ESG integration considerations for private market investors

Shouldn’t an investor’s primary objective be to maximize returns? Absolutely. But over what time period? And should short-term profits be prioritized over long-term sustainability? Pursuing short-term gains can cause some investors and portfolio companies to neglect the sometimes-costly actions required to ensure the long-term sustainability of a business. For example, if a company fails to invest in proper data privacy infrastructure and their customers’ data is leaked as a result, there are legal, regulatory, reputational and financial implications that can jeopardize that company’s enterprise value and operationality.

Over the past decade, Environmental, Social and Governance (ESG) investing has gained attention as investors increasingly acknowledge the materiality of risks beyond traditional accounting-based and financial analysis. And slowly, the desire to move away from short-term risk-return perspectives has trickled into the private markets. Increasingly, LP stakeholders are requesting LPs to incorporate sustainability into investment allocations, with many LPs then turning to GPs and requiring ESG integration in portfolio decisions.

When it comes to ESG investing in the private markets, the process can be less straightforward than evaluating ESG risks and management for public equities due to less widely available data. However, due to the long-term nature of private market investments and investor ability to influence the direction of a company, LPs and GPs may be well-positioned to shape and benefit from ESG policies. And increasingly, private market participants are integrating ESG factors into their investment process to optimize the risk-return characteristics of their portfolios as well as make better-informed decisions.

ESG integration in the private markets

In recent years, private market participants have increasingly incorporated ESG into their investment processes. According to our 2021 Annual Sustainable Investment Survey, 57% of LP respondents stated that they assess GP prospects’ ESG risk frameworks during fund manager due diligence. And unsurprisingly, 61% of GP respondents noted that they have implemented sustainable practices at the fund level, mirroring a rise in LP demand for the transparency and assessment of ESG risks.

However, ESG investing can take widely different forms depending on a specific investor’s ESG philosophy and risk tolerance. For example, some LPs might choose to only invest in green industries while others may invest in companies with high levels of unmanageable ESG risks, committed to the implementation of ESG improvements over the investment’s lifespan. And these different approaches to ESG investing results in a broad spectrum of ESG portfolios—a phenomenon detailed fully in our analyst note ESG, Impact and Greenwashing in PE and VC.

Additionally, there is nuance surrounding how ESG initiatives are executed in various private market asset classes. For example, private equity investors face unique challenges from VC investors in that they invest in more mature companies, requiring extensive due diligence, whereas VC investors can tackle ESG issues from a more formative state.

Here, we examine some general manners of integrating ESG considerations throughout the private market lifecycle from pre-investment to exit.

ESG integration considerations for LPs during fund manager selection

Before committing to a fund, LPs conduct thorough due diligence on GPs, evaluating factors like their performance history, legal terms and governance structure. Integrating ESG factors into this process provides LPs with insight on how ESG is factored into a GP’s due diligence and performance reporting along with any reputational risks they may face surrounding ESG issues when investing with varying GP prospects. By incorporating ESG-related questions into their due diligence questionnaires, LPs can identify GPs that meet their ESG obligations and make investment decisions aligned with their expectations and fiduciary duties.

Some questions LPs might consider include:

• Do ESG risks and opportunities affect the selection of your investments?
• How do you manage material ESG-related risks and opportunities during the holding period of your investments?
• Do you identify and monitor material ESG KPIs for your investments?
• Do you incorporate ESG factors into your exit strategy?

The Institutional Limited Partners Association, along with the UN’s Principles of Responsible Investment, have both released due diligence questionnaires with ESG sections that LPs can reference as a starting point for drafting questions geared towards illuminating ESG risk and exposure management in GPs’ investment processes.

Additionally, while GPs have discretion over investment decision-making, LPs can place some parameters around how their capital can be invested by negotiating fund terms. In terms of ESG, this can involve outlining ESG provisions either directly in the Limited Partner Agreement (LPA) or more commonly, in a side letter. Another resource LPs can leverage are GPs’ private placement memorandums (PPMs), which often disclose any of their responsible investment policies or strategic ESG initiatives.

