Alongside Bono, Richard Branson, and eBay founder Pierre Omidyar, private equity firm TPG launched the Rise Impact fund in 2016. The offering committed “to deliver positive and sustainable impact” while creating a “top-performing fund.” At the time, Bono remarked that “capitalism is going up on trial, and I think that it’s clear that putting profit before people is a nonsustainable business model.” Bain Capital followed suit, launching its own Double Impact fund, and KKR recently closed a $1.3 billion impact fund.
These efforts reflect a growing commitment to environmental, social, and governance practices by private equity firms and their limited partners. Speaking in 2019 at a forum on public aspects of private equity, Emily Mendell, former managing director at the largest association of LPs, noted, “ESG is critical. It’s critical to returns, it’s critical to value creation, it’s critical to our planet. It is also going to be critical to the PE industry and the viability of the PE industry long-term.” The director of sustainable investing at a major PE firm agreed, explaining to us in an April interview, “Today we are seeing [ESG] questionnaires coming from LPs all over the world.”
This all sounds promising. But does the progress match the headlines?
Absent reliable data, this question has been hard to assess. Private equity is very private. Different from public companies that have regular and extensive reporting requirements, most private equity firms disclose far less. Thus to assess progress we interviewed PE firm chief sustainability officers, reviewed PE responsibility reports, and analyzed the database of signatories to Principles of Responsible Investment (PRI is a nongovernmental organization focused on encouraging responsible investment).
What we found: The vast majority of private equity ESG efforts remain nascent and superficial.
Last August the Business Roundtable shocked many in calling on companies to deliver results for all stakeholders — not just for shareholders. In December, Klaus Schwab, founder of the World Economic Forum in Davos, issued a manifesto stating, “Performance must be measured not only on the return to shareholders, but also on how it achieves its environmental, social and good governance objectives.” These expectations increasingly extend to private equity.
The PE asset class is now more than twice as big as it was ten years ago. The largest firms within this class — Blackstone, Carlyle, and KKR — are now, in fact, public companies, each responsible for managing more than $200 billion of assets. Though the average company owned by PE is far smaller than the average publicly owned firm, private companies with 500-plus employees now outnumber public ones by more than two to one, BlackRock data shows. As a result, PE companies have a growing and consequential influence on social and environmental outcomes.
The increasing pressure on privately owned companies to deliver more than first-rate returns stems from a number of converging factors. These include: an erosion of trust in governments; the immediacy of climate change, environmental degradation, and resource scarcity; and gaping income inequality. In addition, technological advances (including sensors, satellite precision, accessibility of the internet, and the pervasiveness of smartphones) have enabled collection of nonfinancial information (such as carbon dioxide emissions, water usage, and waste production) and produced levels of transparency that were not possible even ten years ago.
In public markets a buildup of data has produced a shift in investor perceptions of sustainability. According to a study of the impact of ESG ratings on sell-side analysts’ assessments of a company’s future financial performance, analysts and investors used to see ESG initiatives as gratuitous, with little payback. However, over a 15-year period starting in the early 1990s, “analysts [started to] assess these firms less pessimistically, and eventually they assessed them optimistically.” Said differently, sustainability transformed from a negative signal into a positive one.
This shift accelerated as additional studies demonstrated a positive correlation between “high sustainability” companies and positive equity returns. One influential paper, completed in 2014, looks at 90 matched pairs of companies — one “high sustainability” and one “low sustainability” company from the same space (two retailers, two energy producers, etc.). The high-sustainability companies significantly outperformed their counterparts in terms of both financial and stock market performance. Such research has helped dispel the myth that a focus on sustainability means a trade-off in financial performance.
PE + ESG: Intention vs. Action
So far the case for ESG looks good. The combination of research reinforcing its value, a growing demand for sustainable products, and an expanding asset class portends good outcomes for investors, the planet, and social equity. And yet our research indicates that rhetoric is ahead of reality and that the focus on process far exceeds the delivery of progress. What evidence can we offer to support the claim that private equity still has considerable room to deliver improved public (read: social and environmental) outcomes?
To get a better sense of the depth of PE commitment to ESG, we scanned the database of PRI signatories. Of the 8,810 global private equity firms with a total of $3.4 trillion under management, only 703, fewer than 10 percent, belong to PRI.
Examining the 431 PE firms that directly invest and commit to PRI’s six principles, we found that fewer than one in eight publicly disclose that they receive ESG reports from their portfolio companies, and only 16 share whether ESG issues impact financial performance.1 As such, it is very hard to determine the depth of the PE commitment to ESG and nearly impossible to figure out the ESG performance of PE-backed portfolio companies.
Our analysis shows that the majority of the PE firms reporting to PRI have a responsible investment or ESG policy. This is a move in the right direction, but represents a signaling of intention versus an assurance of progress. According to Michael Cappucci, managing director of compliance and sustainable investing at Harvard Management Co., “The existence of a [policy] is not a reliable indicator of a firm’s commitment to or performance on sustainable long-term goals.”
