How to Excel at ESG: The Definitive Guide for Private Equity Investors

ESG – what does it mean to you? If your answer is sustainable investing as it relates to Environmental, Social, and Governance criteria, congratulations! You are ahead of the curve. ESG has only recently gained traction in the European private equity industry, but now it's virtually impossible to make an investment without taking ESG performance into consideration. 

This means that you need to understand what people are talking about when they talk about ESG and business impact, especially if you want to excel at private equity. So where can you go for that knowledge? (Hint: you’re in the right place.)

By the end of this article—you will understand:

• What ESG measurement is all about and how it benefits PE funds and their portfolio companies

• Key considerations for conducting quality ESG research and analysis

• How to implement ESG into your investment process in a quantifiable way

What is ESG?

ESG focuses on the impact that investments create outside of financial metrics. For example, you could use an ESG framework to evaluate how a company treats the environment or its employees. These factors are not one-size-fits-all so each investor will have their own selection criteria. But at its most basic level, ESG boils down to three different classes: 

1. Environmental - How does an investment perform in relation to current and/or future environmental issues? 
2. Social – How does the company manage its relations with its employees, stakeholders, and broader communities?  
3. Governance – How is a company being managed by management and boards? 

Lacking good clarity around what goes into your investment decisions means running the risk of making wrong investment decisions. Being aware of ESG and impact considerations means that investors and stakeholders have more agency to demand a solution if they’re not happy with how certain businesses are operated. 

It's also worth pointing out that sustainable investing has been around since long before ESG became popular in Europe so this isn't something new to worry about.

Why Does Excelling at ESG Matter?

To really drive home why ESG matters, here are some statistics which show the benefits when forward-thinking investors position it at the core of their strategies:

• Fortune 250 companies that score higher on environmental, social, and governance performance than those that don't outperform those that do by 12% over six years.

• A study on Australia's Future Fund found that investments in companies with strong ESG characteristics had significantly outperformed those without them over a ten-year period (260 basis points versus 80 basis points).

There is an overwhelming amount of data to show why you should invest with ESG considerations as part of your strategy. This isn't just some feel-good idea either, this actually makes money!

However, this doesn't mean that ESG factors will dictate every investment decision you make. And just because a company scores highly with ESG doesn't mean it's a good investment; you still need to consider financial metrics as well.

How is ESG Data Collected?

ESG data can be found in countless different ways. There are both qualitative and quantitative sources of information that you can use depending on your objectives (often it requires both types of data to paint a full picture of your fund’s impact story):

• Qualitative data examples – Management interviews, media articles, customer or employee satisfaction surveys, reports from non-profit organizations and credible institutions. 
• Quantitative data examples – Historical filings, assessments from ratings agencies, indices created by third-party companies, publicly available data sets.

Importance of Managing ESG Beyond Just Measuring It

Since ESG data is becoming more readily available, it's important to put a process in place for managing and acting on the information you collect. A lack of a plan could result in you missing out on some great opportunities to enhance your portfolio or worse—putting together an incomplete picture, which can lead to uninformed business decisions.

The first step of the process is to understand what specific ESG factors apply to your investment. This can be as simple as reading about the companies you're interested in and gaining a deeper understanding of their business model.

Companies should communicate how they behave in terms of ESG factors and provide evidence to support this. If a company doesn't take steps to indicate what it is doing, investors may feel like there is more risk involved with the investment since they don't know exactly what's going on underneath the surface. 

Although some companies may shy away from disclosing their data due to competitive reasons, we do recommend that any company that wishes to stay ahead of the curve should provide this type of information and transparency to its stakeholders. 

In fact, entities like the Value Reporting Foundation have been working closely with investors and businesses to promote integrated reporting – one way for this data to be shared proactively.

ESG Data Reporting Standards to Look Out For

There are a number of ESG factors that most companies should report on regardless of sector or industry. Below are some key examples:

1. Environment – Carbon footprints, pollution control measures, energy consumption levels, emissions controls, etc.
2. Employees – Employment statuses, training opportunities/hours, diversity initiatives, employee wellbeing, etc. 
3. Community – Location impacts, investments in local communities, community development programs, etc. 

