How can private equity firms avoid suspicions of greenwashing as the industry embraces ESG?

Key points 

  • ESG has become more mainstream in private equity over the past three years
  • Many private equity firms create their own ESG scorecards for companies in which they invest
  • Greenwashing is a danger when firms develop their own ESG methodologies
  • What really matters is measuring the true impact companies are having on the world

There is no doubt that the ideas behind ESG have become mainstream in the world of private equity. What the implications are though, and differentiating ‘greenwashing’ from truly positive impact investing, remain challenges for both investors and general partners (GPs). 

The recognition of ESG as an integral component of investment has only taken off in the past three years. This has been true even for firms such as Actis, which spun out of CDC, the UK’s development finance institution, and was therefore steeped in the philosophy of creating positive impacts in societies through private sector investment. Until recently, the focus of development finance institutions (the original impact investors) was purely on the creation and the quality of jobs, says Shami Nissan, head of responsible investment at Actis. 

SDGs provides trigger
What has been transformative was the widespread adoption of the UN’s Sustainable Development Goals (SDGs) in 2016. The system was electrified when large private equity GPs who previously had no ESG involvement, raised large funds focused on impact such as the Rise Fund, launched by TPG, with Apollo, Bain, Blackstone and KKR following suit, says Nissan. This has caused a expolsion of limited partners (LPs) asking questions around ESG and impact to their GPs.

The change in PE firms’ attitudes towards ESG, says Sophie Béric, sustainability and impact manager at Idinvest Partners, can be seen in several ways. PE firms are increasingly required to disclose their non-financial impacts alongside reporting on financial performance. “In some countries, it is even mandatory by law to report on specific issues,” she says. “In France, for example, article 173 of the law on energy transition requires financial institutions to assess and report on climate risk.” GPs are also taking a more active approach towards improving the ESG credentials of their investee companies. In addition, there is a trend towards themes such as cleantech. GPs have also started collaborating on several ESG-related initiatives such as gender equality.  

Alex Scott, a partner at Pantheon, leads the firm’s ESG initiatives. He sees an impact spectrum starting with traditional approaches with no concept of impact at one end. It then moves to the idea of ‘responsible investment’ which excludes sectors such as tobacco, gambling and weapon manufacturerss. It is followed by sustainable investing which focuses on investing in firms with good ESG credentials. Next is impact investing where investors are prepared to accept disproportionate risks in favour of the resulting positive impacts. The end of the spectrum is pure philanthropy, where investors are prepared to accept full loss of capital in pursuit of a social good.

Scoring in private
The problem for any PE firm is how they measure and monitor ESG when their investments are in private companies that ESG rating companies do not cover. The solution for many is to create their own ESG scorecards. HarbourVest Partners, for example, a multi-manager private equity investor, uses an ESG score card for 240 fund managers that it follows, says managing director Peter Wilson. This enables it to build a comprehensive database and to work with GPs to improve their individual scores. 

Shami Nissan

Idinvest has also developed a scoring system based on six pillars: governance and management, business ethics; diversity; health and security; environment; and community and society. This information is collected annually and used to help their investee companies identify areas of improvement. Actis similarly has created its own ESG scoring system, which has become part of their mandatory reporting system. “The impetus has come from our LPs. We did not want to develop our own system, but there was nothing out there for us that was able to show our LPs clarity of purpose, and confidence that we are producing positive impacts on the environment and society,” says Nissan.

The problem with ESG scoring systems is that they are notorious for their lack of consistency. This can be seen in the listed marketplace, where ESG ratings for listed companies produced by different rating agencies appear to have zero correlation with each other. With private equity investments, problems may not even be apparent since the only score being produced is by the GP that holds the investment. The problem with this, as Béric points out, is that any score results from a specific methodology which can be influenced by normative convictions. “Is fighting against hunger worth more or less than gender equality?”

Threat of the greenwash
The danger for LPs focused on ensuring their GPs have taken ESG into account is ‘greenwashing’. If each firm creates its own ESG methodology, there will be a temptation to emphasise the ‘greenness’ irrespective of reality. 

Béric says such ‘SDG–washing’ can occur in three ways. First, some firms may only push forward the positive contributions a company brings such as electric mobility, while leaving in the shadows the negative impacts such as raw materials extraction, disposing of batteries or how the company runs its business (decent working conditions for example); secondly, firms may focus on one positive aspect, when it only represents a small part (for example, an eco-designed product that only represents 1% of overall revenue, the rest being conventional); and finally, some firms may claim that their impact is neutral since the positive offsets the negative (for example, medicine production). This is misleading since both positive (healthcare) and negative (pollution) impacts have actually happened and should be equally accounted for. 

What really matters is not putting subjective ESG scores onto investments, but objectively measuring the impact companies make. But as Nissan argues, the majority of private equity GPs are still figuring out what ESG means. There are several managers of impact funds of sizeable scale who have highlighted their strategic impact themes but have not shared how they measure impact either based on forecasts or actual results while others have made their measurement approaches open source. But, few PE firms that have a sophisticated impact measurement story let alone a measurement system. “We are still at the embryonic stage as an industry,” says Nissan. 

Actis is grappling with impact assessments. Issues being examined include what are the key impacts a company delivers to the world? What is Actis going to do during ownership to increase that impact? What are the key impact metrics that are going to be tracked to ensure delivery according to or ahead of the plan? “Actis measures the impact on day one of an investment and can then calculate the “impact multiple” as time progresses so it answers the question: ‘how did you increase impact during your time at the helm?’” says Nissan.

Idinvest has also developed a proprietary SDG impact measurement tool, to assess both potential positive and negative impacts of activities. “Our objective here is to engage the investee to understand where they can focus their action to improve on sustainability. If ESG scoring is only a means of turning qualitative data into figures, it is not very useful. What matters is outcomes: to what extent does the money the PE firm invests actually make a positive contribution to society or not,” says Béric. 

Determining objective assessments of impact is clearly the way forward for private equity firms purporting to have an ESG focus to their investments. But, as Nissan says, “If LPs are demanding that we produce detailed impact studies, someone has to be able to produce that.” Given the tidal wave of interest coming this way it is unlikely to be long before that gap will be filled.