ESG AND PRIVATE EQUITY: UNDERSTANDING THE CURRENT STATE OF AFFAIRS

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Madeleine Campbell
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1 ESG AND PRIVATE EQUITY: UNDERSTANDING THE CURRENT STATE OF AFFAIRS

2 ESG MOVING OUT OF THE COMPLIANCE ROOM AND INTO THE HEART OF THE INVESTMENT PROCESS Ioannis Ioannou, Assistant Professor of Strategy and Entrepreneurship, London Business School Francesca Cornelli, Professor of Finance and Director of the Coller Institute of Private Equity, London Business School Thomas Zhang, London Business School

3 An Ambitious Academic Project A research agenda for ESG in PE Whereas a lot of rigorous academic research explores the integration of ESG factors in public equity markets (e.g. corporates and SRI funds), essentially no such work exists exploring the integration of ESG issues in the private equity industry. Accordingly, we would like to rigorously examine and gain a nuanced understanding of the emerging role of ESG, and the implications of integrating such issues in the PE process. Specifically, we would like to explore issues such as a) the extent of value creation through the integration and monitoring of ESG issues at the deal level, b) the mechanisms through which ESG policies and KPIs may generate value (and at which stages of the investment process) and c) how potentially different ways of integrating ESG issues may have differential value-creation implications across PE firms and/or deals. Phase 1: this survey and the resulting report. Phase 2: an academic study. 3

4 Project Scope The focus of phase 1 We first conducted a series of structured interviews through several open-ended questions with multiple GPs, to ensure the relevance, validity and timeliness of the questions we asked and the comprehensiveness of the survey as a whole. Our first objective was to move beyond a simple description of the survey results, but rather, to develop a consistent big-picture narrative based on the synthesis of responses across the survey questions and towards understanding ESG integration in the PE industry. Our second objective was to link our findings to the broader academic literature that explores ESG and the capital allocation process, as well as to interpret our findings through a theoretical academic lens. 4

5 Project Scope The focus of phase 1 Our goal was to explore crucial aspects of the ESG integration process in the PE industry. To what extent is the private equity industry facing current (or expecting future) pressures to integrate ESG factors, and where do such pressures come from? What are the most important barriers to the integration of ESG factors and what are the reasons why some firms do not integrate ESG at all? How is the integration of ESG factors structurally embedded across private equity firms in terms of the level of authority, responsibility, monitoring and accountability? How sophisticated is the current state of ESG integration and implementation in terms of the array of existing policies, the stage of investment cycle at which ESG issues are considered, and the extent to which ESG data is being monitored, gathered and reported? 5

6 High-Level Sample Profile 42 private equity firms. 33 provided AUM data. 13 respondents 11 respondents 9 respondents 6

7 Geographic Distribution A representative sample in terms of firm size and distribution of geographic focus 7

8 Investment Focus A representative cross-section of investment focus across sectors 8

9 Current Pressures for ESG Integration All firms, large ones especially, are currently facing pressures from investors to integrate ESG 9

10 Future Pressures for ESG Integration However, future pressures are expected from government and regulators, not by investors 10

11 Barriers to ESG Adoption and Implementation Difficulty in collecting ESG data and its idiosyncratic nature are the main barriers to adoption 11

12 Lack of Uniform Adherence to ESG Policies ESG policies are mainly implemented through Guidelines rather than Rules 12

13 Types of ESG Policies by Geography Increasingly ESG policies are becoming ESG+E; incorporation of Ethics in evaluation processes 13

14 Integration of ESG Policies by Geography ESG policies are mostly internal; less likely to be included in LP or portfolio company contracts 14

15 Internal Accountability for ESG Policies Internal accountability for ESG now resides at the top of the hierarchy: the Board and the C-suite 15

16 Responsibility for Implementing ESG Policies ESG is moving into the heart of the investment process: Implementation by investment personnel 16

17 Stage of ESG Policies Implementation ESG is considered at Origination and Ownership. No longer viewed as window dressing at Exit 17

18 Systematic ESG Data Collection The systematic collection of ESG data is consistent across all phases of the investment process 18

19 Reporting of the Collected ESG Data ESG Data is used for internal purposes and disclosed mainly to LPs and the Board 19

20 Risk Mitigation vs. Value Creation through ESG Policies For the largest firms risk mitigation and value creation are at par for all ESG dimensions! 20

21 Conclusion We document an intriguing heterogeneity across private equity firms, in terms of the processes of ESG integration into investment decision-making. A heterogeneity that may arguably have important implications for any given firm s ability to realize value at portfolio companies through the active management of ESG issues as strategic opportunities for value creation. The findings indicate that ESG integration far from being a peripheral consideration emerges as a core value-creation strategy for private equity funds in portfolio companies. The emphasis and coherent implementation of ESG policy as a core private equity valuecreation strategy is particularly prominent in the largest of the private equity firms, where investor pressure is currently reported to be most acute. 21

22 Project Scope The focus of phase 2 Our goal in the next phase of the project is the rigorous investigation of the ESG integration process and its implications for value creation. Specifically, we would like to explore issues such as a) the extent of value creation through the integration and monitoring of ESG issues at the deal level, b) the mechanisms through which ESG policies and KPIs may generate value (and at which stages of the investment process) and c) how potentially different ways of integrating ESG issues may have differential value-creation implications across PE firms. Accordingly, we would be delighted to invite interested GPs and LPs to discuss the next phase of the project with us and explore how firms could potentially contribute to the relevant data requirements for this phase of the project. 22

23 Thank You!

24 Appendix 24

25 Current Pressures By Geography 25

26 Future Pressures by Geography 26

27 Additional Uses of ESG Data ESG data often used for benchmarking performance targets and milestones of portfolio companies 27

28 ESG AND PRIVATE EQUITY: UNDERSTANDING THE CURRENT STATE OF AFFAIRS Panellists: Anne Arlinghaus, Principal, KKR Capstone Ioannis Ioannou, Assistant Professor of Strategy and Entrepreneurship, London Business School Graham McDonald, Head of Private Equity, Aberdeen Asset Management David Russell, Co-Head of Responsible Investment, USS Moderator: Sven Liden, CEO, Adveq

30 ESG AND PRIVATE EQUITY: UNDERSTANDING THE CURRENT STATE OF AFFAIRS

ADVEQ Applied Research Series

ADVEQ Applied Research Series ESG moving out of the Compliance Room and into the Heart of the Investment Process text Francesca Cornelli, Ioannis Ioannou and Thomas Zhang February 2015 www.collerinstitute.com