While many market trends and strategies have emerged in recent memory, few seem to have achieved the same degree of prominence and sparked the same level of debate that surrounding ESG strategy. This rings especially true with respect to both current and prospective investment, as the risk management and value creation framework has seen adoption from small venture capital firms to private equity giants and beyond.
Though ESG KPIs are able to extract insights that wouldn’t emerge from standard asset-based analysis, its non-traditional approach can also present challenges to those newer to this framework. For those that have a grasp on what ESG is, but may need some help refining their methods, here are five ways to improve your ESG strategy:
1. What is ESG to you?
The most important step to take before seeking out LPs, GPs, or portfolio companies that will be a good fit for your ESG strategy is to really understand your relationship with ESG and how you would like it to factor into your decision making. Having an idea of where you fall on the spectrum of ESG philosophies and how much you want to lean on this framework to create and protect value can help streamline the selection of an LP, GP or target company.
The biggest question surrounding your ESG preferences is what types of companies and industries fall within your band of risk tolerance. Your individual expectations of portfolio cleanliness and involvement after investments will shape what opportunities are available to you and are therefore important factors to consider when assessing your ESG strategy.
Knowing your values, intentions, and areas of flexibility or rigidity when it comes to ESG can make the selection process for LPs, GPs and target companies much more efficient.
2. Identify important ESG KPIs
As you explore the implementation of a sustainable investing strategy, determine which ESG KPIs are most relevant to your concept of ESG and your portfolio. This task often falls to the GP, as they are typically charged with gathering and synthesizing portfolio company information. However, if an LP knows there are ESG KPIs that it prefers to have reported during the holding period, early communication of these can lighten the lift for GPs.
Keep in mind that although gathering as many ESG metrics as possible may seem conducive to more comprehensive observations, it can actually make it more difficult to aggregate metrics at the portfolio level.
Stay focused on what is more important and material to the company. Beyond the aggregation problem, GPs and portfolio companies can balk at laundry lists of information being requested. Ensuring that the amount of time spent on this process is reasonable by keeping the metrics-gathering process efficient and repeatable can help avoid management fatigue that might erode compliance in future quarters.
At a minimum, agreeing up front on a few key metrics to be gathered can get the ball rolling on the data collection process and provide a valuable baseline for comparison throughout the lifetime of the investment.
3. Dig deeper on ESG reporting
Whether it’s coming from a GP or a company, you should always investigate ESG claims of an entity before investing. One can avoid mismatched expectations by verifying in advance that a GP or company views ESG in the same way as you. This item refers back to our first tip—if you know what you are looking for, you can communicate this vision to others and ensure you are aligned before any funds change hands.
It may very well be that you and any prospective investments have fundamentally different definitions of ESG. If this communication gap is unidentified and goes unaddressed, it can lead to disappointment when the investment fails to meet the investor’s expectations. Though it may not seem that better communication is necessary before an investment is even made, on this topic, it is worth having the conversation to ensure alignment.
Depending on the space, there will be those with a broader or narrower definition of ESG. For example, there are many that just regard ESG as a synonym for green investing; if you were only in dialogue with these community members and their definitions, you would neglect or devalue the social and governance elements of ESG.
4. Be flexible with your ESG strategy
Even if you feel confident in your definition and application of ESG and find that it matches up with some of the GPs and companies you’ve encountered, this doesn’t always mean that your approach shouldn’t be revisited periodically. In this rapidly changing area that is sustainable investing, new approaches continue to be developed or old approaches are revised.
Always keep an eye on what is developing in the market so you are open to incorporating the tools and information that suits your ESG philosophy. ESG metrics are still fairly nascent in the private markets. Over time, what is accepted and available will change and expand, and your approach should be flexible enough to incorporate the information as it evolves.
5. Don’t start an ESG framework from scratch
When all else fails, don’t be afraid to copy frameworks and strategies from others. If you’re new to ESG investing, it can be greatly beneficial to follow where others have led and reduce the effort required to implement this approach by using something tried and tested.
Ideally, you can redirect the time you would have spent starting from scratch into other facets of ESG implementation, such as researching and communicating with GPs and companies. It may seem advantageous to have a bespoke framework completely designed to your specifications, but if it means requesting highly specific information and lacks flexibility.
If the investor world can come together on what is material when it comes to private market ESG reporting, it will simplify the efforts taking place to produce actionable data.
