Garrett James Black May 20, 2016
As part of our 2016 Private Equity ESG Survey (sponsored by R.R. Donnelley), we spoke with Andrew Malk, managing partner and founder of Malk Sustainability Partners, regarding environmental, social & governance (ESG) issues in PE. He has encountered different perspectives than were on display in the report, so we solicited his thoughts to complement our findings.
What’s the current state of engagement with ESG issues in the PE industry?
Our experience and consistent interaction with more than 130 private equity firms indicates a very different state of engagement from what PitchBook has found in its 2016 survey. Though as the report states on page five, because the 2016 survey sample changed and skewed dramatically toward much smaller firms (GPs with less than $500 million in AUM comprised only 22% of the sample in 2014 and a whopping 59% in 2016), the survey results are less an indication of trends for the overall PE market than of sampling changes.
For some time, the PE industry has seriously considered ESG issues throughout the investment process to satisfy limited partner expectations and with the recognition that managing ESG well can protect and create value. Over the last year, we’ve seen a significant increase in the number of firms, from small-market to large-buyout, that consider ESG an increasingly important part of their investment process. These firms are developing the basics, such as an ESG policy, but also going far beyond—including annual training of investment professionals on evolving ESG issues, and most importantly, a review of ESG issues in due diligence of every acquisition, and monitoring material issues in their current portfolios. This ramping of integrating ESG review into the investment process is an indication of the genuine appreciation firms now have for ESG in risk management, but also matches the priority that LPs are placing on ESG in the fundraising process. For the dozens of firms we work with and speak to, 2016 is not 2012, nor even 2014 when it comes to the ESG expectations of many of the world’s biggest PE LPs.
There have been some recent studies that impact investing does not necessarily mean sacrificing returns, like that of WSII. What are your thoughts on that?
There’s an important distinction to make between ESG management and impact investing—both are critical contributors to the larger responsible investment movement. Impact investing is placing capital with the primary goal of measurable social or environmental benefit. ESG management is incorporating similar principles, but with the primary goal of producing better-performing investments. I am not surprised that positive results are being published from impact-oriented investors, as these practices generally translate into lower volatility, lower cost of capital and fewer governance problems, among other positive outcomes. For years now, PE firms have seen that managing ESG issues well leads to greater visibility into portfolio company management performance, avoided costs and generally better-performing investments, so why couldn’t that process apply to other types of investments?
What are the most prevalent ESG strategies that firms are implementing currently?
By far, the most important and fastest growing practice for PE is conducting ESG due diligence reviews of potential acquisitions. Firms have seen that it’s the area of the investment process where ESG visibility is most critical; it’s also the area of ESG management where LPs have the highest expectations. It’s becoming harder and harder to find firms with more than $2 billion in AUM that aren’t already including ESG in due diligence or planning to start in the coming year.
Can you give examples of the most effective ESG initiatives you have helped firms implement recently?
While I can’t discuss specific initiatives as they are confidential, I can give perspective on two areas of significant activity. The most common issue needing review is data privacy and security, and an equally important issue to companies in the food industry is food safety. Data privacy and security has come up time and time again in the past 18 months at both the portfolio company and the firm level. We work with these companies to first and foremost understand the types of sensitive data they’re collecting and map the legal, regulatory, and customer expectations around that data. You’d be surprised how many middle-market companies are behind in this area—it’s astonishing given the risk exposure. After that initial step, we look at strategies to ensure the security of that data, whether network infrastructure and technology tools or procedural initiatives. PE is investing aggressively in new food concepts, which are often smaller but fast-growing businesses, and food safety is perhaps the biggest area of ESG risk in those investments. We have worked with several portfolio companies to identify gaps in their practices and partner with management to mitigate those gaps.