Comprehensive ESG data helps investment firms assess and manage portfolio risks—as well as meet increasing pressure from potential investors and limited partners.
In the last few years, leading multinational corporations have made huge strides towards more sustainable business practices in their internal operations, including environmental and social issues. For many, however, when it comes to supplier transparency and accountability on these same issues, the progress is far from remarkable. Pressure for companies to be accountable for the sustainable business practices of their suppliers comes as governments, consumers, NGOs, and international stakeholders, such as the UN World Commission on Environment and Development, require companies to leverage their purchasing power to drive improvement within their supply chains.
Because investment firms often write the checks that finance these businesses and the supply chains that enable them, investors are starting the feel the pressure as well. Early adoption of ESG strategies is fueling a massive transition of capital to more sustainable options. According to figures from the Global Sustainable Investment Alliance, sustainable investing is a $30 trillion market that’s only getting started—A Bank of America Merrill Lynch report predicted that “$20 trillion in assets will flow into sustainable funds and strategies over the next two decades.”
However, as momentum builds and more investment firms understand both the requirements and opportunities around ESG, it’s critical that they have methods to comprehensively manage ESG factors within their portfolio companies – and their suppliers.
The majority of responsible investing (RI) and ESG policies were formalized after the global financial crisis in 2009. But the evaluation of operational risks had always been part of the general partner’s (GP) remit—risks like severe weather events, political turmoil, and other disruptive events that could damage the value of a company were scrutinized as part of the investment process.
Only now, ESG risks are gaining parity with traditional risk factors. Investors are beginning to conduct more thorough levels of due diligence in an effort to identify ESG risks—both existing and potential—in investment opportunities. In doing so, they take into account a company’s potential environmental impacts, health and safety issues, and legal compliance with anti-corruption and labor policies, all of which can have substantial impacts on a company’s reputation and business continuity.
Responsible investment in private equity is typically defined as an approach to investing that aims to incorporate ESG factors into investment decisions. By taking this route, investors hope to manage and mitigate any ESG risks and ensure long-term returns on capital. It’s important, however, not to confuse this with socially responsible investing (SRI), which aims to avoid unethical stock or industry investments in a business portfolio through negative screening.
Additionally, we must distinguish between responsible investment in private equity and impact investing. The latter, impact investing, describes when asset management firms primarily invest in companies, funds, organizations, or projects intending to generate and measure mission-related social and environmental, rather than economic returns.
That’s not to say that responsible investing lacks impact—it certainly has one—but when we say ESG investing, we’re referring to the act of measuring, monitoring, and acting on data to improve a portfolio company’s overall performance. As has become abundantly clear from analysis of stock performance of ESG-focused public companies, this increased focus on sustainability will increase investment returns at a company’s exit and as a forward-looking strategy, will attract and retain more capital from LPs.
The majority of private equity investors still don’t incorporate ESG standards within their portfolio management strategy. According to a survey by EY (Ernst & Young), only 24% of the firms take ESG matters seriously. Although half of the respondents said they intended to increase their ESG private equity (PE) and venture capital (VC) allocations in the future, 48% claimed that they lacked sufficient investment options to do so.
So, rather than simply look for investment opportunities that can be positioned as “sustainable investments,” many firms are turning to active measurement, management, and improvement of ESG in their existing and future portfolios.
In EY’s survey, 41% of large firms reported ESG efforts with an internal task force, followed by 37% of mid-size companies and 12% of small companies. Many specifically appointed a head of ESG to lead the sustainability charge: 34% of large companies with a task force employed a leader, followed by 12% of mid-size companies and 2% of small ones. Even small firms devoted considerable resources to change: 19% of small firms relied on a COO or CFO, and 19% relied on a CIO or senior portfolio manager.
Despite the increase in resource allocation for ESG considerations, investors still struggle to find actionable ESG data. Fifty-four percent of investors agree that ESG data is not currently reliable or precise enough to help them achieve their goals. Part of the issue is that historical methods of ESG monitoring include largely superficial, “check-the-box” efforts: ESG rating platforms, which lack real-time, bespoke scoring; performance reviews, which remain subjective and prone to bias; and annual sustainability reports, which lack scale, depth, and sufficient insight into privately held companies. Therefore, these methods, while a step in the right direction, lack the necessary depth of analysis, and do not incorporate supply chain ESG performance, and so do not provide a comprehensive measure of ESG overall.
“Investors are looking at how firms are ‘walking the walk,’” said Kyle Burrell, a partner at EY. In other words, do they contemplate ESG risks and opportunities as a serious and critical part of the investment process? But he emphasized that there is still significant room to grow. “32 percent [of firms],” he said, “are still saying ‘we’re not taking ESG into consideration at all’ or ‘we look at ESG issues, but investment returns are still the most important factor.’”
Comprehensive ESG data will help fill this gap, and the firms that apply data to innovate on ESG opportunities will pave the way for other firms to follow.
In today’s private equity environment, general partners are under greater scrutiny than ever before. Driven by demand from limited partners, regulatory developments, and talent pooling, PE firms must start to emphasize purpose and transparency. Eighty percent of CEOs, according to the 2019 EY CEO Imperative Study, believe that government, business, and the public will reward companies for taking meaningful action over the next 5–10 years. Indeed, there’s a massive amount of pressure from every angle.
But investors (private equity firms and investment managers) should prioritize ESG for a myriad of reasons. First among those is performance. Companies that rank well on ESG metrics have surpassed the market by up to 3% per year over the past five years, according to the 2019 Bank of America Merrill Lynch Global Research.
