About our Contributors
ICS Group is a regulatory compliance consulting firm specializing in providing compliance support to the financial services and insurance industries. We help our clients comply with regulatory requirements and industry standards. Our clients include: registered investment advisers, private equity funds, hedge funds, mutual funds, broker-dealers, insurance companies and state pension plans. Our team of highly experienced compliance professionals know from first-hand experience what regulators are looking for, the industry standards that apply, and how to develop and implement cost-effective business-oriented solutions.
The focus on environmental, social and governance (ESG) as a means of creating sustainable value is on the rise. Institutional investors are increasingly considering nonfinancial performance, such as ESG issues, when making investment decisions. The three factors of ESG and the corresponding investment-related sustainability issues are:
ESG as a Private Equity Concern
Of all the sub-industries within the asset management industry, private equity (“PE”) is well-positioned to take the lead in integrating environmental, social and governance issues into the investment process (“ESG integration”). Due to the size of the industry (about 2.4 trillion in AUM ) and the characteristics of its business model, the PE industry has a tremendous opportunity to create social value and improve the environment and, in doing so, improve their financial returns.
In May 2015, CalPERS announced that it will require all its managers to identify and articulate ESG in their investment processes. It will factor into its decisions about hiring and monitoring external investment managers the degree to which managers assess ESG factors and integrate them into their processes. Anne Simpson, director of global governance, said that CalPERS considers managers that do not identify and manage these risks as having a “sub-par investment process”.
In October 2015, the DOL cleared the way for ERISA-governed plans to consider ESG factors. Interpretive Bulletin 2015-01 clarifies that ERISA plans may take ESG benefits into account as “tiebreakers” when investments are otherwise equal. When ESG factors have a direct relationship to the economic and financial value of an investment, “these factors are more than just tiebreakers,” the DOL statement said. Over the past several years the market has seen a marked increase in the number of public and ERISA pension funds mandating that their asset managers integrate critical ESG issues into their investment decisions.
Customizing Your ESG Program
Although many firms in the asset management industry are aware of the growing importance of ESG integration, not all firms are aware of how to customize ESG integration to their specific business model. The ESG considerations material to investment decision-making vary from firm to firm. For some PE firms, environmental factors are at the forefront; for others social or governance issues may represent the ESG themes key to decision-making.
In particular, PE firm may focus on value creation by improving eco-efficiency and environmentally sustainable products and services and other firms may focus on labor, health and safety factors affecting portfolio company stakeholders. Other PE firms may focus on whether portfolio companies have a robust governance structure which enables effective business review and control. Although effective governance has long been an integral facet of private equity ownership, PE firms may pay extra attention to anti-bribery, anti-corruption, and environmental & social performance reviews in the context of ESG.
Ultimately, the focus point of a PE firm will be largely driven by a fund’s individual investments and a firm’s investment mandate as the relevance of ESG factors differ from one geography to another, and one industry to another. Some examples of actions PE firms can take to improve their ESG integration, include:
When shaping your ESG policies and procedures you should consider current ESG trends and the effect they will have on your business. The three major ESG trends are:
How to Integrate ESG into Your Investment Strategy
PE firms that have not yet integrated ESG into their investment strategies will want to start requesting more information from their portfolio companies or potential portfolio companies. PE firms can gain valuable ESG information by requesting an integrated report that combines both financial and ESG (also called nonfinancial) information. This will enable the PE firm to better assess how its portfolio companies are creating value for the LPs, and the risks and opportunities they face. LPs with a long-term investment horizon—such as pension funds, sovereign wealth funds, and family offices—are especially attuned to this kind of information.
The firm will need to determine how to effectively use ESG information and how to successfully monitor ESG initiatives to improve portfolio company performance. The success stories from improving portfolio company performance through ESG integration will give a firm a competitive edge in the industry and ultimately, improve the firm’s bottom line.
ICSGroup’s ESG Practice Group can provide the help your firm develop or enhance your ESG standards, policies and procedures and achieve effective ESG integration.