Standardized reporting is critical to getting a complete picture of how investments perform from an ESG perspective. Some indices already do this, such as MSCI, which uses its own proprietary methodology when rating index constituents.

Although there are various ESG indices available, they are not perfect. It's important to also look at the companies you invest in through your own analysis and due diligence process. This way, you can put together a more comprehensive picture of how well their ESG factors align with your own impact goals.

Going Beyond Self-Reported Data

Many companies currently self-report their ESG data. They should, however, also provide evidence to support claims made around their business impacts. This is where third parties come into play, such as rating agencies or better yet—trusted ESG subject matter experts who can provide both data collection / analytical tools as well as more in-depth consultative services.

In addition to researching how companies handle their ESG factors, it's also important to look at sustainability-related risks.

The following are examples of the areas investors should focus on:

• Financial – Exposure to counter-party risk, liquidity risk, default risk
• Operational – Energy costs’ impact on operational performance, supply chain risks
• Reputational – Brand value/image impacted through association with harmful business practices or bad regulation

Focus your attention on these aspects to gain a more holistic picture of an investment opportunity. Making an informed judgement will lead to better returns for you and your fund in the long run.

Excelling at ESG With These Top Trends

ESG Reporting Regulations 

A number of countries and governments are already working towards regulating standards and guidelines around ESG reporting. Many of these initiatives focus on promoting integrated reporting, which is a process to help companies report financial and non-financial information in line with the triple bottom line (people, planet, and profit). 

Staying ahead of such regulatory developments is critical for any company that wishes to maintain a competitive edge in the market. Regulators are looking beyond simply a verbal commitment to ESG, and any possibility of greenwashing could open the door for an audit. The time is now to start building out the internal infrastructure necessary for your fund to properly measure and report on its impacts. 

Increased LP and Shareholder Scrutiny 

ESG factors are also becoming increasingly important to investors and stakeholders, particularly in recent years as our economic mindset begins to shift from shareholder capitalism towards stakeholder capitalism. In addition, shareholders themselves want to understand how their investments are performing from a sustainability perspective. Disclosure is key to being able to communicate the value of your investments across all of these different audiences.

More Challenges For Small & Mid-sized Firms

Many small and midsized organizations currently lack the resources and capabilities needed to produce comprehensive ESG reports. This means that they will continue facing challenges when trying to implement more sustainable business practices.

Here are some key points for SMEs and their investors:

1. Start by learning about how ESG/sustainability factors affect the business and what is required to report on (by LPs, investors, and government regulations).
2. Create a clear picture of the variety of data they'll need to provide. What data is already available, how often will it be collected, and who will be in charge of doing so?
3. Outsourcing and expanding the business may seem like a daunting task, but it doesn't have to be. Working with a third-party expert who can perform the heavy lifting for them will help them get more out of their work. Outsourcing part of the job allows you to collect better data—at a larger scale and at a lower cost than attempting to do everything in-house.
4. Smaller businesses, who must work with restricted resources, need to get serious about investing in ESG if they want to succeed. They'll need to include it into their yearly plans from the beginning (versus tacking it on as a box-ticking exercise as an afterthought).

It’s also important to find a balance between integrity and efficiency. Sticking close to home with the data you collect might help you avoid errors, but it will also increase costs and timeframes. The best way forward is to take stock of your current resources and learn how ESG affects their business. Then, look into which tools are available for them to do so and who might be the best partner for them to work with.

Focus On The Triple Bottom Line to Excel at ESG

There should be a greater focus on the triple bottom line as opposed to just profits alone, as the latter often leads to short-term thinking. While profit certainly shouldn't be ignored altogether, it needs to be balanced with the other two factors to ensure sustainable long-term growth.

Divesting From Unethical Companies 

Divestment demonstrates that socially or environmentally irresponsible business activities can negatively impact a corporation's bottom line. The divestment movement has gained significant traction over the years, particularly alongside the rise of responsible investing in the mainstream. One common example of this is the widespread lobbying for universities and pension funds to divest from fossil fuel funds. 

Divestment sends a powerful public message. But it’s also a risky strategy. 

