How do you apply ESG to a portfolio without assets? That is a dilemma that investors in private equity face. We speak to LGT Capital Partners’ Tycho Sneyers about the key aspects of ESG implementation in private equity.
Much has been said about the increasing importance of data in investment management and one clear area that has benefited from this is environmental, social and corporate governance (ESG) analysis.
Whereas only a few years ago institutional investors would perhaps have one or two analysts looking at this space, more or less in isolation, today there are many big-name suppliers of ESG data, including MSCI and S&P, that feed right into investors’ risk management systems.
Investors can then match this data against their portfolio holdings and almost instantly get a sense of their carbon exposure, the gender diversity in the companies or any supply-chain issues.
But what if the portfolio that you’ve committed to doesn’t hold any assets?
That is the problem private equity investors face.
“In private equity you start with a blind pool so you have an empty private equity fund that is raising capital,” Tycho Sneyers, a Managing Partner at LGT Capital Partners and board member of the Principles for Responsible Investment, says in an interview with [i3] Insights.
“At that moment in time, you can’t look at specific underlying assets and analyse them and come up with an ESG assessment. Obviously you don’t have that much to analyse so you really have to understand the policy and the intentions of the manager very clearly.”
In private equity you start with a blind pool so you have an empty private equity fund that is raising capital. At that moment in time, you can’t look at specific underlying assets and analyse them and come up with an ESG assessment. Obviously you don't have that much to analyse so you really have to understand the policy and the intentions of the manager very clearly
It is possible to get some sense of how a manager looks at ESG issues by analysing its previous vintages, but this only gives a limited view on its current practices, Sneyers says.
“Many funds have a three to four-year fund cycle, but the world can be very different from an ESG perspective every three or four years. So the past is not always a good predictor of the future,” he says.
“People have made investments three or four years ago that from an ESG perspective they wouldn’t do today, just because there is a much higher level of sensitivity and data availability.”
LGT Capital Partners is a long-standing investor in private equity and has mapped out its own method of assessing ESG practices of the managers and companies it invests in.
“What we do, when we look at a manager who has already implemented an ESG policy previously, is really look at the work they do, look through the files and literally take the books off the shelf and, for example, look at how they incorporate ESG in their 100-day value-creation plans,” Sneyers says.
“We also look at how they incorporate ESG on an ongoing basis in board agendas and how they incorporate it in setting objectives for the management teams. These are all very concrete elements where we want to see clear documentation as proof that they incorporate ESG within their activities.
“So from that perspective, it is quite different from public markets, where you tend to just get data feeds from data providers as a first base and then maybe have a discussion with the management team, or maybe you do your own desk research in terms of how the company is or isn’t sustainable.
“But these data streams that you can buy on publicly listed companies unfortunately are not available for private equity.”
Although ESG considerations are perhaps not as straightforward to analyse in private equity as they are in listed markets, there are a number of features of the asset class that make it particularly suitable for ESG-orientated investments.
Firstly, private equity investors have far greater control over the companies they invest in than in listed markets, Sneyers says.
“As an outright majority shareholder, or at least having a very significant influence on the board … in public markets you would never see a single shareholder have such an influence. So this control element is really important because [managers] can obviously drive an agenda of change that includes ESG and sustainability to an extent that is not possible in public markets,” he says.
“The second element is that in order to effect these changes you need time and private equity is far more patient capital than public markets. This patience is partly related to the fact that most investors in private equity are institutional investors with long time horizons, including pension funds.”
Carbon Footprint
If we delve deeper into the assets that are generally held in private equity portfolios, it becomes clear most portfolios tend to be less carbon intensive than broad public market portfolios as they skew away from the most carbon-intensive industries, such as energy and utilities, while having a greater exposure to lower-carbon sectors, including technology and healthcare.
“The carbon footprint of your private equity portfolio is much lower and that is just because in a listed portfolio the carbon footprint is very much driven by a small number of industries, such as utilities, or oil and gas, which private equity basically avoids. They don’t invest in these industries, so the private equity footprint is very different,” Sneyers says.
He argues this is not a new phenomenon as it was already noticeable before the Paris Agreement, which forms the basis for the 2050 net-zero commitment, came into force.
“This pre-dates the Paris Agreement. Private equity just tends to invest in growth. It has been investing a lot in technology, service industries, healthcare and financial services. These are industries that don’t really have a carbon footprint or at least not a very large carbon footprint,” he says.
SDGs
The United Nations-endorsed sustainable development goals (SDG) form a more recent framework to test investments against, but are increasingly adopted by investors as part of a broader ESG policy.
