ESG in Private Equity: What’s the End Game?

ESG is to Responsibility, as Impact is to Strategy.

The upheavals of recent months — from the COVID-19 pandemic and Black Lives Matters protests, to the current wildfires out West — have put a renewed and intensive spotlight on corporate citizenship and responsibility for environmental, social and governance (ESG) action. Certainly, the need for ESG, and the related topic of impact investing, have been much discussed — but exactly what these terms mean and their role in private capital markets remain less well-defined for limited partners (LPs) and general partners (GPs). In particular, investors new to the world of ESG may feel besieged by all of the differing views they have to sift through, when what they’re searching for is a clear understanding of why they should care and how to take action.

When it comes to managing ESG signals in the world of private capital, most media coverage centers on a vague call to action while highlighting fund managers’ slow adoption and the barriers they face. Many of the articles out there do little to educate fund managers about fiduciary duty in the 21st century, or offer up strategies for how to institutionalize and capitalize on the benefits of a robust ESG program — regardless of whether your investment mandate targets market rate returns, or market rate returns +positive impact.

Energy Impact Partners (EIP) is at the vanguard of ESG program development and adoption, and its intersection with impact investing. We believe these topics warrant a deeper dive than a single blog entry, so we have parsed them into a four-part series intended to:

• Cut through the noise surrounding the role of ESG in private capital markets versus investment strategies focused on impact returns.
• Offer up some straight talk to fund managers and LPs who, like EIP at the start of our journey, are seeking education, instruction and best practices on ESG program adoption and integration.
• For impact investors, identify appropriate methods and metrics for environmental and social impact measurement and reporting.

Part 1 (below) explains what ESG means to the broader investment community and why ESG program adoption is not only critical to all modern analyses of investment risk and opportunity but has become a core responsibility for all fiduciaries.

Part 2 will address the unique value drivers and process efficiencies for launching internal and external ESG and impact initiatives. The key here is to re-envision traditional relationships between GPs and LPs as a collaborative forum for ESG policy development, investment due diligence, portfolio monitoring and impact measurement and reporting.

Part 3 will cover relevant policy frameworks, including the United Nations Principles for Responsible Investment (UN PRI) and guides for investment mapping to the Sustainable Development Goals (SDGs), which each can serve as scaffolding for performing ESG due diligence.

Part 4 will discuss best practices and strategies for impact measurement and reporting.

So onward with our first entry!

Part 1 — ESG is to Responsibility as Impact is to Strategy

Whether used as a noun, verb or adjective, ESG — environmental, social, and governance — represents evaluation factors that live outside the realm of legacy, traditional investment analysis. While no single process has been developed for how ESG themes and metrics should be integrated into modern investment analysis, the fact that they are essential criteria is no longer up for debate.

In our rising and fast-changing world, investors and their stakeholders understand that following sound ESG practices and management procedures provide vital risk and opportunity signals for what is simply responsible investing in the 21st century; not sustainable, not impact — just responsible.

I often like to think of ESG as a kind of chess game. The more you play and the better you understand strategies of risk and reward, the better equipped you are to protect your valuable pieces, while advancing on strategies for upside positioning. Conducting a legacy investment analysis that ignores ESG as a critical identifier of risk and opportunity is a bit like forgetting to think two steps ahead of your opponent. You could find yourself caught completely off guard when the inequality rook or the climate change bishop cuts across the board putting you in check. Of course, then your hand is forced to counter with a move that is reactive, rather than proactive, making it progressively harder to get back to an upside position, and before you know it — checkmate.

Consider a timely example: While many describe the economic, social and financial catastrophes stemming from the COVID-19 pandemic as a black swan event, some investors, researchers and politicians have been talking about pandemic risk for at least 15 years. Yet, governments continued to underfund research and development of vaccines and neglected to set in place comprehensive disaster recovery or emergency response plans, both decisions (or lack thereof) posing unfathomable material risks to society.

