“Everything Everywhere All at Once" — What’s Front of Mind for Private Equity on ESG Right Now
ESG
February 27, 2023
When it comes to ESG, a Head of ESG at a large private equity firm summed it up as “Everything Everywhere All at Once” – which is where we find ourselves as we head into 2023.
Often it can be hard to cut through the noise – especially given that ESG can differ in application depending on factors such as the identity of the firm, its culture and the founders’ values, the strategy or size of a fund, its sector, its geography, investors, and so on. ESG is also not static. It is constantly evolving from a regulatory, practical, and talent perspective, not to mention an overlay of fluctuating attitudes and mindsets.
To help fund managers navigate this complex subject, we have outlined five areas we believe should be top of mind for ESG leaders within private equity firms (which can include founders and their CFOs, COOs, GCs, and CCOs):
Regulatory headwinds (and tailwinds). ESG reporting for PE firms existed in a largely voluntary paradigm until relatively recently. That has now changed. Fund managers have spent the last few years getting their heads around the Sustainable Finance Disclosures Regulation (SFDR) and EU Taxonomy. This has been followed by the SEC’s proposed rule changes which will likely require registrants to include certain climate-related disclosures in their registration statements and periodic reports, as well as greenhouse gas emissions data. And now, most private equity firms are turning their attention to the EU’s Corporate Sustainability Reporting Directive (CSRD) that came into force in January.
The CSRD represents a profound change in ESG reporting that should not be underestimated. Under this new directive, non-EU headquartered fund managers may be required to issue CSRD-aligned reports in relation to their entire global group, including companies that, on a standalone basis, have no business in the EU. No need to worry – there is still time to prepare. CSRD reporting requirements for most firms will begin in January 2025 – but firms should be working now out whether or not they are in scope and, if so, what processes, resources, and controls are required to comply.
Regulatory change will hopefully usher in an era of standardized and audited reporting of non-financial disclosures, which, in turn, will focus LPs and GPs on the key components of a successful ESG program, including data, talent, and technology.
ESG resources. Each founder or Head of ESG is required to think about where he/she turns to for the right resources to manage ESG risks and opportunities and determine how these costs are allocated. For larger funds, particularly those with a focus on sustainability or impact, it may make sense to have a larger team at the GP level, with a range of capabilities, all reporting to the Head of ESG. However, similar to a firm’s General Counsel, it can be difficult for a Head of ESG to argue for a large team and, therefore, will outsource work to trusted third party service providers.
Carbon accounting firms are an obvious area where private equity firms can outsource. As requirements increase and specialist knowledge is increasingly sought, other areas have become increasingly common for GPs to outsource. For example, managing annual ESG questionnaires and portfolio monitoring is often incredibly time-consuming. Gone are the days of completing this analysis with Excel. Top-quartile ESG reporting requires the right technology solution overlaid by experienced sustainability professionals who can collect large swathes of accurate data and highlight trends and areas for improvement.
Risk management. On February 7, the SEC announced its 2023 examination priorities. Unsurprisingly, one of these priorities relates to ESG and, specifically, whether funds are operating consistently with the manner outlined in their ESG disclosures. Similarly, in the UK, the FCA has recently proposed new labeling and disclosure rules to combat greenwashing. This new regulation has been prompted by the issuance of claims by LPs and other stakeholders as they look to hold fund managers accountable over whether ESG integration matches the ESG disclosures being made. For a Head of ESG, regulatory and LP scrutiny requires a doubling down to ensure that the relevant resources within and outside the firm are drawn upon to validate each ESG disclosure from a risk management perspective and that the ESG outputs continue to consistently live up to what has been disclosed. Needless to say, the legal and reputational impact of not getting it right can be immense. Consistency is key to credibility throughout the organization.
ESG data. Investor demand for ESG information has grown exponentially in recent years. A wide variety of data is now being requested by LPs, which has led to pressure on the portfolio companies to supply this information. Often ESG data is imprecise, ambiguous, and subject to assumptions. The multitude of ESG frameworks, standards, and taxonomies that exist, plus evolving ESG regulation, can be highly confusing and can often result in a mismanagement of resources, costs, and at worst, increased risk and reputational damage. In recent years, the consensus has been an urgent need to reconfigure this so that the data requested is comparable, consistent, and, ultimately, auditable.
There is some light at the end of the tunnel through work being undertaken by the ESG Data Convergence Initiative and the IFRS Foundation’s International Sustainability Standards Board. However, the challenges with data, data quality, and comparability, in particular, remain. As ESG regulation takes shape, there should be a convergence on what constitutes generally accepted non-financial disclosures. Key to success in this area is understanding the overlaps between the different data required by various stakeholders, refining the collection and validation process to ensure that GPs are meeting LP and regulatory requirements from a reporting perspective, and focusing on the material issues at a portfolio level.
Proportionality. Finally, whether you are on your first fund or are a seasoned manager with billions of dollars under management, one challenge linked to the above points is proportionality and ESG cost management. With a new fund, the founder may push for an Article 9 SFDR fund and then ask his team to put processes and controls in place to meet the classification, which can be challenging. For more mature ESG programs, certain constituencies within the GP often desire to push for more ESG “wins” or sustainability-linked products when the personnel and infrastructure to deliver on these are not fully equipped to deliver meet these ambitions. A Head of ESG often has to tread a fine line between showing measured year-on-year progress on ESG without promising the earth. In doing so, it is important to recognize who the GP’s key audiences are and their expectations. It often makes little sense to set lofty targets or embark on ambitious projects if LPs and regulators are not requesting or mandating this.
As ESG considerations continue to grow in importance, the role of the private equity Head of ESG is becoming increasingly critical. These challenges highlight the need for ESG leaders within GPs to stay informed and proactive in their efforts to advance sustainable business practices and deliver long-term value for their firms and stakeholders.
At Petra, we focus on practical ESG policies, processes, and tools. Leveraging our experience of having built out sophisticated ESG programs, we can help GPs establish ESG best practices early on and enhance their firms’ reputation in the eyes of investors.
