How ESG credentials can fuel fundraising

An understanding that responsible investing is essential to risk mitigation and value creation means ESG is playing a greater role in manager selection.

The private equity industry is facing some of the most challenging fundraising conditions in decades. Investors are both technically constrained in their ability to make fresh commitments due to the denominator effect, and highly cognizant of the turbulent markets that managers now need to navigate.

Selectivity is therefore paramount and limited partners are rigorously examining firms’ ability to replicate historical performance in a downturn. But what role will ESG credentials play in future decision-making? Sustainability has soared up the agenda in recent years. But will environmental, social and governance considerations become more important differentiators than ever in a cash-constrained environment, or will they lose significance as both LPs and GPs prioritize returns at any cost?

Early indications are that ESG remains a critical component of manager selection. “We are supporting our clients through some of the choppiest markets we’ve seen in quite some time, and we expect continued turbulence ahead,” says Chavon Sutton, a senior investment director in Cambridge Associates’ sustainable and impact investing team. “There will be greater selectivity – especially pronounced in private markets due to the so-called denominator effect, as investors manage around that and aim to simplify.

“Still, we believe ESG and diversity and inclusion are material to investment decisions, and we fully incorporate them into our due diligence process. Our rigor won’t change, as we continue to help our clients to maximize risk-adjusted returns in this market. ESG and DE&I are not carrots to dangle before investors, and we remain vigilant in our assessment of managers. The best managers will continue to rise to the top.”

Paula Langton, who co-heads Campbell Lutyens’ fund placement activities in Europe, as well as leading the firm’s sustainability practice, says that top ESG performers had a notably easier time in the fundraising market last year than those that have failed to stand out in this area. “Against the backdrop of a difficult fundraising market, it is no accident that the funds we have raised that have been oversubscribed or that have reached their hard-caps fastest, are either climate funds or what we call ESG++,” she says. “ESG++ refers to funds in all sectors that have market-leading tools and approaches to ESG.”

Langton cites Bregal as an example. “Bregal has a senior-level individual, who has been instrumental in setting up science-based targets for private equity, and has an industry-leading decarbonization strategy for the portfolio. Meanwhile, other groups that use consultants or mid-ranking individuals to lead on ESG have still managed to raise funds, but in some instances have found the process more challenging. What is important is that ESG is fully integrated into the investment process and that a senior person is involved to really help drive change.”

No compromise

Of course, many investors now fully embrace the idea that good ESG and good investment performance are mutually reinforcing. Over two-thirds of LPs in affiliate title Private Equity International’s LP Perspectives 2023 Study said they believe that a strong ESG policy leads to better long-term returns in private markets portfolios.

“It is well understood that ESG is a powerful source of risk mitigation and, in an uncertain environment, mitigating the risk profile of your investment is more important than ever,” says Nina Kraus, a principal in Hamilton Lane’s fund investment team. “So we are not seeing any let-up in the positive momentum that has been building behind ESG as a result of today’s macroeconomic conditions. If anything, quite the reverse.”

Indeed, Hamilton Lane has recently announced an increase in the weighting that it will attribute to ESG and DE&I factors. “Over the long-term, we believe the winners in the GP universe will be those that have invested heavily in these areas,” says Kraus. “That doesn’t mean that everyone needs to look perfect today, but if a GP is mitigating risk better than another GP we think that often leads to more attractive risk-adjusted returns.”

Meanwhile, investors have increasingly been viewing ESG through the lens of value creation as well. In a rising interest rate environment where GPs can no longer rely on financial engineering to guarantee performance, hands-on operational value-add, in all its forms, is a critical differentiator.

“Investors can either look at ESG through the lens of risk mitigation or value creation,” explains Joana Castro, a private equity partner at Unigestion. “As a house, we have been focusing on risk mitigation – in other words, not losing money as a result of ESG considerations – for a very long time, but a few years ago we shifted to the value-creation approach. As more and more LPs think about ESG in those terms, they will realize that managers that don’t fully integrate ESG will be leaving value on the table and that will inevitably impact their fundraising fortunes.”

Investor variables

The emphasis that is placed on ESG varies by investor, though pronounced regional differences also persist. As a generalization, European investors tend to prioritize environmental considerations, while those in the US are often more focused on social concerns. 

