While a quantitative financial assessment of private equity opportunities is undoubtedly important, equally so is a thorough understanding of non-financial risks. This holistic approach is particularly important given private equity’s long-term and illiquid characteristics.
Recent years have seen a growing awareness of ESG (environmental, social and governance) investing, which aims to incorporate a variety of key non-financial criteria into investment evaluation. These include a company’s energy efficiency and waste management, employee diversity and governance issues such as compliance, corruption and competition.
Several studies have found that companies that incorporate ESG factors may outperform their peers. Various reasons for this outperformance have been proposed, but the basic gist is that ESG is a proxy for management quality. Companies with poor track records on ESG issues carry greater idiosyncratic risks including financial litigation and higher regulatory costs. They are also more likely to suffer the fallout from environmental disasters. Those companies with robust governance, on the other hand, often have lower employee turnover, more productive workforces, and better brand reputation and customer loyalty, all of which help boost financial performance.1
Several studies have found that companies that incorporate ESG factors may outperform their peers.
In the future, as investors grow more aware of ESG factors, they will likely put pressure on fund managers to incorporate such factors into their decision-making process. In January, Morningstar2 announced plans to rate portfolios on their inclusion of ESG information for a large proportion of the 200,000 funds it tracks. This will be another factor that investors can use to encourage managers to consider ESG issues in their investment process.
The growth of ESG has put new emphasis on the importance of good stewardship –when a manager is an active and involved owner of the investments you hold. A manager’s active dialogue with the underlying funds and companies is a crucial part of the investment process as it helps to remind companies that they are accountable to investors, thus encouraging greater focus and enhanced performance over time.
Evaluating investment opportunities holistically –both financial and ESG aspects – and weighing these together goes much further than a simple pass/fail decision on investments to be included or excluded – it involves a qualitative assessment of the long-term impact of corporate policies and behavior to evaluate risks.
Stewardship in private equity
As the private equity (“PE”) asset class has matured, it has gone through three distinct value creation phases. The first focused on financials, the second focused on operations and the third and current phase is focused on achieving sustainable growth taking into account ESG concerns.
This has been driven primarily by investor demand as well as acknowledgement by General Partners (“GPs”) that products in which ESG plays a significant role tend to have improved returns. Increasingly, GPs have focussed on what ESG key performance indicators to measure in post monitoring value creation, crisis escalation reporting and general best practice on ESG reporting.
Into the mainstream
Almost every year, we hear of a new corporate governance scandal. In the last five years, we’ve seen household names – Barclays* and Tesco* in the UK, Volkswagen* in Germany, Olympus* and Toshiba* in Japan and Petrobras* in Brazil – involved in corporate malfeasance as a direct result of poor corporate governance standards.
Disregarding ESG considerations can clearly have damning effects. Poorly governed companies tend to be more prone to unforeseen events. By contrast, companies that put ESG at the heart of their business are generally better managed, likely better able to mitigate risks and are thus better prepared for all eventualities. This means they are far more likely to perform to the upside.
Asset managers play a unique role here in acting as responsible stewards for the funds and companies they invest in.
*Companies mentioned for illustrative purposes only and should not be taken as a recommendation to buy or sell any security. It should not be assumed that recommendations made in the future will be profitable or will equal the performance of the securities in this list.
International investing entails special risk considerations, including currency fluctuations, lower liquidity, economic and political risks, and differences in accounting methods; these risks are generally heightened for emerging market investments.
Image credit: © Boris Lyubner/Illustration Works/Corbis
1 “Perspectives on ESG Integration in Equity Investing: An opportunity to enhance long-term, risk-adjusted investment performance,” Calvert Investments, July 2015.
2 Morningstar is a Chicago-based investment research firm that compiles and analyzes fund, stock and general market data.