ESG is a growing focus for the private markets, but which metrics matter most?
This is part 2 of a series on ESG investing. View part 1, "Top 3 ESG Trends in the Private Markets."
Environmental, social and governance (ESG) issues have become an important part of the decision-making process for 85% of limited partners (LPs) surveyed by Private Equity International (PEI).[1]
But the increased focus on ESG is not without challenges. While organizations such as the UN’s Principles for Responsible Investment (PRI) and the Institutional Limited Partners Association (ILPA) have developed ESG guidelines, there is no single standard
for general partners (GPs) to follow. In addition, limited partners (LPs) are finding it difficult to collect the data they need. According to a recent Morgan Stanley survey, 23% of investors identified the quality of ESG and sustainability data as their top
challenge.[2]
In our own surveys of private market participants, including multi-strategy groups, institutional advisors and fund of funds, we confirmed that while investors are prioritizing ESG, GPs and portfolio companies struggle to identify, collect and report relevant
data. Nevertheless, we found consistency among LPs on which ESG metrics are typically most relevant to due diligence and investment oversight processes.
The top 10 ESG metrics commonly sought by PE fund investors are:
- ESG Policy: The presence of a formal ESG policy provides a valuable starting point for conversations between investors and the management team of the portfolio companies or fund.
- Assignment of ESG Responsibility: The distribution of responsibility within the management team of a portfolio company or fund can indicate the level of ESG integration across the organization.
- Corporate Code of Ethics: The presence of a formal code of ethics indicates a foundational process to guide management and employees as they carry out organizational objectives.
- Presence of Litigation: Any litigation, specifically that related to environmental, social and ethical affairs, typically requires disclosure to investors to allow an assessment of the wider risk profile.
- People Diversity: Diversity among employees, board members and management promotes a wider range of perspectives in decision-making processes and organizational management.
- Net Employee Composition: Examining workforce management, including the ratios of part-time and contract workers, gives investors visibility into the way the management team allocates a key component of the organization’s budget.
- Environmental Policy: The presence of a formal environmental policy provides insights into a management team’s ability to monitor and address the environmental costs of the organization’s office or facility practices, product and service development
and delivery and post-use impacts.
- Estimation of CO2 Footprint: The ability to estimate the organization’s direct and indirect emissions, including those produced by the wider value chain, indicates management’s efforts to formalize their environmental policy through quantifiable
metrics that correlate with a leading environmental indicator.
- Data and Cybersecurity Incidents: Data management processes can put the organization at considerable risk. Management needs to demonstrate a track record of transparency in reporting all incidents and their potential legal impacts.
- Health and Safety Events: While management is responsible for providing products and services to customers, it is also responsible for providing safe working environments for employees, contractors and the wider value chain. This can be measured
through accident and incident rates.
Collecting and tracking these metrics during the investment lifecycle enables GPs to better manage risk, drive value and exhibit differentiation to LPs. While the process can be cumbersome without technology, platforms such as iLEVEL are bringing these and
other ESG metrics into an electronic framework, helping GPs to aggregate portfolio data and making it easier for LPs to benchmark ESG performance with dashboards and other reports.
[1] PEI Perspectives 2019 Special Report, December 2018
[2] Morgan Stanley, Sustainable Signals Asset Owners 2018 Survey, June 2018