At the beginning of April, barely two months into the global pandemic, more than 3.9 billion people –over half of humanity — were confined to their homes; economies were shut down as business closures skyrocketed, and millions were, and still are, unemployed. At present, the Wall Street Journal reports that U.S. national debt is set to exceed the size of the economy next year for the first time since World War II.

We had so many warnings: Repeated close calls with bird flu, swine flu, SARS (severe acute respiratory syndrome) and MERS (Middle East respiratory syndrome) were seen largely as false alarms and pandemic risk, to the scale of threat we know today, was not perceived as imminent. This oversight sadly grew into a fast-spreading death sentence for millions, like a chess move where Black has a clear series of steps to force White first into check, and then check mate, but White neglects to make a move for downside protection.

While earned at a high social, economic and personal cost, the pandemic’s silver lining is that we have an opportunity to build back better. To me, this potential future is rooted in an enlightened, universal understanding of how the world works and cooperates with all living creatures and resources systems in it, coupled with an unwavering and all-encompassing appreciation of the risks and opportunities faced by governments, businesses, investors and citizens.

ESG — it’s not one size fits all

The evaluation of ESG risks and opportunities extends beyond the normal financial analysis investors have historically performed during due diligence screening. As alluded to above, ESG signals can result in very real, financially material, positive or negative outcomes that affect long-term value creation and risk-adjusted performance in an investment portfolio.

ESG integration and program development are often misinterpreted as undertakings that require organizations to adopt a set of one-size-fits-all principles and policies that must be implemented in a set order, effective immediately, and publicized for the world to see. First-time ESG adopters often fear that taking action prior to having a fully fleshed-out execution plan could expose them to shareholder scrutiny and greenwashing claims. Others see the media using the phrases “ESG,” “sustainable” and “impact” interchangeably, which adds to their confusion as to whether or not ESG is even a topic of relevance.

The reality is that implementing the high-quality, transparent, comprehensive, and accurate processes and procedures required for best-in-class ESG integration is a significant undertaking. It takes time — and the planning, staffing, enterprise-wide buy-in and go-to-market strategy all must be flexible to constantly change and adapt to emerging definitions of risk, opportunity, and materiality.

ESG should be thought of as a living, continually evolving governance platform, underpinned by a set of principles, procedures and policies, some standardized and others individualized, based on specific asset classes, geographies, target sectors and impact strategies. These principles are intended to serve as a framework for fiduciaries to ensure business is conducted in a responsible, accountable, and mindful manner, considering the full spectrum of existing, emerging and future material risks and opportunities related to ESG themes.

Impact, on the other hand, is not a responsibility shared by all investors. It is an elected investment strategy, largely focused on capturing opportunities related to environmental and social themes, through which investors seek double or sometimes triple mandates in capital allocation by targeting both positive impact and competitive financial returns.

A common misconception has emerged over the past five years with regards to impact investing, which is that these strategies implicitly accept concessionary returns in exchange for positive environmental or social outcomes. While this notion is certainly appropriate, and often expected, in philanthropic investing, today, concessionary return strategies among impact investors have become the exception, not the rule.

EIP is a great example of an investor seeking to maximize profitability and deliver risk-adjusted returns, while also being staunchly committed to ESG integration in due diligence, monitoring, and portfolio benchmarking in our exercise of ownership. Finally, as an impact investor, we have the added responsibility to report on both ESG performance, as well as the quantified, positive environmental outcomes enabled by our portfolio companies.

As traditional GP-LP environments tackle what’s next with ESG programs, our next blog entry will address how fund managers and limited partners can discover unique value drivers and process efficiencies in launching internal and external ESG/Impact initiatives. This can be accomplished by re-envisioning traditional GP/LP relationships as a collaborative platform for ESG policy development, investment due diligence, portfolio monitoring, and impact measurement and reporting.

What’s your next move?

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If you would like to contact Energy Impact Partners please email Bethany Gorham directly at gorham@energyimpactpartners.com.