ESG integration considerations for GPs during pre-investment due diligence

GPs can harness ESG integration during their pre-investment screening and due diligence to confirm prospect portfolio companies’ compliance with their fund’s policy, exclusion list (if applicable) and LPA requirements, identify key ESG risks and opportunities in potential investments and outline ESG action plans and reporting requirements.

Before investment, it’s helpful for GPs to identify any major red flags pertaining to ESG risks that could jeopardize the long-term sustainability of a portfolio company. Some high-level screening analysis GPs can consider during due diligence include:

• Is the target company or its parent company located in any high-risk geographies?
• Does the target company have a history of serious, repeated human rights abuses or labor violation issues?
• Does the target company have a history of repeatedly failing to meet regulatory compliance in their industry?

• Is there any evidence that the target company has a history of bribery or corruption?
• Has the target company experienced any product boycotts, employee walkouts, or other negative media coverage?

One of the ways GPs can gain insight into these ESG risks and how well they are currently being managed is to identify and request relevant ESG KPIs from prospect portfolio companies. These ESG KPIs can include employee turnover rates, diversity statistics, data privacy and security incident and audit data, litigation data, employee injury and illness rates, among others. Once all relevant ESG KPIs are identified, GPs can formalize reporting and monitoring processes of them to be executed during the holding period.

In addition to ESG KPIs, GPs can reference the ESG risk scores of comparable public companies when screening portfolio companies to better understand the risks they may be exposed to in pursuing varying investments. ESG scores offer a quantitative resource for understanding the degree to which a company’s economic value is at risk due to ESG factors and identifying financially material ESG risks and opportunities in different companies. However, there is no universal ESG scoring system, and there is a wide selection of ESG risk score providers, meaning different providers may have different ESG scores for the same company. PitchBook’s ESG risk score provider is industry-leader Sustainalytics. Their two-dimensional architecture to calculating ESG scores involves scoring companies on both ESG materiality and exposure.

There are also a couple of widely accepted ESG standards published by organizations such as the Global Reporting Initiative (GRI) and Sustainability Accounting Standards Board (SASB) that GPs can look to for guidance on material risks and important ESG metrics.

In general, by utilizing ESG integration in investment screening, fund managers can make more informed investment decisions based on both their own and potential portfolio companies’ capacity or willingness to address or capitalize on ESG risks and opportunities. Additionally, GPs can use their pre-investment ESG assessment to either forgo or reprice an investment.

ESG integration considerations during the holding period

ESG risk factors within a private market portfolio are affected by changes—positive or negative—to internal practices and operations within the fund’s portfolio companies. This makes it essential for GPs and LPs to regularly monitor ESG risks and opportunities throughout the investment lifecycle.

During the holding phase of their investments, LPs can monitor ESG performance in their investments to confirm that any commitments to responsible investment practices made during fundraising are being delivered and ensure that ESG risks are being managed. ESG reporting is often leveraged by LPs during the holding period to gain insight into the directionality of ESG metrics.

Similarly, GPs can monitor ESG throughout the holding period by ensuring their portfolio company’s compliance with applicable standards, supporting implementation of any ESG action plans and evaluating movement of ESG KPIs identified during screening. It’s also essential for GPs to stay informed and respond to any developments of new ESG risks that have arisen or actualized within their portfolio company’s operations to optimize risk mitigation.

It is important to note that one of the major pain points for both LPs and GPs in regard to ESG investing is the lack of standardized ESG frameworks available. For example, it is not uncommon for various LPs investing in a fund to request different ESG metrics from the fund manager and for LPs to receive largely varied ESG reporting from all the GPs they are committed to, making it challenging for them to achieve an accurate portfolio-level view of their ESG performance.

ESG integration at exit

When investors are getting ready to exit their investments, they can perform an ESG assessment to evaluate their portfolio company’s current risk exposure, mitigation and posture. Through consolidating relevant ESG data and outlining a summary or the risks, management, and improvements over the investment, GPs may be able to attract a broader base of investors or exit their investments at a green premium.

The ESG integration considerations in the pre-investment, holding and exit phases of the private market investment lifecycle discussed here provide a general overview of some best practices investors can use to improve awareness and management of ESG risks and opportunities. However, ESG integration can manifest in a variety of forms, depending on an investor’s ESG philosophy.

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