ESG policies focus on process, not outcomes. Almost all PE firms’ ESG policies include commitments to comply with applicable laws, respect human rights, provide timely information, consider ESG issues, and improve sustainability. They are closely vetted by PE firms’ legal teams and typically contain words such as “seek to” and “encourage” to provide shelter in the event that portfolio companies do not adopt sustainable practices.
Another way to assess ESG progress at PE firms is to examine their reporting. A review of the top PE firms highlights a diverse range of approaches.2 Though a minority of the biggest firms are signatories to PRI, a majority of these same firms provide qualitative case studies. Surprisingly, only four in ten of the examined firms produce ESG reports, and disclosures at both the general partner and portfolio company levels are rare. None of these top firms connects ESG metrics to financial impacts or provides science-based targets.
Our results do come with a number of caveats. First, we do not mean to suggest that the only firms implementing ESG practices are PE signatories to PRI. Other firms are engaged with ESG but choose not to sign up because of concerns about PRI’s shifting standards and the administrative costs of reporting. Nevertheless, becoming a PRI member requires a commitment to ESG and transparency, and it is telling that the signatories represent a very small share of PE firms. Second, our analysis relies on public disclosures to PRI. It may be that some general partners offer limited partners more detailed reporting on ESG than what is available publicly.
Overall, the opacity of ESG reporting by PE firms contrasts with the increasing transparency provided by many public companies. Though public companies’ sustainability information remains mostly unaudited and imperfect, reports adhere more and more to one of the major sustainability standards (either Global Reporting Initiative or Sustainability Accounting Standards Board). This enables analysts to review time series information to assess progress (or the lack thereof) on key ESG measurements (such as diversity, carbon emissions, and water usage).
How might PEs’ ESG intention translate into impact? Here we recognize some of the obstacles and then present a list of recommendations to accelerate reporting and progress.
The growing prevalence and severity of environmental and social challenges have elevated the issue set to the highest ranks of PE firms. According to a PwC 2019 survey, when firms were asked if they were concerned about climate risk, 83 percent responded affirmatively. Sixty-four percent were interested in the opportunity for recycling and reuse and energy efficiency. Yet only 31 percent said they had taken action to address climate risk, and just 17 percent had acted to address circular ecoefficiency.
What accounts for this intention-versus-action gap? Based on our interviews, we suggest that the following factors explain the discrepancy.
Hold period. The median hold period for a PE-owned portfolio company is 4.5 years. Investments in sustainability at portfolio companies must compete with other requests for funding. As a result, sustainability investments are often deprioritized given limited resources and a desire to show financial improvement over a tight timeline. Says one chief sustainability officer at a major PE firm, “[An ESG issue] was always number eight, nine, or ten on the list, and the CEO was focusing on the top six initiatives.”
Incentives. According to a study by State Street, more than 40 percent of asset owners and asset managers thought that the right time horizon to deliver ESG outperformance was greater than five years. However, only 10 to 20 percent use these same time frames to evaluate financial performance. This mismatch likely causes some PE firms to underinvest in ESG, especially given the competitive pressure to deliver high returns on investment to raise subsequent funds.
Quantification. Unlike an investment in an e-commerce site or in machinery to improve productivity, an investment in ESG is often hard to quantify. For example, how might a GP measure the return on investment tied to a commitment to diversity? Or how should an analyst determine the financial and reputational value of a crisis averted thanks to an investment in human rights monitoring in an overseas factory? Although all investments rely on uncertain forecasts, ESG investments are relatively disadvantaged owing to the hard costs and, often, soft benefits that characterize such undertakings.
Causation versus correlation. Research broadcasts that ESG is profit-making. A meta report of more than 2,200 individual studies concluded that “roughly 90 percent of studies find a non-negative ESG–corporate financial performance relation. More importantly, the large majority of studies report positive findings.” Notwithstanding this evidence, an active debate continues over whether these findings are correlated or causative. Said differently, do “high-sustainability” companies outperform because of a focus on ESG, or do they deliver great financial results because ESG is a by-product of a well-run company? Absent additional empirical evidence that ESG leads to value creation, it is easy for general partners to invest elsewhere.
Company type. Almost all PE-owned companies have never been public. They are also, on average, far smaller than the average public company. As a result, the vast majority of PE-backed portfolio companies have had less stringent disclosure requirements and do not likely have the resources, expertise, or inclination to prepare sustainability reports. In addition, ESG matters manifest differently at different types of companies. For example, whereas a consumer company might have to manage carbon emissions, labor issues, and raw materials inputs, a service firm might be focused on cybersecurity and have a far smaller list of ESG issues to consider.
Standardizing ESG. The definition of ESG is imprecise. As a result, it is much harder to understand the depth of a PE firm’s commitment to ESG than, say, the quality of its accounting. Financial statements are always audited, whereas independent third parties almost never vet ESG filings. According to a report by Private Equity International, “The current state of affairs allows flexibility for GPs to choose how much to report and how often to do it, which leaves the door open for managers to cherry-pick examples of favorable outcomes while burying unfavorable ones.” In addition, GPs can determine if they want to share ESG information at the GP or the portfolio company level; if they want to present data or qualitative case studies; and which of the thousands of E, S, or G metrics they believe are relevant to disclose.
