ESG Integration in Private Markets Investments: Key Impact Themes, Fund Selection, Governance & Risk Management

The increasingly acute recognition among institutional investors that traditional portfolio theory does not capture the systemic risks in investment portfolios, coupled with the desire to understand the overall impact of investments, is driving investors to seek strategies based on environmental, social and governance (ESG) factors. Additionally, the proliferation of stewardship codes across the world have raised corporate governance expectations and led to pressure on investors to adopt ESG frameworks.

Institutional investors — also known as limited partners in private equity funds, or LPs — are increasingly seeking ESG strategies, as they are becoming more relevant in their portfolios, said Sid Vittal, senior infrastructure specialist at investment consultant Mercer, at a recent CleanTechIQ forum.

The forum brought together experts to discuss ESG integration in private market investments. Institutional investors, fund selectors, private equity fund managers (also known as general partners or GPs) and investment consultant speakers discussed high-priority investment themes, frameworks for disclosure, LP due diligence and engagement around the growth of ESG integration in private market investments.

Panelists across the board cautioned that investors are unwilling to sacrifice financial returns to gain ESG criteria in their investments.

At APG Asset Management, a subsidiary of Dutch pension fund ABP that manages $450 billion on behalf of European pensions, there is a growing desire among its LP clients to invest in themes outlined in the UN’s Sustainable Development Goals (SDG) agenda. This takes LPs into private investments that are deemed – and themed – as socially conscious, including opportunities rooted in healthcare, poverty alleviation and education. Still, institutional investors are holding the same risk/return standards across all their investments, said APG senior portfolio manager Megan Bethke.

Private equity fund managers acknowledge shared concerns around being able to find suitable investments and generate strong financial returns for social-themed institutional mandates, said Akhil Unni, a partner who overseas private market investments at GCM Grosvenor. GCM manages $45 billion in private markets on behalf of institutional investors, including selecting funds, co-investing and direct investments.

While the firm has a focus on ESG and seeks minority-owned GPs, its social mandates typically focus on specific themes and geographies that utilize state-sponsored programs. These restrictions often make finding opportunities more challenging, and can result in lower capital deployment due to fewer types of investments available to meet social mandates, Unni said.

Still, private equity GPs have begun advising LPs that ESG integration can create value in their portfolios, explained Damien Mitchell, a partner at private market investment specialist StepStone. This represents a change, as private equity managers previously viewed ESG integration mainly as a way to mitigate risk. StepStone oversees $120 billion in private market investments, including direct investments and funds of funds.

In addition, leading consultants believe that a strong ESG policy can be a competitive advantage for asset managers.

Kristine Pelletier, senior consultant at investment consultancy NEPC, said the firm incorporates ESG analysis into their fund due diligence process. If they identify a fund manager that has a compelling ESG integration process, they believe it can be an advantage in generating financial returns which will then be highlighted for their institutional investor clients, she said.

She cautioned, however, that it is still too early to gauge the long-term financial performance of ESG in private market strategies; GPs have only really been articulating their ESG policies over the past few years, Pelletier said.

Strong ESG Themes in Demand by LPs

Interest around infrastructure is currently growing. As infrastruture investing becomes even more popular, GPs need to have ESG policies and procedures in place and communicate them clearly to their LPs, said StepStone’s Mitchell.

“What we talk about now is how GPs communicate policies and procedures and how they are monitored,” he added.

Implementing ESG principles into infrastructure investments is critical because of the long-term consequences of those projects on communities, said Mercer’s Vittal. And since infrastructure is a “relatively young asset class,” he said, there’s greater opportunity for GPs to shape the discussion around ESG integration.

In addition to infrastructure, greater awareness of climate-related risks in LP investment portfolios is driving the issue to the forefront of conversations about ESG. Fund managers say they are seeing strong LP demand for specific environmental strategies, as well as a growing push to exclude investments rooted in fossil fuels from portfolios.

Social issues are also becoming increasingly important to LPs, particularly the issues highlighted in the UN’s Sustainable Development Goals.

Social themes incorporated into private market investing include health and safety, supply chain issues, anti-corruption, diversity, labor conditions and human rights. LPs are also interested in investments that focus on social and technological improvements for people in economically challenged and developing regions, panelists said.

Job creation is another strong social theme with incredible enthusiasm and momentum in private markets investing.

ESG Disclosure and Monitoring

Investor vigilance when it comes to monitoring ESG disclosure and investments has been significant. Several LP panelists said that upfront due diligence on a fund manager’s policies and procedures around ESG – including how it communicates with its LPs – is a very important consideration even before they make a commitment to a GP.

Accordingly, LPs are increasingly requiring GPs they are evaluating to complete extensive due diligence questionnaires (DDQs) with ESG considerations for their review. These questionnaires are often modeled around the United Nations’ Principles for Responsible Investment private equity questionnaire, which the agency developed for LPs in 2015.

Some LPs are also adding requirements around diversity and climate change to the DDQs. Additionally, being a signatory of the UN’s PRI is a minimum requirement for GPs to be considered for ESG mandates issued by institutional investors, panelists said.

GPs are also being required to provide disclosure on key performance indicators around their ESG processes. At the same time, there is not yet a clear and accepted set of ESG disclosure standards from the private equity community.

“We want to see some kind of systematic approach to provide information to LPs, on a quarterly or annual basis, on how they monitor the portfolio, as well as how they consider aspects of ESG in their investment strategy,” said Lars Pace, a principal at $356 billion fund of funds manager Hamilton Lane, which focuses on infrastructure, energy and real assets.

APG’s Bethke added: “It is important to see progress on those [key performance indicators] over time and to verify that the GP continues to be managed in accordance with its ESG practices.”

Materiality, however, remains important. NEPC’s Pelletier emphasizes that fund managers must define what is material to report on, and that the GP should only focus on providing data on material issues related to its investment strategy.

Furthermore, engagement by GPs with their portfolio companies remains important to LPs. Once an investment is made, GPs are expected to engage with their investors, particularly when it comes to identifying and communicating ESG issues in their portfolios, panelists said.

“If there are concerns that arise in the portfolio, we do full due diligence with the fund manager to understand the issues and how to resolve them and then will report back to our [LP] clients,” said StepStone’s Mitchell. “For our clients, the most important thing we can do is to be engaged in conversation and knowledgeable about the issues.”

Perhaps a testament of that commitment is shown by a recent trend in which LPs with strong ESG commitments are increasingly seeking board seats of private companies.

That’s because LPs want to participate and not just invest, said GCM’s Unni. Being on a corporate board of directors is where the “rubber meets the road” in relation to engagement on ESG issues.

 Our Top 5 Forum Takeaways In Brief:

1. ESG is being applied across private equity and infrastructure sectors and is seen as a way to both manage risk and generate financial returns.
2. Climate change is a key priority for LPs to address risk in their portfolios.
3. There is a growing interest in socially-conscious investment activity driven by the UN’s SDGs, and a focus on job creation in cities struggling with unemployment.
4. GPs need a process for monitoring investments and engaging with portfolio companies around ESG issues. There is also an even greater need for disclosure standards and benchmarking in the private markets.  
5. Fund managers should focus on providing data on material ESG issues related to their investment strategy, rather than taking a cookie cutter approach.