Why? There's a good chance that the person or organization taking over your shares will be less concerned about the project's negative externalities. What if a new investor purchases more shares than you, and subsequently makes decisions that reflect poorly on the company's mission? How would you feel knowing this is happening after you’ve removed your support? Such a decision could pave the way for lasting negative impacts far beyond the cost of the original transaction.

Some investors choose to stay involved in "dirty" industries (as a type of shareholder activism) to help improve the fundamental business model for good. It's not only about the numbers. At the end of the day, it's also vital to think about the tangible effects of your actions and the real-world impacts they spark.

Before leaving an unethical sector/business, consider this: removing oneself from the equation may look appealing on paper, but you're also giving up your influence over that investment. 

On the flip side, the practice of shareholder activism represents a growing opportunity for ethically-minded individuals and institutions looking to catalyze change from the inside out. This often takes the form of dialogue and shareholder resolutions. 

By staying behind and influencing the firm with your voice and ownership, it's possible to push the company towards more responsible ESG policies and practices. If you believe in helping others by improving externalities associated with certain industries (e.g., fossil fuels), then it'd be worth your while to advocate for improving those conditions instead of simply walking away.

Bottom line: divesting from a company or industry entirely does not guarantee that it will become ethical or conscious of its impacts. Staying on board gives you more power to effect real change (even if progress is slow) than by opting out. 

The Way Forward for Private Equity ESG Strategies

Over the next few years, we expect to see more investors and practitioners incorporate ESG factors into their private equity strategies. The top performers will stand out from the crowd and attract a greater pool of talent, more sources of funding, and a stronger brand reputation.

While there's still much work to be done, one thing is clear: ensuring that companies address their ESG performance and business impacts is critical for creating opportunities for sustainable long-term growth. 

As previously mentioned, improved ESG disclosure can help investors better understand an investment's value and determine if the company's long-term prospects are as promising as they seem. This should lead to more confident business decisions and—if done right—better returns.

While ESG analysis may seem intimidating at first, there is in fact already a huge number of resources on the subject that will provide you with the foundational knowledge you need to excel at it.

How Tablecloth Can Help Your Firm Get Ahead with Top-Level ESG Analysis

Tablecloth's platform and expertise allow PE funds and LPs to seamlessly incorporate ESG criteria into their investment processes. It's an intuitive and easy-to-use platform anyone can make use of as it doesn't require any technical knowledge or design skills. 

Our data analysts work with investors across the globe to help them better understand where they're exposed to ESG risks and uncover opportunities for value creation. 

As we mentioned earlier, ESG strategies that can be integrated into investment workflows are more effective and less costly than non-integrated solutions. 

Specifically, Tablecloth can help you:

• Raise capital faster
• Keep ahead of your LP's ESG reporting expectations
• Assure impact happens in your portfolio companies
• Help GPs become experts in ESG and impact

No matter what framework your firm uses—whether it's UN PRI, IIRC, or another sustainability standard—Tablecloth makes it easy for you to create compelling disclosures. You can use our online platform to capture and measure ESG performance, craft an engaging impact story customized to your fund, and easily export that information to include in your next ESG report. 

Tablecloth's resources save investors and PE funds months of work by providing access to a wide network of subject matter experts who are passionate about ESG and impact. 

You don't need to know how to analyze companies from an ESG perspective as our team is on hand to guide you through. You'll receive a bespoke solution with actionable insights that you can use to get ahead of the curve and secure returns for your LPs.

In this article, we've taken a look at how to excel in private equity from an ESG perspective. Investors are setting themselves up for success (and better longer-term returns!) by investing in companies that proactively address ESG issues. Furthermore, it's critical for private equity professionals to consider ESG issues to help them stand out from the crowd and attract a greater pool of talent and funding, particularly in today’s rapidly evolving investment landscape.

At Tablecloth we're here to help you get ahead. Our technology platform and subject matter experts provide you with all the latest data and research on the ESG factors that matter most for your portfolio. Do you want to access these tools and insights? Reach out to our team!

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You can check out more articles on ESG and impact investing at about.tablecloth.io/articles.

Learn more about how Tablecloth's team of subject matter experts can help you drive ESG value creation across your portfolio by contacting us today.