In part two of our ESG insight series, produced by Edelman’s EMEA ESG team, we’re focusing on the forces influencing ESG within private markets.

Are private markets a sanctuary for less ESG-friendly assets? There is certainly evidence of investor pressure, particularly within the energy sector, to separate and delist “dirty” assets from public markets – or keep them private for longer. This market trend does little to address prevailing environmental or social issues and, as Larry Fink argues, could potentially lead to the “largest capital-market arbitrage in our lifetimes”.

The intensifying focus on ESG within private markets indicates that they will no longer be viewed as a hiding place. In fact, I contend that there is a clear business imperative for private companies to ensure their ESG strategies and disclosures are in line with ‘best practice’ public issuers.

A principal reason for this is the rapid growth in responsible investment and ESG integration among private investors. Now, at least a third of global private capital assets are managed with ESG goals in mind, and 49% of private debt strategies are dedicated to ESG.

There is a strong argument to suggest that private equity can actually have a more positive role than most public institutional investors when it comes to governing the implementation of ESG practices in investee companies, given the majority ownership position they usually take. In addition, PE typically views investments and value creation on a longer time horizon compared to the often far too short-termist “quarter-on-quarter” view within public markets.

In the run up to the 2007 financial crisis, the private capital industry accounted for $2.2 trillion in assets under management. That figure has grown rapidly, by four to five times in the past 15 years. Consequentially, companies now tend to stay private for longer, as they can readily access capital without having to go public. These factors have given private markets investors more influence than ever before in the corporate world.

PE ramps up focus on ESG 

PwC’s Global Private Equity Responsible Investment Survey 65% of private equity respondents have developed a responsible investing or ESG policy (and tools to implement it) and 60% rank value creation as one of their top three drivers of responsible investing or ESG activity.
Preqin H1 Investor Outlook 72% of investors believe fund managers are adopting ESG policies because of pressure from existing and prospective Limited Partners (LPs), in line with previous years.
Mergermarket 2022 Global private equity outlook c.60% of North American respondents and 49% of EMEA respondents expect a significant increase in LP scrutiny of ESG reporting and deals over the next three years.

In tandem, a large proportion of private equity General Partners (GPs) appreciate that their ability to realise an investment, and exit successfully, requires their investee companies to have a sustainable, long-term ESG strategy in place. There is also an increasing expectation that GPs ensure the implementation of their ESG policies at the portfolio companies they invest in. An Edelman private equity survey in 2021 showed that 35% of LPs surveyed said that it is important that portfolio companies are held to the same ESG standards set out by the GP.

As a result, GPs are actively recruiting ESG experts and training internal teams on industry-specific frameworks, such as those produced by the Sustainability Accounting Standards Board (now named the Value Reporting Foundation).

There are other demands for better ESG information from private markets that are worth noting. Independent scrutiny over the ESG performance and practices of private companies is also on the rise. Data providers such as the ESG ratings agencies are beginning to look at private company ESG disclosure, applying their proprietary methodologies to result in a rating that will make private companies comparable to their listed counterparts. MSCI, for example, now tracks the carbon emissions of over 15,000 private companies.

These market forces are creating opportunities for private enterprises that have already committed to implementing an ESG strategy and publishing transparent ESG disclosure, particularly those seeking to raise capital (either debt or equity).

Private debt investors often hold the keys over whether private companies can invest in and develop their assets, or, for some, even remain a going concern. Incorporating ESG considerations into many of these financing decisions can have an impact on the cost of capital and affect whether certain projects receive funding on optimal terms. The growing trend of embedding sustainability metrics into loan or bond covenants adds significant weight to the financial implications associated with delivering on the asset’s stated ESG objectives or performance.

Of course, the business case for more transparent ESG disclosure comes with some challenges. Collating accurate ESG data for private assets remains a pervasive problem. Making matters more complicated, the current variation of voluntary disclosure standards adds to the difficulty with obtaining consistent ESG data across the market. While disclosing comprehensive ESG information remains a ‘choice’, there will always be a significant discrepancy when it comes to the accuracy and quality of private market data.

On this front, there have been growing calls for some form of standardisation and an upping of reporting requirements (more on this in our next Insight piece). We are already seeing encouraging steps on global frameworks. In the UK specifically, mandatory reporting against the Task Force for Climate-related Financial Disclosure (TCFD) for many private businesses came into effect as of 6 April 2022. There has also been strong momentum behind some industry-led moves to address the disclosure problem, such as the ESG Data Convergence Project.

As a final thought: many early-stage, innovative private enterprises are pioneering tomorrow’s solutions for the environment and society. Impact capital, a market which reached $2.3 trillion in 2020, is flowing towards these important ventures. While we must be careful to distinguish ‘impact’ from ‘ESG’, without supporting ESG data it is much more difficult for the stated impact to be measured. Therefore, there is a pressing need for these growth companies to be equipped with the ESG skills, tools and capabilities to improve the consistency and accuracy of their data.

The bottom line?

Private markets should not be viewed as a refuge for less ESG-friendly assets. In fact, there is a clear business imperative for private companies to commit to an ESG strategy and level of disclosure equivalent to public markets, in order to meet the needs of increasingly ESG-focused private investors and broader stakeholders.

Get in touch with the ESG team to find out more about ESG trends and how we can help you, or your clients.