By Winna Brown, EY Americas
In a positive step for the private equity industry and for investors, the US Securities and Exchange Commission (SEC) has released proposed rules that would require public companies to provide information on climate-related risks, including greenhouse gas emissions, on financial statements and in annual reports.
Investors have acknowledged environmental, social and governance (ESG) matters as a competitive differentiator — from monitoring portfolio performance to investing in funds that focus on ESG principles. Indeed, the latter continued to soar in 2021. According to Bloomberg, global ESG assets are on track to exceed $53 trillion by 2025, representing more than a third of projected total assets under management, including funds managed by private equity firms as well as others.
ESG issues have been increasingly top of mind for many private equity (PE) firms, particularly with regard to environmental sustainability, and a number of firms are already using ESG to guide their investment decisions. The EY 2022 Global Private Equity Survey found that 39% of all private equity investors said they had invested in ESG-related products, up from 33% in 2021. The increase was even more pronounced among investors in smaller firms, those with assets of less than $2.5 billion, which rose from 7% in 2020 to 31% in 2021.
The survey also found that 42% of the largest PE fund managers say they consider ESG issues either seriously or very seriously when making investment decisions. In addition, 39% say they consider these issues seriously in certain risk areas. Yet in that same global survey, nearly half of the fund managers who responded said they were hesitant to launch ESG funds due to the concern that they may not provide the risk or return profiles that they believe investors are demanding.
Integrating ESG and financial measures for value creation
The lack of common standards for measuring ESG progress may be one factor inhibiting fund managers from offering ESG funds, as well as limiting their ability to effectively evaluate investment performance for both ESG and financial results. Research from FCLT Global — a nonprofit focusing on long-term value creation research and tools — shows that there are over 600 ESG frameworks that companies use to report nonfinancial performance and demonstrate long-term value creation.
Private equity fund managers and institutional investors have sought for years to establish a standard reporting format for ESG metrics that they can use to compare companies and track progress over time, and the proposed SEC guidance is a reaction to this market demand. Disclosing details on ESG issues helps the firms and institutions decide where to invest and also informs how shareholders should vote on board appointments and executive pay during proxy season.
In the last few years, momentum has been building on efforts to increase transparency and establish common ground on ESG metrics. The EY organization has collaborated with the World Economic Forum’s International Business Council, the other Big Four firms and Bank of America to identify a set of common metrics for measuring ESG progress. This CEO-led initiative has over 150 companies formally supporting the industry-agnostic metrics. Specific to the private equity sector, over 100 limited partners and general partners are supportive of the ESG Data Convergence Project, a set of common ESG metrics for private equity to report across all its investments, launched in September 2021.
As we await further SEC guidance and additional progress on consistent frameworks, private equity firms should take this opportunity to strongly consider requiring portfolio companies to voluntarily report on key ESG topics. Doing so will meet investor demands today, as well as position companies to comply with new ESG reporting requirements.
We recommend three steps to get started:
- Perform a materiality assessment to identify ESG topics that are significant to your stakeholders and organization
- Choose the metrics and qualitative disclosures to measure and report on key issues
- Collect the appropriate data to measure and monitor performance
Moving toward more clarity on ESG progress
Whether or not an organization has a dedicated ESG fund, expectations are growing from limited partnerships (LPs) and broader stakeholders that ESG principles should be considered in a private equity firm’s investment decision-making.
Private equity can support portfolio companies by helping them address ESG risks and increasing transparency in this area. More fund managers are taking an active role in influencing the policies and decisions of their portfolio companies with respect to issues like diversity, equity and inclusion (DEI); climate risks, waste management and community engagement. This preparedness can have a positive impact on their valuations on exit and prepares companies for future mandated reporting. In fact, the latest EY PE divestment study found that nearly three-quarters of PE firms (72%) said they expect to capture an ESG premium from the businesses they’re selling.
Overall, the movement toward incorporating ESG when assessing investment performance is long overdue. Adopting common standards will result in consistent and comparable reporting across portfolios, allow firms to refine their sustainability narratives and demonstrate that they are being responsive to requests from their investor and broader stakeholder base regarding ESG principles.
Winna Brown is EY Americas financial accounting advisory services private equity leader