Making the Case: Benefits of Measuring ESG in Your Portfolio [FAQs]

What is ESG? 

ESG stands for the Environmental, Social, and Governance factors within a business. It's a set of standards that investors use to screen potential investments. Examples include whether a company manages its carbon footprint, how well it treats employees, and if it has governance policies in place for addressing issues like diversity and inclusion.

Directing capital towards investments where such factors are evaluated and taken into account is known as "ESG investing" or "sustainable investing."

Why measure ESG? 

Because businesses cannot ignore material risks that threaten the stability or profitability of its operations. Investments are at higher risk when they ignore ESG-related risks – particularly as the consequences of global concerns like climate change, inequality and racial injustice become more closely tied than ever to the bottom line. 

• BP lost 54% of its value during the Gulf spill crisis.‍
• Facebook ran into problems ranging from advertisers pulling their ads and antitrust inquiries from Congress partly due a lack of checks and balances amongst its executives.
  

ESG measurement is an early indicator of such risks.‍

In addition, investors, consumers and other stakeholders are increasingly interested in ESG measurement. According to a survey conducted by the CFA, 73% of investors take ESG factors into account for investment analysis and decision making. PwC’s 2021 Consumer Intelligence Series survey indicates that 83% of consumers now believe companies should be actively shaping ESG best practices.

Does ESG measurement exist in private equity? 

Yes! Though ESG measurement first started in the public sector, a 2018 RBC survey of Private Equity investors shows LPs are pushing for ESG investments in portfolios because they are convinced ESG investing pays off via increasing returns, creating alpha, and decreasing risks. 

ESG is no longer a simple “box-checking” exercise but rather an integrated part of the investment process.

There are currently 4,000 signatories and counting for the Principles for Responsible Investment (PRI), a United Nations-supported international network of investors and a leading proponent for sustainable investment.

Why else do investors care about ESG in their portfolios? 

Companies that prioritize sustainability factors perform better financially. The market reflects this global shift in the investment landscape:

• Institutional investors place a premium valuation on funds that excel at ESG and impact performance.
• 88% of LPs globally use ESG performance indicators in making investment decisions.
• And 91% of U.S. institutional investors expect to increase their prioritization of ESG as an investment criteria.

There is a continued emphasis on sustainability and impact as the younger generation enters the workforce:

• 64% of Millennials consider a company’s social and environmental commitments when deciding where to work.‍
• 83% would be more loyal to a company that helps them contribute to social and environmental issues.

Young employees want to work for socially conscious employers. Companies that incorporate ESG factors in their values attract and retain more talent and boost worker productivity. The evidence suggests that these gains are worth up to 2% of a company’s annual stock price. 

Many companies are proactively reporting on ESG as a result of these factors.

Is ESG investing a luxury, given the challenges of short-term market trends in 2021?

ESG investing was on a steady rise prior to the COVID-19 pandemic, in both public and private sectors. A 2020 Bain report states that since 2015, impact fund assets have swelled by 154%, up to $28 billion.

ESG investing hasn't slowed despite the pandemic.

According to HSBC, ESG-aware companies outperformed in the pandemic’s early weeks. Companies now face greater scrutiny with regard to how they're treating human capital, consumers and society.

Investors also have preferred sustainable assets during the downturn. In the first quarter of 2020 alone, global sustainable open-ended funds brought in $40.5 billion in new assets, a 41% increase year-over-year.

If anything, the pandemic has only further highlighted the need for robust ESG measurement and evaluation when making investment decisions.

Will the ESG “trend” last?

Since the long-term gains are proven, it seems unlikely that this is merely a trend. More and more investors recognize that ESG metrics are not vanity metrics. The benefits stretch far beyond simply good PR marketing and brand image. 

ESG outperformance boils down to factors such as employee job satisfaction, the strength of customer relations, or the effectiveness of the company’s board, which lead to overall resilience and stability for the business.

ESG considerations pave the way for long-term sustainability. They’re also key to factoring in risks not normally priced into value through traditional analyses.

How does ESG investing compare to traditional investing methods? 

There is growing evidence that not only does ESG investing produce returns, those returns actually outperform standard investments.

• Harvard Business School reported high sustainability firms (HSF) significantly outperform low sustainability firms (LSF) in the long term – a $1 investment in an HSF portfolio grew to $22.6 while that same investment in a LSF portfolio grew to only $15.4 (1993 - 2010).
• A meta-study of over 2,000 studies conducted by researchers from the University of Hamburg and DWS found that 63% of those studies saw a positive correlation between ESG investments and returns, while only 8% indicated negative effects.

Key takeaway: ESG integration drives greater value at exit by demonstrating specific and measurable evidence of additionality to investors and stakeholders while meeting global commitments.