Private equity (PE) firms have been increasingly interested in pursuing environmental, social, and governance (ESG) strategies. A key part of any ESG-focused plan is careful reporting, or documenting progress and risks related to ESG goals (i.e., climate impact, diversity, and ethical governance). In fact, ESG reporting substantiates an organization’s commitment to ESG.

However, experts have long wondered whether ESG in PE is actually beneficial, or if it’s more of a marketing tool. 

Here at Allvue, we firmly believe in the promise of ESG for PE firms and the economy as a whole. Below, we’ll touch on five of the biggest benefits it has, both for the world at large and for enterprising investors and firms seeking out ROI and sustainable growth.

#1: Making positive impacts on the world

First and foremost, ESG reporting tracks ESG progress and measures companies’ actual impacts on the world around them. If the underlying purpose of ESG is to create a more sustainable, just, and soundly governed business environment, then ESG reporting quantifies those goals.

The most obvious (and measurable) immediate impacts are in the business world.

Specifically in PE, the uptick in ESG embrace has already created a more inclusive, equitable workforce. McKinsey’s investigation into the state of diversity in private markets indicates that women and people from minoritized racial/ethnic backgrounds are better represented in 2022–2023 than before. Investment committees are approaching population-wide demographics.

And the impacts of ESG and ESG reporting can also be seen beyond the corporate world.

For example, researchers found that ESG investments in China had significant positive impacts on environmental outcomes. Specifically, ESG investing was shown to reduce greenhouse gas (GHG) emissions across the country, both short- and long-term, and advance efforts toward meeting the goals of the 2021 United Nations Climate Change Conference (COP-26).

#2: Creating value across the portfolio

To turn to more conventional metrics most investors are likely concerned with, pursuing ESG initiatives and accurately reporting on ESG metrics is also a critical value driver across PE.

According to a recent PwC survey on the upside of ESG in PE, about half of all PEs considered ESG a value driver in some of their recent PE deals, and about a third say ESG is a driver in a majority of their recent deals. Value creation is the #1 driver for ESG investment in PE.

Among stakeholders surveyed, these are the top reasons ESG was seen as a value driver:

• ESG enhances a firm’s reputation and branding
• ESG expands the scope of risk mitigation (see below)
• ESG leads to greater competitive differentiation
• ESG helps to attract and retain quality clients

None of this would be possible without ESG reporting. Accurate recordkeeping and analysis of ESG goals and progress against them are the logistical and operational underpinnings of value.

Business benefits of socially conscious investment

Companies that make a concerted effort to improve diversity, equity, and inclusion (DEI) across their staff—including reporting and assessing along these metrics—often outperform other organizations that are not making similar efforts. Simply put: diversity is sound business.

For example, consider these direct business benefits of diversity highlighted by Forbes:

• Leadership in gender diversity is correlated with above-average profitability
• Ethnic diversity in executive teams makes businesses more likely to overperform
• Female representation in management leads to greater innovation revenue

As a corollary, investing in companies with strong DEI and overall ESG practices and/or prioritizing these programs as part of a post-acquisition turnaround will maximize returns.

The piece goes on to illustrate PE’s opportunity to maximize these benefits following PE firms’ resilience throughout the turbulence of 2020–2021 (relative to other industries). ESG reporting is the primary way to track and accelerate the progress that can come from ESG initiatives.

#3: Analyzing and mitigating risks

In addition to creating value outright, accurate ESG reporting also helps investors and firms retain value by preventing and mitigating risks. In-depth insights into the state of ESG practices across portfolio companies and prospective assets allow investors to see and avoid threats.

Some of the biggest factors, per a KPMG breakdown of ESG risk best practices, include:

• Reputational risks related to lacking or inaccurate ESG reporting
• Operational risks stemming from incomplete internal analyses
• Model risks belying misunderstandings about external factors
• Credit risks and miscalculations of fraud or default possibilities
• Liquidity risks from ESG friction with potential buyers or partners
• Market risks stemming from sector-specific ESG expectations
• Compliance risks across portfolio companies (see below)

As with value creation, ESG reporting is critical to ESG’s capacity for risk mitigation. Creating accurate metrics for risks like the ones above allows investors to retain the value ESG creates.

#4: Staying ahead of regulatory obligations

One of the major appeals of PE investing, overall, is that regulatory burdens are relatively lax when compared to publicly traded companies. Focusing exclusively on buying privately held companies, or bringing public companies private, means side-stepping many of the legal and fiduciary responsibilities that take priority over ESG and value-laden concerns in public firms.

But that doesn’t mean that ESG investing in the private market is devoid of regulations.

According to a PwC overview of ESG and sustainability reporting, one of the most important kinds of ESG reporting involves environmental impacts. Several EU regulations may apply to portfolio companies if they operate or have clientele in Europe. For example, the Corporate Sustainability Reporting Directive (CSRD) applies to select large companies based in the EU, along with companies that generate €150M on EU markets, irrespective of their location.

Accurate ESG reporting is necessary for meeting these and other compliance obligations.

