ESG Investing: Will Private Equity Firms Refocus on Stakeholder Value?

By Arun Maganti

ESG (Environmental, Social, and Governance) investing has become much more prevalent as of late. Private equity firms, which have often been portrayed in a negative light due to aggressive leveraged buyouts and “vulture capitalism,” have recently been pushing for ethical investments. But is ESG investing genuine? Or is it instead an attempt to improve brand image during a period of increased public scrutiny?

What is ESG?

At a broad level, ESG investing requires that investors consider the implications of their investments from a sustainability and societal impact perspective. Traditionally, financial return was the primary objective pursued by private equity firms. Even though financial return remains important, investors are also beginning to consider societal impact when evaluating their investment. To do so, these investors are excluding investments in certain geographies, industries, and companies while assisting their portfolio companies with ESG practices. Examples of evaluating societal impact may involve examining a company’s waste management standards, the diversity of its board, use of responsible marketing practices and conformance to human rights.

Many private equity firms have begun considering ESG impact in their investment process. Indeed, both KKR and TPG have adopted principles set by the International Finance Committee (IFC), which requires that the firms’ investments be assessed by independent auditors in terms of ESG compliance. The IFC’s principles are useful because they establish a standard framework for considering ESG impact. Ken Mehlman, the Co-Head of KKR Global Impact, justified his firm joining the IFC’s Operating Principles for Impact Investing though the following statement:

“The IFC has been leading impact investors for many years and we look forward to learning from their thinking, as well as from other stakeholders who are committed to investing for positive and shared value.”

The use of stakeholder is particularly interesting because it includes all parties affected by KKR’s investments, rather than merely its shareholders.

Below is a graph displaying the most common sectors in which ESG-conscious investors participate. Note the prevalence of areas such as microfinance and water sanitation, both of which are strongly associated with human development and sustainability.

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Included below is a chart produced by PwC that demonstrates that private equity investors are increasingly incorporating an ESG framework in their investment process.

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Why ESG?

Why have private equity firms begun to consider ESG issues in recent years? One major reason involves poor public perception of the industry after the financial crisis, which is exacerbated by notorious incidents such as the Abraaj scandal. Private equity firms and other financial institutions have been subject to heightened criticism by politicians for neglecting social impact assessments and considering ESG is perhaps a means for these firms to self-regulate with the intention of shielding themselves from further government regulation. Another factor involves the rising awareness of ESG issues among limited partners; the largest pension fund in the world, Japan’s Government Pension Investment Fund, began in 2017 to require that fund managers consider the ESG implications of their investments. A 2019 survey by Bain found that 60% of private equity general partners in the Asia-Pacific region feel increased pressure from limited partners to focus on ESG.

ESG examples

A prominent example of a social and environmental impact fund is TPG’s Rise Fund. TPG describes the fund as follows:

The Rise Fund invests in companies driving measurable social and environmental impact alongside business performance and strong returns. With $4 billion under management, The Rise Fund Platform works with growth-stage, high potential, mission-driven companies that have the power to change the world.

Looking at the fund’s investments, there is a distinct focus on economic development and sustainability. For example, the fund invests in DreamBox, which seeks to leverage technology to increase the accessibility of education in North America. Another firm in its portfolio is Fourth Partner Energy, which finances and develops renewable energy in India.

Leapfrog Investments is another example of a private equity fund focused on ESG practices. Having signed the IFC’s Operating Principles for Impact Investing, Leapfrog focuses on the financial services and healthcare sectors within emerging markets. One of its past portfolio companies, BIMA, provides insurance using mobile technology; the fund successfully exited this investment by selling its stake to Allianz for nearly $100 million. Although it is too early gauge Leapfrog’s success, its first and second funds have raised $135 million and $400 million, respectively and its portfolio companies have witnessed revenues increasing by 40% per year on average since investment.

Can ESG investors generate returns?

A significant question that arises is whether or not private equity firms can continue to generate strong returns while conforming with ESG standards. One perspective holds the position that ESG objectives limit returns since there would be a smaller pool of investments that funds could make. However, in an extensive study performed in 2015, researchers at the University of Hamburg and the DWS Research Institute found that 63% of studies demonstrated a strong correlation between conformity with ESG goals and positive financial returns. Why might this be case? Portfolio companies that promote ESG may appeal more strongly to key groups such as millennials, especially in industries such as retail. Another benefit of incorporating ESG practices is improving a firm’s reputation in the eyes of limited partners.

ESG investing has become a significant force in private equity and all signs indicate that this trend will persist. Indeed, investors must now consider social return alongside risk-return considerations. As the environmental and social implications of investments play a larger role in the decision-making process, the private equity industry will continue to evolve accordingly. Although the outlook for ESG remains bright in the near future, its success will determine whether it will become a permanent component of the investment process.

 

Editor: Eric Peghini

Author: Arun Maganti