PE investors view ESG as ‘supportive activity towards value creation’

By James Williams

It is becoming increasingly clear that private equity investors are training their sights on how GPs think about ESG issues. The degree to which they engage on the topic, and their approach to influencing portfolio companies, is now firmly entrenched in manager selection and it is a trend that is not likely to reverse anytime soon. 

One of the pioneers in sustainable investing is LGT Capital Partners. It uses something known as the ESG Cockpit to track company KPIs within the public markets, across equities and fixed income, which informs the team’s security selection. This approach has led LGT to create synergies and use analytical insights gleaned from the public markets to build an ESG framework for rating managers in its private market portfolios. 

Last week, I spoke to Keimpe Keuning, Executive Director at LGT Capital Partners, on the extent to which GPs are embracing ESG and what LGT’s rating system has revealed thus far. 

To clarify, Keuning focuses on ESG and sustainable investing in private markets so it was no surprise to hear him speak effusively on the topic. 

“We see a continuous improvement on the PE manager side with regards to ESG integration,” he said. “On an annual basis we re-assess each underlying GP in the portfolio. We send them a questionnaire, which is broadly based on the PRI questionnaire, which we co-helped develop and we see a continuous improvement, year-on-year, as a group.” 

LGT uses four levels to evaluate its managers. The first is manager commitment - are they committed to ESG and do they have an ESG policy? 

Second is the investment process – what does the manager do in terms of ESG due diligence when buying companies? 

Third is during the ownership period – is the manager actively engaging with the management team to make changes to lower energy costs, reduce carbon footprint, improve employment conditions etc. 

And fourth, the reporting process – how does the manager summarise its ESG activities when reporting to LPs, and how often does it produce these reports? Is it discussed as a standing item during the Limited Partners Advisory Committee (LPAC)? 

“That gives us quite a good picture of what a manager is doing in respect to ESG and then we apply a rating system, from 1 to 4, where 1 is ‘excellent’, 2 is ‘good, 3 is ‘fair’ and 4 is ‘poor’. For managers who are rated 4, we encourage them to engage in ESG. If we find a manager not willing to engage over two to three years, we will consider terminating our cooperation,” explained Keuning.

There are inevitably going to be differences on the extent to which PE groups embrace ESG criteria in their investment strategies. 

Large-cap managers have the resources and organisational size to spend the requisite amount of time and money to do it right. But as highlighted in a recent investor survey1 LGT produced – which it is worth noting, found that 75 per cent of LPs integrate ESG into their investment decisions – size is not a barrier to ESG adoption, but rather that greater scale facilitates the institutional adoption of ESG.

As Keuning tells me, while 95 per cent of large-cap managers in LGT’s PE portfolio had a rating of 1 (‘excellent’) or 2 (‘good’), 62 per cent of mid-managers shared the same rating profile. 

Like LGT, another institutional investor which has, for several years now, actively incorporated ESG into its manager selection programme, is Stafford Capital Partners. 

Lucy Nicholls is Partner, Private Credit, at Stafford and like Keuning, she is seeing a clear rate of adoption among PE groups. 

“For us it is an integral part of the due diligence process,” explained Nicholls. “We do an operational and governance review where we spend a lot of time understanding our managers’ approach to ESG; not only have they got an ESG policy but how is it implemented and what areas does it cover?

“I wouldn’t necessarily say, however, that it would preclude us from investing if we felt a manager’s ESG policy or approach to it was not what we wanted, but we would discuss it with them and encourage them to implement a proper policy. We have a watch list for anyone that doesn’t do that.”

A huge section of Stafford Capital’s due diligence process relates to sustainability. 

Nicholls added that if there is a lack of interest from the manager in developing an ESG policy “it would be a problem for us, in terms of future commitments”. 

One area where PE groups are starting to adopt - or at least think about - best practices, relates to climate change, based on what large-cap companies are doing. As a result, this is starting to trickle down from public to private markets, with 65 per cent of investors in LGT’s survey citing climate change/carbon emissions as their number one environmental concern.

But the key question, in all of these ESG debates, comes back to performance. Ultimately, can ESG adoption deliver any meaningfully positive impact to a PE fund? 

I ask Keuning this, and how LGT thinks about low-rated managers delivering exceptional financial returns, relative to high-rated managers delivering average returns.

“Our first priority is financial returns but we do implement certain exclusion policies such as weapon manufacturers, and we now have a group-wide policy in place not to invest in thermal coal companies. Outside of the exclusion discussion, financial returns are the top priority, and then we look for positive ESG benefits from managers in our portfolio,” explained Keuning.

Some 84 per cent of LPs surveyed by LGT believe that integrating ESG has had either a positive or neutral effect on risk-adjusted returns. This assertion is stronger among investors who have applied ESG principals for longer: 62 per cent of those with seven years’ experience or more felt that ESG improved risk-adjusted returns, compared to 32 per cent who have 12 months’ experience, or less. 

Benefiting from the virtues of ESG appears to be a long-term play among investors. Logically, this same mindset ought to apply to GPs who are recent converts to the sustainability theme. 

“We’re not only doing this for the greater good,” said Nicholls. “There is always a commercial aspect to investing but we do see ESG as something that can add value on a long-term basis. We believe in it and we believe it is an important part of the business world.” 

Keuning is of the opinion that PE groups increasingly view ESG as a supportive activity towards value creation. “The next step is to specify ESG goals and use it as a stronger outcome-oriented tool towards this value creation. It needs to become even more tangible and measurable,” he suggested.

He concludes that LGT is reluctant at this stage to say that ESG considerations can lead to outperformance. “It depends on the type of strategy, vintage year comparisons, investment style comparisons, geographic comparisons. But overall, we think ESG can add value to a portfolio, first of all from a risk perspective and in addition by providing more insights into the underlying investments.”   

1: ESG to SDGs: the road ahead (a survey of investors in alternatives)

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