Additionally, the impact of ESG reporting is not limited to regulations directly related to ESG initiatives. Stronger reporting, especially on governance, facilitates all regulatory compliance.

Breakdown of new rules impacting PE funding

In August of 2023, the Securities and Exchange Commission (SEC) adopted a new set of rules applicable to PE funds and advisors working with and for them. While these rules are not explicitly related to ESG, they do concern and require sound governance at a minimum.

Of the new mandates, the Quarterly Statement Rule will be among the most impactful. It requires PE fund advisers to disseminate formal notices to investors on a quarterly basis, covering everything from expenses and offsets (including calculations) and standardized information on liquidity (or illiquidity) going back as far as ten years or to fund inception.

Rules like these put an immense recordkeeping and reporting burden on PE funds, their partners, and the stakeholders that their investment decisions impact. But they also bring companies in line with ESG/governance outcomes for transparency in management.

ESG reporting makes meeting new and evolving requirements like these much easier.

Global regulations concerning ESG reporting in PE

As noted above, PE firms operating in the US need to be aware of both domestic and international regulations related to companies in their portfolios. There’s a global network of rules and regulations applicable to PE funds, many of which directly require ESG reporting.

For example, consider the following contexts for global ESG reporting:

• United Kingdom (UK) – Parliament rolled out Climate-Related Financial Disclosure Regulations in 2022, and there is ongoing discussion about further laws being passed.
• Singapore – The Monetary Authority of Singapore (MAS) has established ESG disclosure guidelines, emphasizing transparency, enforced by the Green Finance Industry Taskforce.
• Additional EU Rules – Beyond CSRD (see above), funds active in the EU are subject to the ESG requirements of the Alternative Investment Fund Manager Directive (AIFMD).

As PE firms expand and diversify portfolios and take advantage of the many advantages an interconnected global market has to offer, ESG reporting helps them stay compliant at scale.

#5: Keeping up with the (forward-thinking) Joneses

Finally, ESG reporting is beneficial for PE firms because, irrespective of what an individual’s perspective on ESG is, the industry as a whole is embracing it. If for no other reason, PE firms should be practicing ESG reporting to keep up with their peers who are thriving because of it.

Allvue conducted a comprehensive survey about ESG in the PE industry in 2022. Our results illustrated that ESG is here to stay, as a whopping 90% of general partners (GPs) agreed that incorporating ESG into their strategies would improve returns. In addition, 82% of GPs and 65% of limited partners (LPs) already had an ESG policy in place—figures that have likely risen since.

There’s no longer any question as to whether ESG investing and reporting are worthwhile.

These realities have led many experts to speculate on the central importance of ESG for PE success—EY even questioned whether PE firms can win deals without taking DEI seriously.

How data availability facilitates ESG reporting

Here at Allvue, we believe in the promise ESG investing has for both firms that engage in it and the world at large. And we know that ESG reporting is essential to reaping its benefits.

We’re also keenly aware of the challenges facing PE firms with respect to ESG reporting. Per the survey mentioned above, 51% of GPs and 40% of LPs indicated that their biggest challenges with ESG revolved around data (collection for GPs, analysis and aggregation for LPs).

That’s why our private equity software and platforms are dedicated to data availability. We provide software that allows GPs, LPs, and investment professionals unparalleled visibility and analysis across ESG metrics.

To see just how easy robust ESG reporting can be, request a demo today!

 

Sources: 

European Commission. Corporate sustainability reporting. https://finance.ec.europa.eu/capital-markets-union-and-financial-markets/company-reporting-and-auditing/company-reporting/corporate-sustainability-reporting_en

EY. Can PE win deals if it doesn’t deal with DEI? https://www.ey.com/en_us/private-equity/can-pe-win-deals-if-it-doesn-t-deal-with-dei

EY. ESG in private equity: marketing tool or value driver? https://www.ey.com/en_lu/private-equity/esg-in-private-equity–marketing-tool-or-value-driver-

Forbes. The Business Case For Tackling Diversity, And Private Equity’s Role. https://www.forbes.com/sites/forbestechcouncil/2022/07/22/the-business-case-for-tackling-diversity-and-private-equitys-role/?sh=26181ffa7705

KPMG. ESG Risk Practices. https://kpmg.com/us/en/articles/2023/esg-risk-practices.html

McKinsey & Co. The state of diversity in global private markets: 2023.  https://www.mckinsey.com/industries/private-equity-and-principal-investors/our-insights/the-state-of-diversity-in-global-private-markets-2023#/

PwC. ESG Reporting and Preparation of a Sustainability Report. https://www.pwc.com/sk/en/environmental-social-and-corporate-governance-esg/esg-reporting.html

PwC. Generating upside from ESG: Opportunities for private equity.  https://www.pwc.com/gx/en/services/sustainability/publications/private-equity-and-the-responsible-investment-survey.html

ScienceDirect. Role of ESG investments in achieving COP-26 targets.  https://www.sciencedirect.com/science/article/abs/pii/S0140988323002554