ESG and sustainability has been rising up the agenda for almost a decade and it is about to become a necessary consideration for PE firms. According to Cambridge Associates’ recent survey, there has been an approximate 150 per cent increase in institutional sustainable investments in the last four years, and it is likely that this figure will rise in the years to come.

As ESG becomes more and more commonly placed within private equity, why is it so important?

HarbourVest’s managing director Carolina Espinal highlights that her firm uses evidence of ESG as a contributing factor to manager assessments. “We see solid ESG practices as a proxy for fund excellence - it’s typically an indicator of how managers think about risk and opportunity more holistically, and of how they stay competitive,” she says.

Joana Castro, principle and head of primary fund investing at Unigestion, agrees with Espinal, claiming that ESG will be “critical for future growth” and navigating PE in the next few years. “PE firms should take this opportunity to fully integrate ESG considerations into their investment strategy as this is very likely to be critical for future growth in the years to come,” Castro says.

LEGAL FRAMEWORK

With that in mind, the Sustainable Financial Disclosure Regulation (SFDR), will have a large impact on how managers consider and report ESG. Set out by the European Commission, the regulation came into effect on 10 March this year. As part of the EU Commission’s Sustainable Finance Action Plan, the framework essentially aims to streamline how financial markets define, market and report on how their investments and activities are sustainably conscious.

In practice, the regulation will mean that private equity firms and fund managers will need to adhere to periodic reporting, at both firm and portfolio level.

Transparency and accountability are at the forefront of the SFDR’s ultimate goals and will assist with greater visibility in the industry.

Elin Ljung, director of comms and sustainable investment at Nordic Capital, says: “It’s always good to increase awareness, that’s where all change management programs start… you need to prioritise a set proactive plan to get started on making people accountable to drive that progress.”

However, whilst transparency of PE funds is ultimately a good thing, Nicole Downer, managing partner and head of investor relations at MV Credit, is worried that the fear of being “caught out” could eliminate transparency altogether. Speaking at a Natixis Investment Managers’ webinar in February, Downer said: “It’s just a matter of making sure that the regulation doesn’t inadvertently make things less transparent, because everyone might just go for the safe-zone to avoid being caught out by regulation.”

Since SFDR has been criticised for taking a ‘one size fits all’ approach, there are worries about how severe of an impact it will have on smaller PE firms too. Maria Carradice, portfolio director- ESG at Mayfair Equity Partners, notes that firms that aren’t prepared to take up the detailed reporting will see the regulation as a “compliance burden, rather than something that’s of real value”.

But, with the recent launch of the regulation, there will naturally be some teething problems. There has been confusion surrounding how to go about ESG reporting. Neil Brown, chief risk officer at Earth Capital, worries that the regulation itself tries to tackle financial markets as a whole, making it “too prescriptive” for PE.

“To capture bonds, money-markets, equity, real estate, private equity and everything else all under one regime is very prescriptive. You either focus it on one to get it right, and it fits that quite well but doesn’t do a very good job elsewhere, or you try to be all things to more people and it could end up a bit of a mess,” Brown says.

There are concerns about a lack of clarity from an advisory point of view too. Eve Ellis, a funds regulatory partner at Ropes and Gray, says: “Another area where clarity is needed is around the different product categories, in particular, what funds fall within the category of funds which promote environmental or social characteristics.”

LEVELS OF ENGAGEMENT

An element of this lack of clarity could come down to the fact that Level 2 measures of the SFDR have not yet been set by the European Commission. The current framework of SFDR is considered Level 1, and should be complied with at its “high level and principle-based requirements”, according to the Commission. However, the Level 2 measures should aim to supplement the methodologies in greater detail.

Bregal Investments’ head of ESG and responsible investing Alvar de Wolff says that his firm is already preparing for this next stage: “With Level 2 rules coming into place next year, we are now also actively working to ensure that all our data collection processes are in line with regulatory expectations.” The Level 2 measures are expected to come into place in early 2022.

Some hope that the Commission will take onboard grievances, so that the next level can be better mapped out. Carradice adds that she would expect the authorities to consult and make any necessary changes. “I would expect there to be a series of reviews and refinements, so hopefully we end up in a place in a couple of years’ time where the data is useful and you can then start to see the value of investing in businesses with good ESG profiles,” Carradice says.

In terms of making investments, Carradice and Beth Houghton, head of ESG and impact at Palatine, are in agreement that just because SFDR encourages investments in “good” ESG funds, it doesn’t mean that funds are necessarily going to be deterred from making deals with the “bad” ones.

Carradice says that as long as the financial criteria is favourable, there is “significant opportunities to add and create real value, by working alongside management to put in place bespoke ESG strategies and sustainability programs that will give them the competitive edge.

“We could perhaps use SFDR data to argue a reduction in price on the way in,” Carradice adds.

While “bad” ESG deals could be negotiated to a lower price, the reverse of that is that investments with particularly “good” ESG will be in higher demand and so, can average at a higher price point.

Castro predicts this will go on to cause a “polarisation” within PE: “It should also be expected that investment opportunities that are beneficial for the transition to a lower carbon economy will be in higher demand. This may create a polarisation of the PE investment universe where the ESG-friendly or neutral opportunities will command a premium versus the rest of the market.”

WHAT THE FUTURE HOLDS

So, as SFDR begins to take its course, what is next for ESG and what should managers be considering? We know that better all-round ESG leads to better returns, but what will be next on the agenda for ESG and sustainable investments going forward?

Firstly, SFDR will bring an element of reputational risk in this next year. Managers are going to need to prove that they are in fact ESGconscious, especially as investors become increasingly conscious of which funds they choose to deploy capital too. Investec’s Michael Zornitta says that this could be a risk for managers when they look to invest in new companies too. “There’s a potential for inability to deploy capital, as potential target companies may not wish to be associated with the manager should they not uphold strict ESG criteria,” Zornitta says.

Secondly, SFDR is likely to raise the bar as to what qualifies as “good” ESG, and how we differentiate the good from the bad. De Wolff says: “It is no longer enough to have an ESG policy or a high-level programme. It is becoming increasingly important to be able to demonstrate how exactly ESG is integrated and how actions drive progress.”

The Cambridge Associates Survey, released in February, found that resource efficiency and climate change were listed as the top priorities for its respondents in 2020, closely followed by social equity and inclusion.

Meanwhile, Houghton predicts that the cyberspace will be a key element for many portfolio companies: “We’ll see a lot more focus on cybersecurity and data protection and making sure people are doing the right thing along those lines. Since we’re all working from home and we’re all on remote systems, it seems even more important.”