Using ESG Data to Generate Alpha in Private Equity
ESG initiative implementations and ESG reporting are fast-growing trends in private equity. The demand for gathering real data on ESG initiatives in PE portfolio companies is growing stronger within the global limited partner base. Historically, this demand has been larger in Europe than in the US, but we’re starting to see real growth and adoption in the US markets.
“[ESG] has advanced more quickly in Europe than in the US. The Europeans have made it a greater priority in terms of hearing from their GP’s and portfolio companies about ESG policies,” Emily Mendell of ILPA explains, “In the US, we are moving in that direction as well. When you look at the type of information LP’s are requesting, 5-8 years ago there were hardly any ESG-related questions in DDQs. Now, most LP’s have significant sections on ESG policies and how fund managers monitor ESG at portfolio companies”
What Caused the Shift?
For many funds the shift at the portfolio and fund level was brought about by LP demand. As LP’s become more savvy to private equity, the demand to see not just return data but sustainability has grown much like we’ve seen in public equities.
“There [is] an obvious alignment between responsible investment and private equity - you have a lot more influence with the company and the LP has influence at the fundraising stage,” explains Natasha Buckley of UNPRI, “It’s about engagement and being in a position where you can affect that change. This coincides with a push from LPs for more transparency on GP operations more generally.”
Data gathered from public equity ESG studies shows that investors who invest based on material ESG factors outperform those that don’t. While much of the data is based on available information from public companies, the trend is promising for private equity and LP’s have taken notice.
In “The Financial and Societal Benefits of ESG Integration: Focus on Materiality,” George Serafeim and colleagues at Harvard Business School found that firms making investment in material ESG issues outperformed peers in terms of profit margin growth. The issue, of course, is that ESG information is difficult to obtain. Theoretically, investors who accurately understand ESG implications and make investment decisions accordingly should be able to recognize alpha as stock prices eventually adjust.
Realizing the Potential
Intentional Endowments, a network that supports colleges, universities, and other mission-driven tax-exempt organization in aligning their endowment investment practices with their mission, values, and sustainability goals, published a study titled, “The Business Case for ESG” back in 2016. Intentional Endowments regularly reached out to investment managers about whether they are PRI signatories, if they’re implementing ESG policies, and what affect those policies have on their investments.
Fund managers like Valdur Jaht of Avaron place equal weight on ESG factors as other investment factors.
“In our investment process ESG issues have the same weight in decision-making as other conventional things that investment managers analyze.”
The trouble with using ESG as a factor in investments is the accessibility of data. Tools like S-Ray have moved the possibilities forward in public equities but as you move into small-cap listed equities or private equity, hard data on sustainability and ESG efforts becomes increasingly difficult to gather and analyze. Historically, gathering this information takes added resources and personnel within a fund.
Allocating the added resources needed to capture and analyze ESG data in a private equity portfolio requires a full understanding of the benefit and often, a change in perspective.
ESG Is More Than Downside Protection, It’s Upside Potential
Many funds collect and report on ESG data because at some point in their firm’s lifetime an LP asked them to. For ESG initiatives to truly have an impact, there needs to be a will to tie data to results, and understand the upside potential in running a sustainable business, not just the downside protection.
“I often hear issues such as ‘cyber-security’ and ‘data privacy’ discussed as ESG considerations. I don’t agree with this view. Companies should manage these issue proactively as part of their general responsibility to stakeholders and there is obvious reputational and financial downside from not doing so – but I see this as an example of a firm protecting its downside vs. promoting ESG considerations to drive value creation and upside.”
“Investors’ understanding of ESG has changed markedly over recent years, and awareness has grown regarding its link to alpha. ESG is about risk management and the performance of firms on environment, social, and governance risks. It’s about how well they run their business, not what their business is.”
“Part of building value is increasing [a company’s] governance and reporting so it can be ‘middle market ready’ and be acquired by a middle market PE firm or a strategic. Strong ESG initiatives often translate to higher multiples in that respect.”