Second, employee satisfaction increases. According to the New York Times, employees at purpose-driven companies are 1.4x more engaged and enjoy 1.7x more job satisfaction.
Third, and perhaps most importantly, ESG credentials attract Limited Partners. According to the Pitchbook 2020 Sustainable Investment Survey, 95% of LPs are either already evaluating ESG risk factors or will be increasing their focus on ESG risk factors in the coming year.
Even as ESG has gained traction in private equity, the supply chain element is severely lacking. Not all private equity firms are convinced that they need to care about the supply chain as a component of ESG. If you still adhere to this mindset, you may be overlooking the investment risks of unsustainable supply chains. In 2010, the Deepwater Horizon oil spill cost BP $53.8 billion; a 2021 BYU-led research project showed that the market value of companies caught using suppliers with labor or environmental issues dropped 11% immediately after that information was made public; in 2020 alone, hundreds of companies sacrificed profits to pandemic conditions, which were largely driven by disruptions that may have been weathered with better transparency into the supply chain.
But leaders in the ESG investment space go beyond oversimplified ESG ratings. It’s no longer enough to judge a company as sustainable through a single, reductive score. Firms need to investigate the very real practices that live behind those scores, and most importantly, the factors that account for the greatest impact—supply chains. And the more rapidly investors get on board, the better. In 2021, the EU Taxonomy—an initiative primed to channel capital into sustainable assets—will require European asset managers to reveal compliance. Undoubtedly, such global regulatory measures will create incentives to invest in ESG-compliant supply chains.
It’s imperative that before you invest in companies, you examine where they stand in terms of ESG compliance – their own operations and their suppliers. Companies at a base starting point possess limited visibility over their supply chain, emphasize short-term profits, and disclose only limited information about their supplier details. In contrast, companies that represent good ESG-compliant investments will be transparent about the challenges, employ ways for employees to raise ESG concerns, and outline policies that go beyond mere legal compliance.
To take initial steps towards engaging in supply chain management with the relevant companies, investors should examine the following information:
Many ESG investment tools on the market right now are passive. They give firms a credit score for their portfolio companies but not in-depth insights into their supply chain, audits, or workforce. In contrast, tools suited for today’s circumstances will push investors to actively manage ESG in their portfolios, helping them find and mitigate ESG risk hotspots before they implode, and allowing them to strike up conversations with portfolio companies that drive continuous improvement on ESG related topics.
Thus far, we’ve covered the reasons why private equity firms must emphasize transparency and purpose, why supply chains command an outsized role in ESG compliance, and why investors need sustainable portfolios to compete. Now, we’re going to explain how you can start the process of vetting potential portfolio companies.
In this stage, you should establish a basic understanding of ESG risks and opportunities. While some of this data might be obtainable through third party screening mechanisms, it likely does not exist for private companies. Instead, you can conduct this pre-assessment yourself by requesting initial data from your portfolio companies. Are they operating in high-risk regions? What steps are they already taking on ESG? Have they engaged suppliers on ESG? Answering these questions will get you a sense of which companies are already awake, which is useful to help prioritize your efforts going forward.
For the next stage, you should prepare to ask questions to establish a a more detailed and issue-specific performance baseline. Investors can scan for red flags by investigating four main areas: people, processes, policies, and performance
As part of this step, you should also begin to segment your assessment efforts out by industry. Investors can refer to the Sustainability Accounting and Standard’s Boards’ (SASB) Materiality Map, which outlines the most financially material ESG metrics for each industry, to guide the type of information you should be requesting from each portfolio company.
Finally, your firm has a vested interest in ensuring that your portfolio companies continuously improve their ESG profile and remain compliant over time. This stage is required to encouraging performance improvements and establishing more ambitious KPIs. Keep in contact with company leadership and continue to require accountability for new and continued ESG measures. All in all, investors should prioritize and push companies to develop pragmatic, trackable action plans, monitor their international suppliers, and provide tangible metrics and examples of their ongoing ESG journey.
As supply chains and the scope of business operations evolve, so too will the need to manage and mitigate risks. ESG factors in supply chains will continue to dominate the conversation, which is why organizations and private equity funds must maintain continuous analysis and scrutiny of global networks. If emerging risks are left unchecked, the operations, reputations, and financial performance of companies and their assets may suffer severely.
Consequently, investors should aim to engage with portfolio companies to ensure a solid framework that identifies and assesses ESG risks across their portfolio and their global supply chains.
To ensure that a supply chain adheres to the necessary standards, such frameworks must be filtered through a company’s entire network of interconnected suppliers and manufacturers. Once these systems are designed and established, it’s still imperative that investors remain involved. As previously stated, ESG compliance is an ongoing process—and a long-term investment.
Overall, investors need to successfully manage exposure and risk in an increasingly turbulent and constantly evolving world. ESG supply chain risk management will require continuous improvement from investors and portfolio companies, but the potential payoffs—and peace of mind—are well worth the effort. The best approaches iterate and evolve over time, with the input of both internal and external stakeholders.
InvestShift, the latest product by SupplyShift, is a groundbreaking platform that helps investors navigate the rapidly evolving sphere of ESG with confidence. Through a user friendly engagement platform and a dedicated team of professionals to support you, InvestShift lets private equity firms comprehensively measure ESG performance, including supplier ESG performance, for any current or prospective investment. To learn how InvestShift can help, book an introductory call with us here.
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