“In Europe and the UK, having a climate strategy and reporting is becoming part of a license to operate and meet regulatory requirements,” says Laure Villepelet, head of ESG at Tikehau Capital. “In the US, LPs seem to be more focused on developing DE&I strategy at a GP level.”

There are, however, some investors in the US that are being precluded from taking ESG considerations into account in their manager selection altogether, as a political backlash gathers pace in some Republican states. Texas and Florida are among a number of states that have taken steps to block state fund managers from investing in funds that make investment decisions based on ESG factors. Indeed, ESG is now firmly ensconced at the heart of US culture wars, with high-profile figures ranging from Elon Musk to Mike Pence weighing in on the merit of the ubiquitous acronym. 

But the backlash is isolated and the broader direction of travel appears clear. “Despite a recent wave of anti-ESG investigations by certain US states aiming to discourage net-zero commitments, we are seeing more and more LPs in the US choose to incorporate ESG policies into their portfolio construction and manager selection,” says Villepelet. 

And it appears that the US Securities and Exchange Commission remains set on shaking up disclosure requirements for funds promoting ESG in order to assist investors in their decision-making process. In a move that mirrors Europe’s Sustainable Finance Disclosure Regulation, the regulator is looking to eliminate the scourge of greenwashing. 

Due diligence

The confluence of regulatory evolution, data consistency initiatives and growing investor sophistication around ESG mean the ability to compare and contrast GPs’ ESG competency and performance is growing all the time. 

“Investors are dedicating more internal and external resources to ESG due diligence,” says Castro. “A large number of platforms have also emerged to help advise on ESG topics, and that is something that will continue to evolve. This enhanced sophistication is marked by a shift from qualitative assessment to quantitative analysis. You can’t improve what you don’t measure.”

“LPs and consultants are hiring dedicated ESG, responsible investment and DE&I individuals, and building out ESG teams of their own,” adds Villepelet. “We have meetings that are dedicated to ESG and impact, which raise complex questions and dynamic conversations, and generate a common interest in improving the measurement and reporting on ESG, impact and DE&I metrics.”

The ESG Data Convergence Initiative – of which the Institutional Limited Partners Association is now secretariat – is helping to streamline the key performance indicators that investors are seeking and the questions being asked. 

Hamilton Lane, meanwhile, has recently invested in a group called Novata, a public benefit corporation and technology platform that provides markets with ESG data management solutions.

“We have invested alongside the Ford Foundation, S&P Global and others, and we are really excited about where this is going to lead,” says Hamilton Lane’s Kraus. “Not only accessing data but leveraging that data to make better decisions is a rising priority among investors.”

Indeed, isolated political anomalies aside, it appears highly unlikely that the role that ESG plays in LP decision-making is going to wane as a result of the macroeconomic environment. A pervasive understanding that good ESG is essential for both risk mitigation and value creation, combined with the evolution of tools to help investors compare and contrast, mean ESG’s role in determining fundraising success is greater today than ever before.

Diversity and inclusion

While ESG is playing an ever-greater role in investor decision-making, the picture is less consistent when it comes to diversity, equity and inclusion. 

Ethan Samson, a managing principal who advises on private markets investments at Meketa Investment Group, strongly believes that there is a diversity premium. “Diversity is not just a nice-to-have, but can be important for generating alpha as well,” he says.

“Our due diligence questionnaire includes questions around gender, race and other forms of diversity. We can then benchmark that against the data we hold. Our general practice is to include a quartile ranking of the manager from a diversity perspective in our investment memos for clients.” 

However, while PEI’s LP Perspectives 2023 Study found that 40 percent of LPs have asked to avoid individual investments for ESG reasons, only 13 percent have declined fund investments because of DE&I concerns at a GP level. Campbell Lutyens’ Paula Langton says that while diversity is a hot topic, it is not the sole factor moving the needle on fundraising or yet currently serving as an exclusionary factor in the way that ESG does. 

“US investors place a lot of significance on these issues,” Langton adds. “In Europe, the focus is there, too. However, climate is further up the agenda. There are a number of dedicated pools of capital targeting diversity strategies, but it is a limited number to date.”