This article is sponsored by Crowe LLP.
Why does a highly developed ESG strategy make good business sense for PE managers? What are the main drivers of progress?
ESG as an acronym for environment, social and governance is a relatively new term, but many of the underlying themes and issues have been around a long time. We have seen an increase in reporting over the last decade and a tidal wave of focus on ESG in recent years.
It is important to understand the real drivers and goals for your business, which should be based on the needs of your key stakeholders. In private equity, you need to ask whose voices really matter and what is important to them.
Investors are a critical stakeholder, and the largest institutional LPs are vocal about their expectations around ESG, whether that is the way you are interacting with the environment and managing emissions, addressing diversity and inclusion initiatives, engaging with suppliers or governing to protect data privacy and prevent fraud. All of these and other topics are increasingly important, and you have to be ready to discuss your strategy with investors because you can be sure that your competitors are when they are fundraising.
Regulators are very active globally, proposing new ESG disclosure requirements around climate risk, anti-human trafficking and supply chain due diligence. ESG reporting is migrating from selective and voluntary narratives towards data-driven, audited mandates. Don’t forget other key stakeholder groups, including your customers, employees and even your competitors and activist groups. Your approach to ESG should consider their important voices to ensure you have a comprehensive strategy.
How can PE firms better navigate rapidly evolving ESG frameworks, standards and requirements?
Depending on your resources, you’ll need some of your team to dedicate time to monitoring the evolving regulatory landscape and the various standards. Ideally, a cross-functional team with an eye on fundraising, legal and regulatory compliance, human resources, and IT can coordinate regularly to ensure you’re meeting your goals.
ESG standards and frameworks provide valuable insights and structure for data gathering and reporting. There are many commonly referenced sets, and these are converging to provide more clarity and international consistency for reporting. It’s important to understand the different objectives of the standards so you can extract the most value. For example, the SASB standards are divided by industry and focus on the topics most important to investors. GRI offers a framework for reporting to additional stakeholder groups. TCFD and GHG protocols focus on climate risk and carbon emissions calculations. There are newer offerings, like Initiative Climat International’s report on Greenhouse Gas Accounting and Reporting for the Private Equity Sector, that focus on more specific guidance.
Leverage the updates and repositories that law firms, accountants, and consultants provide to facilitate your education and awareness.
We see PE firms embedding ESG into their processes, from due diligence through to value creation and exit. Adding ESG metrics and topics to your due diligence process is an efficient way to leverage the operational and financial data you’re already gathering to facilitate a broader understanding of ESG risks in target companies. While ESG efforts may require additional investment, there are also opportunities created from the data you capture. Focusing on GHG emissions can yield energy efficiency, circularity assessments may reduce water usage or packaging costs, and better risk management overall could lower insurance premiums, for example.
What are the top regulatory developments in ESG for managers? What is the SEC focusing on?
The SEC’s proposed climate rule is the most significant current development. We are in the comment period now and should have more clarity later this year. It’s important to note the SEC’s view that all information around ESG is material to investors. This will put much greater focus on ESG-related commitments and disclosures.
How can managers prepare to report on ESG practices? What should they prioritize around disclosure?
Once you have a cross-functional team in place, the next step is performing your initial materiality assessment and stakeholder engagement. You can also consult the SASB and GRI standards for help mapping out disclosure topics and KPIs that are relevant to your industry. When you have a good grasp of those, your team should identify the data you will need. Some of it may be already available from your existing reporting systems. You may need time to identify, collect and validate other data streams. Leverage your accounting, finance, HR, and IT professionals to ensure you capture reliable and verifiable data.
As you prepare for disclosures, keep in mind the stakeholders who will use this information – regulators, investors, customers, employees – to ensure you are presenting all the right facts. Also consider whether you have already, or plan to make any specific commitments such as signing on to the UN Principles for Responsible Investment or similar, as that may impact your planning.
How does ESG reporting fit in with financial reporting, and how might that evolve?
Financial reporting and sustainability disclosures, while previously separate, are most certainly converging. Over time, more ESG information has made its way into financial disclosures, and proposed new regulations will continue that integration.
There is a lot of structure built around financial reporting that can be leveraged for ESG disclosures, including data validation, internal controls, management oversight and third-party assurance. At this point, education is key in helping board members and managers build their new vocabulary of rules, standards and processes in the ESG space.
What would you describe as the key ESG trends for private equity firms to watch in the second half of 2022?
For US-based private equity firms, the SEC’s climate rule is a major development that may drive new obligations. We see clients investing in building out their capabilities in anticipation of increased requirements from regulators and investors. The global supply chain is under increased scrutiny, with a litany of responsible sourcing regulations in various geographies. Concerns about forced labor have been highlighted by the recent Xinjiang product ban. OFAC sanctions emerged once again due to the conflict in Ukraine.
There are also constant efforts to be made on diversity and inclusion at every level, from the board of directors to management, employees, and even your suppliers and vendors.
ESG is moving from voluntary and selective to mandatory and inclusive. Narratives will be supported by verifiable data while risks and opportunities will be explored and disclosed. Now is the time to pull your team together and leverage your resources to ensure you have an achievable plan to meet all the needs of your stakeholders.