Tipping point for ESG?
Over 16 months, a trust-building initiative between major private equity limited partners (LPs), private equity associations, and general partners (GPs) has delivered a ground-breaking environmental, social and governance (ESG) disclosure framework that could provide the transparency that LPs say they want. The framework shows that asset owners care about extra-financial risks and opportunities and can send aligned signals. Could this exciting guideline be a tipping point? Five challenges will define its success.
Will GPs adopt a compliance approach to corporate, social responsibility (CSR) policies and reports? This could backfire by increasing internal cynicism and making GPs more
vulnerable should blow-ups happen. LPs can help by formulating forward-looking and outcome-focused questions about impact, performance and learning. What is a GP’s net job creation? How much more eco-efficient are private equity portfolio companies than their listed peers?
The framework suggests very good questions to gauge the depth of GP ESG management on due diligence and disclosure. But when LPs engage with GPs, chances are they will get quite diverse reports. Given the limited capacity of LPs to process these reports, what will they do?
LPs should work with leading GPs and specialists to create benchmarks to track likely wealth and risk creation. Avoiding box-ticking has – quite rightly – been a concern of committed players like Pantheon’s Helen Steers, who warns that “a standardised report might run the risk of dumbing down the issue, and letting certain people off the hook”.
But the other extreme – no benchmarks – will also undermine progress. The framework understandably does not resolve whether its use will result in consistent reporting of material ESG performance, or if benchmarking is completely impossible. This cannot be addressed theoretically. Smaller, focused groups of industry leaders in ESG could, however, feed their know-how into the ILPA’s Private Markets Benchmark.
Thirdly, while environmental efficiency has received most of the attention from GPs, less attention has gone on ‘organisational capital’ (structural, human and customer-relationship capital) and the governance of sustainable wealth creation. Private equity is not any worse in this regard than public – rather, it has greater competitive advantage given that GPs are on the boards and have insider access to sensitive information such as employee engagement. Dealing with this would also address a key concern of LPs, namely the sustainability of cash flows of the post-exit company – for example, by ensuring retention of key staff.
The framework says nothing about two crucial controls: mandates and normal reporting. As with listed securities, integrating ESG into mandates is critical (see, for example, ICGN’s Model Mandate initiative, also led by Hermes). Equally important is integrated reporting by investees and GPs, not bolted-on ESG disclosure. The International Integrated Reporting Council could help.
Missing from this framework are significant alignment of interest issues (benefit/risk sharing, fee design). These challenges seem impossible to deal with today but will be addressed down the road.
Finally, emerging ESG markets – including the US – are not well represented among this otherwise impressive list of signatories. Diversifying the support base outside Europe will be essential.
To conclude, let’s use a sporting metaphor. In the past, the PE industry has focused on stars – deal team, executives, companies. However, an insightful article by Will Hutton in The Observer last August argued that what Team GB showed in the 2012 Olympics is that there is another way to be successful: helping the whole team to be more competitive through an enriched ecosystem. Can this framework be the catalyst for ESG-friendly PE players to make this change?
Raj Thamotheram is an independent strategic adviser, co-founder of PreventableSurprises.com and president of the Network for Sustainable Financial Markets and Guiv-Roger Morin is an ESG/private equity analyst