ESG and private equity: How integrating ESG fast and efficiently can boost transparency for both General and Limited partners

Sustainability is becoming more important for corporate governance and investments all the time. Yet sometimes the private equity industry still lacks clear strategies for introducing and implementing sustainability. But an ESG Performance Monitoring Framework can be used to manage improvement efforts both at the fund level and in portfolio companies.

More and more companies are treating environmentally conscious, socially aware conduct as a relevant management goal and integrating it in their corporate strategies. After all, allowing for environmental, social and governance (ESG) criteria is something both society and regulators are now coming to expect. And those criteria also offer measurable economic potential. It’s true that national legislators and the European Union have taken their first specific steps toward setting uniform requirements for sustainability and social responsibility for financial investors (such as the Taxonomy Regulation, the SFDR, the CSRD). But the associated contents and details have not been worked out far enough yet for us to be able to speak of a global (or at least EU-wide) reporting standard for investment managers. All the same, many private equity investment managers are looking very hard at the topic right now. With no complete legal framework available, a broad variety of voluntarily based approaches to an ESG commitment and reporting have evolved, especially in the past few years. The pressure on private equity firms comes directly from greater demand. Limited partners in particular are proving to be the driving force in boosting the significance of ESG for private equity, and that effect is going to continue to increase sharply. As the details of legal framework become more firmly established, existing ESG reporting is likely to harmonize rapidly in the near future, and the last fund managers who were wavering about ESG can soon be expected to start cooperating and make a commitment.

ESG generally used to be viewed as a niche topic for dedicated investors. But now it’s becoming a market standard. That is clearly evident from investors’ soaring interest, the public attention given to sustainability, and the ongoing effort to develop uniform ESG reporting standards within the EU. Private equity funds can profit from this megatrend, which is why they should pursue a comprehensive ESG strategy even in spite of the associated expense.

1. ESG must be integrated into the entire fund life cycle

Depending on a fund’s intended engagement and strategic focus, it’s important to define principles, criteria and goals clearly. Several questions must be answered before one tries to develop and implement an ESG strategy:

• How will the fund’s ESG goals be reconciled with corporate strategy and enterprise values?
• What is the current status for implementing the ESG strategy?
• What will be needed to achieve the adopted ESG goals?

It’s crucial for a comprehensive ESG strategy at the fund level to be integrated across the entire fund life cycle. So as a first step, it’s important at the deal sourcing level to ensure that screening frameworks are applied that take conformity to the fund’s sustainability goals into account. During the subsequent due diligence, the fund strategy plays a key role as a standard for a full ESG assessment of target companies, and as a starting point for defining ESG value levers as part of a value creation program.

But when introducing an ESG investment strategy in portfolio management, it becomes especially complicated to reflect ESG-compliant corporate goals uniformly and monitor them consistently. The mere question of data availability and quality at the portfolio level, along with gathering, processing and analyzing the data, generally becomes an obstacle on the path to fund-wide ESG reporting. If you want to map historical developments and benchmark best practices, you must thus have at least a partially automated ESG management platform for the portfolio companies. Our clients (general partners) use our ESG Performance Monitoring Framework for this purpose. It unifies software-based and platform-based data from the general partner’s portfolio companies in a structured, standardized way.

Finally, each ESG program will also bear fruit in the end. To realize generated ESG value in a successful exit process, the improvements must be convincing. What counts most of all here is an appropriate communication strategy and disclosure of value potential compared to the peer group.

2. Each general partner’s ESG strategy should be based on the UN’s 17 Sustainable Development Goals.

Each general partner’s core investment principles will always serve as the basis for defining an ESG strategy at the fund level. These internal guidelines for aspects like the environment, society and corporate governance, and for compliant investment conduct, should be set up in line with the UN’s 17 Sustainable Development Goals. The UN goals are now universally acknowledged in the industry, and private equity fund managers, depending on their own ESG strategy, are more and more taking them into account either in full, or at least as an emphasis, in their investment and ESG strategies.

Moreover, for steering and for achieving goals, it’s important to introduce fund-wide ESG reporting. This offers an opportunity to identify and realize a portfolio company’s value-enhancing potential that might not otherwise be immediately evident. On top of that, regular ESG reporting can keep the general partner’s investors posted about the ESG strategy and implementation successes at the portfolio companies.

3. Implementing and establishing transparency with the ESG Performance Monitoring Framework for general and limited partners

The ESG Performance Monitoring Framework embodies the technical and professional requirements for ESG reporting:

• It develops a benchmark-based ESG Rating that establishes comparability across the various industries of the general partner’s portfolio companies.
• It provides monitoring of the key figures defined in the ESG Rating, such as share of renewable energy in power consumption, employee diversity at the management level, and implementation of explicit governance policies.
• It implements a standardized, automated software platform that minimizes the effort of collecting, processing and analyzing data for both portfolio companies and the general partner, and makes it possible to focus on interpreting information and on follow-up measures.
• It provides regular reporting of fund-wide ESG development to limited partners.
• It incentivizes management teams of portfolio companies by way of ESG-relevant drivers.

To produce the ESG Performance Monitoring Framework, base camp has developed a Business Intelligence Reporting system in combination with an online tool. This solution harmonizes the portfolio companies’ various databases so that all key figures and their evolution can be displayed, compared and analyzed at both the company and fund level.

The following reports are the results of a GP Reporting process for the whole portfolio. Here we show extracts of information for all sorts of Environmental und Social aspects:

• Carbon Footprint: CO2 emissions, etc., by energy source and type, along with CO2 offsets
• Social: Numbers of employees, including by contract type and length of time with company, together with analyses of staff turnover and absenteeism.

4. Value creation and long-term management of the portfolio are the key to sustainable investments

Based on the ESG Performance Monitoring Framework, first the historically available data from the portfolio companies are gathered and integrated in a standardized form for analysis. In the next step, sustainability goals are formulated, based on industry comparisons, and are coordinated between the portfolio companies’ management teams and the investment teams in charge. Measures for improvement can be identified on that basis and initiatives can be developed, such as:

• Environmental: Rapid switch to remote work and replacing air travel with rail travel, to reduce the carbon footprint
• Social: Establish a task force to promote employee diversity company-wide, and measure employee satisfaction
• Governance: Expand fund-wide guidelines for compliance and corporate governance at portfolio companies

How well each portfolio company attains ESG goals will now be measured on the basis of its ESG Rating, and its ESG performance will be tracked over the long term.

Developing a strategy, and integrating the ESG Performance Monitoring Framework on that basis, can serve to steer ESG-compliant corporate governance within the fund. This ensures that all companies in the portfolio improve steadily on the basis of relevant, measurable criteria. This benefits both the portfolio company and the financial investor.