from one another.
Read the original article here: https://hbr.org/2022/07/private-equity-should-take-the-lead-in-sustainability