A BCG analysis of 300+ companies published in October of 2017 found that businesses that perform well in environmental, social, and governance areas can improve their valuations and margins. This means ESG has tremendous upside potential for PE fund managers. Recognizing strong ESG initiatives with real data allows fund managers to better predict the future success of a company.
As outlined in BCG’s analysis, there are several areas where strong ESG performance translates to upside.
Opening Up New Markets
Companies who find ways to reach traditionally underserved markets will build new business where competitors have historically not been able to build. The best example of this to-date has been private lenders focused on emerging or developed markets.
In a report released in April of 2018, The Global Impact Investing Network (GIIN) and Symbiotics presented the first comprehensive analysis of the financial performance of Private Debt Impact Funds (PDIFs) and over 100 Community Development Loan Funds (CDLFs). Returns for PDIFs seeking market-rate returns averaged 2.6% since 2012, with low volatility of 0.9%. Such PDIFs had a higher Sharpe ratio than a range of traditional investment products, including bonds and cash CDLFs paid an average of 2.9% to holders of their notes, with very little year-on-year variation.
According to BCG, “Companies that adopt the TSI (total societal impact) lens will often identify new product features or attributes that can provide societal benefits while boosting the appeal of those products.” In 2008, CD&R and KKR owned US Foods, saved $8.2 million in fuel costs and avoided 22,000 metric tons of CO2 emissions (equivalent to more than 4,400 cars) by improving the efficiency of its fleet – as measured in freight tons per gallon of fuel – by more than 4 percent from 2007.
Reducing Cost and Risk in Supply Chains
The development of more inclusive supply chains—those that draw on individuals or companies that have historically been left out—can make those networks more resilient and cost effective because they are less dependent on a few suppliers and distributors, and raw materials can be sourced closer to the end market.
Strengthening the Brand and Supporting Premium Pricing
Companies known for products with positive environmental or social attributes, such as those that are responsibly sourced and have natural ingredients, can inspire customers’ loyalty and trust. That can translate into increased sales and even premium pricing on certain products for certain market segments, a powerful benefit in particular for the consumer goods industry. More than half of consumers in the U.S. are willing to pay more for environmentally-friendly products, according to a 2017 study from GfK MRI.
Gaining an Advantage in Attracting and Retaining Talent
A strong track record in contributing to society can energize the workforce and give a company an edge in the battle to attract, engage, and retain talent. Three-quarters (76 percent) of Millennials consider a company’s social and environmental commitments when deciding where to work and nearly two-thirds (64 percent) won’t take a job if a potential employer doesn’t have strong corporate social responsibility (CSR) practices, according to the 2016 Cone Communications Millennial Employee Engagement Study.
Becoming an Integral Part of the Economic and Social Fabric
Companies that explicitly work to support a country’s economic and social development goals can strengthen relationships with governments, regulators, and other influential parties.
An analysis of more than 300 of the world’s largest pharmaceutical, consumer goods, oil and gas, banking and tech companies by BCG found that those with more ethical operations, for example those seeking to conserve water, make bigger profits and are valued more highly than competitors. For oil and gas companies, the valuation premium was almost a fifth for those that combat corruption, have better health and safety processes or attempt to limit environmental damage. Earnings before interest, tax, depreciation and amortization were 3.4 percentage points higher for these groups, while in the pharmaceutical industry the EBITDA margin benefit was more than 8 percentage points.
Correlation Does Not Always Imply Causation
Like any good data analysis, it’s important to note that correlation does not necessarily imply causation. There are many data points to consider when analyzing value-drivers in private equity.
If you have no idea what is behind a correlation, you have no idea what might cause that correlation to break down. This understanding is one of the many drivers behind our work at Malartu. A group looking to understand the causation of value-drivers like ESG initiatives needs a way to monitor operation data across the portfolio to include ESG metrics alongside financial outcomes to truly understand and replicate positive outcomes in the future.