7 min read 21 Apr 22
For some PE firms, ESG and sustainability considerations have moved beyond being a matter of hygiene and have become part of their value creation ambition. While clear progress has been made over the past few years, ESG integration across the PE industry still nevertheless lags behind public markets, with a lack of uniformity in ESG risk management and disclosure standards across the firms themselves and the companies they own. Often, disclosure standards for privately-owned companies may not be as developed as those for listed companies, which is understandable when thinking about the relatively shorter history of many of them.
Yet, change within the private corporate sector stands to have real-world impact. PE net asset value growth has far outpaced the total market cap of listed companies – growing by 14x since 2000, compared to the public market, which grew fourfold over the same period1.
Many believe that the PE model is particularly well placed to embrace ESG and sustainability given the scale and scope of the industry’s investments as well as PE’s influence over the operations, strategy and governance of its portfolio companies, with PwC noting in a recent report that it is “observing the early stages of an ESG revolution…” The ability to engage, influence and advocate good disclosure across all ESG areas to multiple portfolio companies is particularly pertinent when considering that many privately-owned companies will one day become publicly-listed entities, given that an IPO is the private equity owner’s typical exit objective for large companies.
Global PE assets under management (AUM) hit US$5 trillion at the end of last year, according to Preqin, the alternative data provider, with the amount of dry powder at an all-time-high of $2.2 trillion. Today, a larger amount of private capital considers ESG factors in investment decisions and portfolio company management – with private equity ESG AUM having grown at a compound annual growth rate of 17% between 2015 and 2020 – but only around c.11% of European PE assets were allocated towards ESG funds at end-2020, according to PwC Luxembourg findings2. Under its base case scenario, PwC expects PE ESG AUM in Europe to reach €292 billion by 2025 – reflecting, what it believes to be, the “…increased recognition of ESG’s powerful valuation/protection potential, along with the ongoing shift within private markets…”
Like others, the PE industry still has a long way to go on decarbonisation, but several private equity-specific initiatives announced in recent months suggest that the industry is looking to put climate-change firmly on the agenda and accelerate the path towards net zero in private markets. Private equity behemoth, Carlyle, has pledged to achieve net zero emissions by 2050 or sooner across its investment portfolio, while setting a number of interim targets, including that three-quarters of its portfolio companies’ scope 1 and 2 emissions will be covered by Paris-aligned climate goals by 2025.
Towards the end of last year, seven PE companies, representing $133 billion AUM, announced that the decarbonisation targets they have set for their own organisations and for their portfolio companies had been validated by the Science Based Targets Initiative (SBTi). The private equity-specific guidance is intended to support PE firms’ general partners (GPs) to set ambitious greenhouse gas (GHG) emissions reduction targets (SBTs) for their operations (scope 1 and 2 emissions) and firm-level portfolio SBTs for their investment and lending activities (scope 3, category 15).
The guidance has been widely welcomed given the lack of clarity and consistency in approaches to climate change or specific data standards for private companies. The private equity SBTs are long-term targets with a requirement for validation – firms commit to having a percentage of their portfolio reach their targets by 2030 or 2040.
The Institutional Investors Group on Climate Change (IIGCC) has also released private equity-specific guidance for its Net Zero Investment Framework (NZIF). The original NZIF which was launched in March 2021, covered listed equity, fixed income, real estate and sovereign bonds – with the proposed new guidance for private equity intended as an additional component to the NZIF and includes metrics, targets, scope of portfolio companies to be included in net-zero strategies and recommended actions for GPs and limited partners (LPs). The final guidance for the IIGCC framework is expected to be published in the second quarter of this year.
Data consistency, measurement and disclosure arguably remain among the biggest challenges on the private side, making it comparatively more difficult to provide tangible evidence and data to stakeholders that prove the sustainability of a business or asset operations than for public markets, where listed companies have an obligation to produce a certain amount of data and are typically rated by third-party data providers such as MSCI. There is a multitude of sustainability reporting standards in existence, however, which has also led to inconsistent disclosure and confusion for investors and market participants – although the newly-established International Sustainability Standards Board (ISSB) aims to create standardised ESG reporting rules to guide companies on what sustainability disclosure should be made to investors.
The ESG Data Convergence Project, which was launched in September 2021, and led by the California Public Employees’ Retirement System (CalPERS) and Carlyle seeks to standardise ESG metrics and provide a mechanism for comparative reporting for the private market industry, specifically. At the start of this year, it was announced that global LPs and GPs representing $8.7 trillion AUM and more than 1,400 private companies had committed to it.
The pace and extent of regulatory and policy change is helping to propel sustainable business, investment and capital markets forward – and provide structure for the investment community through new rules, standards and frameworks, designed to mandate greater transparency and prevent ‘greenwashing’ risks.
The growing harmonisation of climate and broader ESG reporting standards for investors across jurisdictions should also be welcomed. The International Association of Insurance Supervisors (IAIS) is helping to facilitate a coordinated approach between jurisdictions on the issue of climate risks and sustainability, while also pursuing efforts to formulate a consolidated capital standard for internationally active insurance groups (IAIGs), in the form of the Insurance Capital Standard (ICS). Considering more than a third of all global IAIGs are European, the ICS will be particularly relevant for European groups when it comes into force in 2024.
In many respects, Europe is leading the charge when it comes to sustainability and ESG standard-setting. MSCI has suggested that many US public companies will have to get their GHG emission-accounting books in order to meet the climate-disclosure rules proposed by the US regulator, the SEC. Unlike the US, companies in Europe are moving to disclose and set targets with momentum, and they will soon be required to do so.
The European Commission has issued a consultation on the proposed Corporate Sustainability Due Diligence Directive, to tackle human rights and environmental impacts across global value chains. The EC estimates that 13,000 EU companies and 4,000 third-country companies would be within the scope of the Proposed Directive. The Proposed Directive is due to work in tandem with the Sustainable Finance Disclosure Regulation (SFDR) and the Taxonomy Regulation, and create obligations on companies to perform ESG due diligence and to adopt ESG policies aligned with global policy commitments.
As privately-owned companies embrace ESG and sustainability, private lenders of these companies look set to benefit not only from the type and scale of climate commitments (and the actions plans to get there), but also from the common standards and formalised reporting frameworks and ESG integration.
While some tolerance of the shorter history of sponsor-owned, private companies may be necessary at times, the standards being set by private company’s stakeholders are rising – especially in Europe – and in some cases, even moving ahead of regulations. Private lenders will need to proactively engage with companies and their private equity owners to ensure that they demonstrate sufficient progress against their targets over time through greater ESG disclosures.
In the next part of this series, we look at the ways in which ESG and sustainability is impacting the leveraged loan market, including record sustainability-linked loan issuance and the proliferation of ‘ESG-labelled’ CLOs in Europe.
1 McKinsey Global Private Markets Review 2022, published March 2022.
2 2022 EU Private Markets: ESG Reboot, PwC Luxembourg.
The value of investments will fluctuate, which will cause prices to fall as well as rise and investors may not get back the original amount they invested. Past performance is not a guide to future performance. The views expressed in this document should not be taken as a recommendation, advice or forecast.