To get a better picture of institutional investors’ views on the SDGs, LGT Capital Partners conducted research among 207 investors from 28 countries who have invested in alternative assets, including private equity, real estate, private debt, infrastructure and hedge funds.
Despite the fact the SDGs were not necessarily intended to address investment issues, LGT Capital Partners found that these investors were very positive on the ability of these goals to help address environmental and social issues.
“We were very surprised that close to 90 per cent said the SDGs will help the financial industry to really address pressing ESG issues that society faces. So I think there is in general a very positive view towards the SDGs that help investors measure more specific outcomes,” Sneyers says.
“Also, 80 per cent believe the goals will create new investment opportunities. So there is a very positive view towards incorporating the SDGs in everything people do.
We were very surprised that close to 90 per cent said the SDGs will help the financial industry to really address pressing ESG issues that society faces. So I think there is in general a very positive view towards the SDGs that help investors measure more specific outcomes
“But on the other hand, there hasn’t been much concrete action and investors often have difficulties incorporating the SDGs in their investment analyses and activities. So it is a bit of a mixed picture.”
But what has become clear is that both the SDGs and Paris Agreement in combination have brought clarity to the question of what ESG policies try to achieve.
“In the last couple of years, the SDGs and the Paris Agreement have become the two main outcome frameworks that people use in their investment analyses. Before 2015, there wasn’t any agreement as to what outcomes we should achieve and that makes it very hard for the investment industry to focus their efforts,” Sneyers says.
“I think especially the SDGs have become the main framework that people use to think through outcomes and their investments, and I think that’s also because it is the only universally agreed upon framework.”
The research also found those investors who had implemented ESG metrics for longer were generally more optimistic about the impact on investment returns. Of those investors with seven years or more of ESG experience, 62 per cent are convinced ESG analysis increases risk-adjusted returns, while only 32 per cent of those who are new to ESG (up to one year) think the same.
Asked whether this result was perhaps skewed by a survivor bias – where those who previously implemented ESG issues but thought it detracted from returns might have stopped doing so – Sneyers answers that this is unlikely to be the case.
“Honestly, I am yet to meet a single investor who started ESG and then stopped. It would be a very hard argument to make to their trustees, their board or whomever from a governance perspective they report to,” he says.
“I think it is just a matter that you need time to see it working. Besides, the people who have been doing ESG for the last 10 years, they might only have been focusing on outcomes for the last five years of that.
“So I probably wouldn’t call it a survivor bias, but maybe there is a participation bias. Obviously we cannot force people who don’t like ESG to participate in our survey, so you have a natural selection bias, where the people who participate in our questionnaire are probably interested in ESG.”
Divesting
The SDGs is largely a framework of aspirations, a description of an ideal world that most people would like to live in. As such, these goals are related to not just the problems at hand, but also the opportunities that might arise from solving them.
But on the flip side, there is the world investors are looking to move away from, which inevitably leads to questions around divestments.
Sneyers points out that, again, the rules apply differently to private equity than to listed markets.
“We don’t have the luxury of divestment; we only have the luxury of not investing. We have the luxury of engaging, but divesting might be technically possible, but it gets very difficult and very expensive, so in practice divesting is hardly an option,” he says.
We don't have the luxury of divestment; we only have the luxury of not investing. We have the luxury of engaging, but divesting might be technically possible, but it gets very difficult and very expensive, so in practice divesting is hardly an option
“For us, it is really all about working with the right private equity managers and engaging with them when something goes wrong.”
Besides, he argues, selling out of a problematic company does not solve the problem. It just transfers it to someone else.
“The theory of change is that not much changes by just getting rid of something bad. But if you can turn something bad into something good, then there is a very clear change,” he says.
“That is also why from a conceptual perspective, we don’t necessarily have an issue with one of our managers, or ourselves, buying an asset that has substantial ESG issues, so long as there is a plan to address these issues.
“From a societal perspective, that is obviously the most positive outcome, because buying something good and keeping something good … again there is no real benefit to society.
“But if you buy something that has ESG issues and you basically turn that into an asset that does well on ESG, that’s where you have the biggest societal impact.”
This article is sponsored by LGT Capital Partners. As such, the sponsor may suggest topics for consideration, but the Investment Innovation Institute [i3] will have final control over the content.
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[i3] Insights is the official educational bulletin of the Investment Innovation Institute [i3]. It covers major trends and innovations in institutional investing, providing independent and thought-provoking content about pension funds, insurance companies and sovereign wealth funds across the globe.