Given the breadth of what is considered ESG, the bar for a firm to get credit is low. Consider, for example, PwC’s reporting that a “staggering 91 percent” of respondents to the firm’s annual survey indicated that they either have or are in the process of creating an ESG policy. Inclusion in the 91 percent does not even require that an ESG policy be in place.
Notwithstanding the progress of the past decade, private equity ESG implementation remains unformed, discretionary, and varied. For most firms, the bulk of the work has been focused on compliance, risk management, qualitative reporting, and satisfying select LPs. Progressive efforts to improve E, S, or G issues at a group of portfolio companies are often offset by the lack of such efforts from other companies within the portfolio. Progress on ESG will require that systems change. Following is a list of ideas that might move the needle.
LP collective action. Customers have power. Although “one-offs” from LPs can motivate, collective action by a consortium of LPs has a far better chance of driving systemic change. Given the size of the largest LPs, one could imagine a like-minded group of fewer than ten asset owners having the ability to influence the entire PE asset class. Were such a group to demand standards for PE sustainability reporting (e.g., along the lines of SASB), it would have a catalytic impact. Such standards would enable investors to assess time series improvements in social and environmental impacts, including carbon intensity and water usage. They would help determine how PE is delivering on its public promise. As a first step, LPs might start with uniform standards for measuring governance factors such as gender balance in senior management or board diversity.
To ensure that this type of action delivered impact, collective LP action would likely have to be mandatory. As one senior PE sustainability director told us in an interview in April, “I see so many voluntary efforts that catch people’s attention, and even spur action, and then the entity never circles back to assess progress [or] provide rewards or penalties for performance, [rendering] the work meaningless.”
LP education. Some ESG issues are straightforward. For example, it is easy to assess if a company has a current code of conduct governing procurement. However, the majority of ESG issues (especially in E and S) are complex and often require scientific and/or subject matter expertise to evaluate. Issues such as measuring carbon emissions (according to the guidelines of the Greenhouse Gas Protocol) or assessing human rights in an Asia-based supply chain are anything but straightforward. Though LPs are increasingly interested in PE firms’ managing risks and delivering on the opportunities of ESG, according to one PE firm’s chief sustainability officer, “very few LPs have any ESG expertise. They don’t know how to stress-test for whether real ESG is happening or not. The interest is strong, but the follow-through is bumpy.” Providing education to boost LPs’ ESG expertise could compel attention and action at PE firms.
Ratings. PE deals include debt. Hence credit ratings impact the economics of deals. Were credit ratings agencies committed to systematically incorporating ESG factors into debt ratings, it is likely that ESG would get more attention from asset managers.3 4Alternatively, LPs might even fund a new ratings agency focused exclusively on ESG and mandate ratings for the portfolio companies of GPs with which they invest.
Investing term. If PE firms committed to longer hold periods for their portfolio companies, they could address the challenges of mismatched time horizons and incentives. In a note entitled “New Horizons for Private Equity,” BlackRock points out that “long-term funds can potentially overcome investor challenges such as friction costs resulting from portfolio turnover,” along with associated reinvestment risk, “while also benefiting from effective private governance of portfolio companies.” Vincent Mai agrees. After a successful run as CEO of PE firm AEA, he adapted this approach with his second firm, Cranemere, an investment holding company with permanent capital that is committed to long-term investing. Mai told us in an interview in May, “We believe that business should be a force for good in society and that the best way to enable positive change is to back great leaders over the long term. This allows our portfolio companies to invest in the well-being of people, the environment, and communities, thereby achieving great returns for our investors.” Since 2017, Blackstone, CVC, KKR, and BlackRock have all raised longer-term hold funds.
Why care about any of this? After all, the primary goal of private equity firms is to steward and grow capital.
Here is why. A vaccine will ultimately be developed to fight the current pandemic. Covid-19 will leave unthinkable damage in its wake, but it will pass. Regrettably, there is no vaccine in the pipeline designed to fight climate change. There is also no cure at hand to ameliorate income inequality, triple crop growth productivity, or properly price water.
To address these challenges, institutions, including those in finance and private equity, will have to play a more active role in social and environmental problem-solving. Understanding this reality, Carlyle co-CEO Glenn Youngkin noted at the most recent Davos gathering, “Every [Carlyle portfolio] company now has an ESG plan.” This is a laudable example. However, the industry as a whole still has much more work to do. It is not uncommon to find PE firms with strong commitments to ESG (including Carlyle) continuing to invest in fossil fuel companies, thereby offsetting (at least some) emission reductions made elsewhere in their portfolios.
Private equity is ubiquitous. PE firms now own stakes in companies in every sector from health care to infrastructure to retail. Given the increasing scale and scope of PE, it is both important and urgent to translate the promise of PE into practice — important to ensure the social value of the asset class, and urgent because PE has a growing ability to positively influence mounting social and environmental challenges.
Absent this progress, Bono, and other investors in PE funds, still will not be able to “find what they are looking for.”