In 2023, we saw private equity firms continue to integrate ESG considerations into their investment processes with LPs and regulators prioritizing the importance of transparency and reporting related to ESG factors. Whether the ESG acronym continues to be used over the long term remains to be seen, but make no mistake, ESG, in one form or another, has cemented itself into the private equity landscape. Irrespective of recent political debate and anti-ESG lawmaking in the US, GPs must accept that ESG has become a strategic imperative and, given the ESG regulation sweeping across the globe, a legal necessity. So what can GPs expect as they look to 2024? Below (in no particular order) are a few predictions.
- Move toward outsourcing routine ESG monitoring and reporting. When it comes to ESG monitoring and reporting, you need to be able to collect data and have the experience and knowledge to analyze and make sense of it and disclose it. Certain PE firms believe in having a larger team at the GP level that is responsible for various activities and reports directly to the Head of ESG. These tend to be the large cap funds – a luxury that is often not an option for the mid-market and certainly not for the firm on its second or third fund. Justifying the need for a sizable in-house ESG team can be difficult. This dynamic is leading to an increasing shift within GPs, with a growing move towards outsourcing ongoing ESG monitoring and reporting functions to reliable third-party providers with the majority of those costs being allocable to the funds. We anticipate this trend gaining further momentum throughout 2024.
- The (rising) cost of ESG. Given that a great deal of external ESG-related costs are ultimately borne by the LPs, GPs need to ensure that they are getting “bang for their buck” when they engage external consultants and the raft of ESG vendors (legal, carbon accounting, tech/AI, etc.) that have sprung up in recent years. A typical refrain from founders through to CFOs and in-house ESG personnel over the last 12 months has been “How has this become so expensive?” and “Should we simply hire/develop the relevant capabilities internally?”. While we would not be surprised to see some market consolidation of ESG service providers in 2024, PE firms will start scrutinizing ESG costs, and in-house legal and compliance personnel will work carefully with their finance teams to ensure those costs are correctly allocated.
- Increased focus on Corporate Sustainability Reporting Directive (CSRD) reporting. The CSRD represents a profound change in ESG reporting that should not be underestimated. While Europe may seem less relevant to US funds, the CSRD will affect a number of US-headquartered firms with European offices and portfolio companies. Reporting obligations for some start in 2025 (on 2024 data) and for many others from 2026 (on 2025 data). We see 2024 as a key year for GPs as they and their EU portfolio companies assess whether they are in the scope and, if so, what processes, resources, and controls are needed to comply. Regulatory change, such as the CSRD, 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.
- Continued politicization of ESG, particularly in the US. Support for ESG as an important lens through which investments should be viewed has gained momentum in recent years while also drawing criticism and, in some quarters, anti-ESG legislation. This is particularly true in the US, where there is a clear divide between states supporting ESG considerations and those that do not. We expect to see a continued backlash to ESG in 2024. ESG integration and the long-term advantage it represents will, however, not go away — notwithstanding short-term political headwinds. Large and mid-cap firms will continue to double down on their ESG reporting efforts, and new funds coming to market in 2024 are advised to do the same. In the wake of COP28 and with elections in the US, UK, and EU in 2024, it will be interesting to see if those in power continue the regulatory work and sentiment of the previous administrations or change tack.
- Rise in ESG litigation and enforcement actions. After years of voluntary ESG disclosures, there will undoubtedly be a steady uptick in the number of greenwashing claims in 2024 as the chickens come home to roost. So, too, on ESG-related regulatory enforcement actions. The SEC’s mantra of “Say What You Do and Do What You Say” may seem obvious to most, but its focus on the truthfulness of disclosures that PE firms make – on ESG or otherwise – will mean continued scrutiny of past ESG disclosures and will unfortunately result in certain sanctions and penalties across the PE sector. Given this and the swath of incoming ESG-related regulation (e.g., the SEC’s much-awaited climate disclosure rules which may be finalized in April 2024), we expect to see GCs and CCOs leaning in more on ESG across the board.
As a postscript, it will be interesting to see if the tension between ESG and antitrust laws develops. European regulators have generally encouraged private sector collaborations that pursue legitimate sustainability objectives. In contrast, regulators in the US have been less permissive of “climate cartels,” with some states actually launching antitrust investigations into ESG initiatives — another reason for GCs and CCOs to assess the risks inherent in their firms' sustainability collaborations.
If you would like to hear more from Charlie on the growing case for ESG investing in private equity and the common ways ESG creates value for private equity firms, please click here.
