Overcoming Common Challenges with ESG Integration

Gone are the days of satisfying an LP report with high-level financial reports on portfolio companies, if not paired with a report that identifies how that investment brought about ESG related benefit as well. If your firm isn’t feeling the pressure from LPs to implement ESG initiatives, it is likely coming soon (and for good reason). For better or for worse, the bottom line has turned into the triple bottom line, making life as a portfolio manager more challenging.

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Considering implementing an ESG strategy at your private equity firm might leave you feeling like you’re standing at the bottom of a mountain looking up. The challenges that must be overcome to reach the top of that uphill battle can be overwhelming. Malartu got in touch with asset management experts, research development professionals, and business consultants to wade through challenges regarding ESG that asset management staff might face.

Four common objections to ESG are:

  • I don't believe the hype.
  • Financial materiality is difficult to track and hard to prove.
  • My current practices, without effective ESG considerations, are working just fine.
  • I do not know where to begin.

Is ESG policy all hype?

So you don’t believe the hype behind ESG? That makes some sense, as the reputation of ESG within PE has taken a few hits over the years. From the time that ESG initiatives went mainstream, its supporters have had to work overtime to convey the legitimacy behind the movement. The overwhelming use of buzzwords and green clip art has resulted in widespread skepticism among the LPs and portfolio companies in which ESG could benefit. Too frequently LPs watch PE firms adopt ESG policy, but never thoroughly implement the protocol in day to day decision to realize true value.

It is becoming more difficult to greenwash. Natasha Buckley of the UN-backed Principles for Responsible Investment discussed a program overhaul on the industry-leading ESG and RI reporting platform that they have developed. PRI requires that all of their signatories annually submit a questionnaire style report detailing responsible investment strategies. Current regulation states that there are no minimum requirements that must be met in order to qualify as a signatory. Come January of 2019, signatory standards will be implemented. PRI will take a look at the information being disclosed and offer resources and solutions to integrate ESG strategies effectively.

If no progress is shown after an extensive effort by PRI to improve the firm, they will be dropped from the signatory list. In other words, those using PRI to check the ESG box will soon be pushed to legitimize their strategy. The greenwashers will not be able to keep up their game for much longer. Increased data transparency with regulated reporting blows the final whistle.

$59 trillion for financial materiality.

Since ESG credibility has improved, the assets managed responsibly has dramatically increased since 2014. The Forum for Sustainable and Responsible Investment concluded that sustainable investing growth jumped an impressive 33% throughout a two-year span. That figure is only going to continue to rise as the millennial population, more concerned with responsible investment than any generation prior, is projected to inherit $59 trillion by 2060.

Millenials are well informed on matters of sustainability. They have been raised in an era of readily available information detailing the dangers that stem from not paying attention to the importance of sustainable and social responsibility. The “oops I didn’t know that was bad” excuse simply does not work for this crowd. Investments are expected to have both financial and intrinsic benefits. Implementing effective ESG principles will enable asset managers to satisfy future stakeholders, and obtain a cut of that $59 trillion.

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“The trend in the market seems clear. Asset class after asset class has been added in terms of ESG considerations. Now we can see increased interest and commitment in the private equity sphere, although much remains to be done.”

Sixth Swedish National Pension Fund – AP6, Sweden

Tracking the value behind ESG can be hard.  

The link between ESG strategy and value creation is tough to track. Since the process is not standardized, most PE firms don’t know where to begin when it comes to ESG indicators. These indicators vary by sector. For example, the ESG report for an oil company should look very different than a report for a software company. “LPs do not have uniform data requests and reporting templates, if at all,” shares Silva Dezelan of Robeco Private Equity. Identifying what is relevant for an ESG report that relays value requires pointed data collection.

ESG Specialists and consultants can offer insight to help establish the reporting framework that works best with your portfolio by identifying the metrics that matter most.

Less than 15% of PE houses calculate the value they create through ESG activity, according to PwC. It is hard to attribute value that an initiative generates without crunching the numbers to analyze the output.

“It is about materiality,” shares Andres Van der Linden, ESG Specialist of Triple Jump. ‘To break into that market you have to prove that sustainability metrics don't take away from that bottom line but can even improve it.” To ensure that these calculations are made, having strategy support from the finance department is critical.

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The industry has evolved.

A distinct generational gap is separating the world of private equity into two groups: Those who are open to updating procedure and policy, and those who are rigid with traditional practices. Again, understanding the millennial influence on private equity can be a game changer in your firm's ability to remain successful in the coming years. The world in which business is done is evolving. Stagnant approaches, specifically in regards to environmental, social, and governance policies will become the abnormality.

Remember car phones?  

Think back to the late 90’s. You had your car phone and were more than satisfied with your ability to communicate with people whenever and wherever needed. The idea of having a mobile phone on hand at all times seemed to be extravagant and frivolous. However, the world around you was rapidly changing, and within a couple of years baseline expectations for communication evolved. Everyone had a cell phone. Whoever was not accessible lagged behind and lost some competitive advantage.

You accepted the societal shift and hopped on board with the growing trend by purchasing a cell phone. If you had not, you could have been left in the dust. Tethered to your 3-pound car phone because you had an established method for communication and it worked just fine.

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Replace the car phone with your existing investment policy, and the mobile cell phone is ESG strategy implementation. You probably already have an effective system that generates a return for your investors. It is proven and efficient. Making adjustments could seem unattractive because it would take a lot of effort, resources, time.

Identifying challenges that come with updating the deeply rooted financial system is the first step in creating an agenda for improvement. “The biggest financial system, they have this machine running. Changing the power on Wall Street is incredibly difficult,” stated Andres Van der Linden. You acknowledged that the world was taking a step into a new era of communication with mobile cell phones. Now it is time to acknowledge that traditional private equity practices need a facelift to meet the needs of a quickly evolving stakeholder pool.

Successful ESG strategy implementation falls on the GP, and a lot of people are working to make the shift simpler. Developmental organizations, consultants, and industry pioneers are sharing their stories so that the success can be replicated.

Just begin somewhere.

PRI regularly updates their “how-to” resources available for download on their website. Familiarizing yourself with these private equity specific guides can aid in identifying the best plan of action for ESG strategy at your firm. INSEAD has put together a comprehensive summary that takes a look at eleven different asset management firms with a successful ESG strategy. SASB has a library of materials outlining ESG integration into the investment decision-making process.

78% of asset owners, managers, and consultants agree that responsible investing is of growing importance according to a survey done by Chartered Alternative Investment Analyst Association. By identifying and challenging a few of the objections that experts say they regularly encounter from GPs, we hope to move that 78% closer to 100%.

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Start talking with our team to get the right ESG reporting conversations going at your firm.

Implementing the ideal ESG strategy that adds value to a portfolio is the first step towards generating excellent reports. Reliable, relevant data that demonstrating financial materiality to LPs and companies is the fuel that makes those strategies sustainable, and securing your future in private equity.

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