Private Equity Industry is warming up to ESG
Synopsis: While ESG investing has picked up significantly over the last couple of years because of several related events, there are questions on whether there is a skew across asset classes when we talk about sustainable finance. This is an important area not only because the environment and social issues need attention across the board but also because the several ESG frameworks like Net Zero Asset Managers’ initiative (NZAMi) explicitly puts the onus on asset managers to ensure that they comply with their targets across different asset classes in their portfolios. While equities or green bonds hog the limelight, the private-equity firms also have become increasingly focused on ESG issues and there has been a visible change over the last eighteen months. However, with institutional investors being important contributors in funds for private equity, this is not really surprising. Up until 2019, private equity as such wasn’t all sure of ESG. But the pandemic and the resulting demand for ESG integration into investments changed the climate for them. Many have already built sustainability teams and hired new ESG heads. For example, Brookfield Asset Management, the USD 600 billion Canada-based real asset and private equity investment firm, in August 2020, hired former Bank of England governor Mark Carney to head its ESG and impact fund investing following which the firm announced the launch of a USD 7.5 billion climate change fund. While it is noteworthy that the activists’ community view private equities venture into ESG as nothing more than just words with the scent of greenwashing, nonetheless it is a big positive step for ESG as a trend in investments.
Private Equity – Why it is different from other asset classes
In a report titled “Everyone’s on the ESG Investing Bandwagon” by Natixis, it was found that the percentage of institutional investors that implement ESG approaches rose 18% between 2019 and 2021. One of the reasons cited by Natixis for this growth was the pressure being put on asset owners and asset managers by the regulators to enact sustainability measures. But does this apply across different asset classes? For example, how is the private equity space evolving in the context of ESG?
Private equity, by its very nature, can dictate the future functioning of a company far more than other investments. Unlike hedge funds or even large and influential long-only institutions in the secondary market, private equity is in the game for the longer term. While they would be monitoring the KPIs (Key Performance Indicators) through regular MIS, private equity would have a far higher risk appetite and a much more patient approach. They would also engage with the management far more regularly and in a much more active manner.
So, the private equity investors will be vocal as it becomes crucial for them to make necessary changes in management, business model, and important operational issues in the company they invest in. It is often necessary because the private equity firms may also buy out a financially distressed private company or take a controlling position in a publicly listed company. So, their approach towards these investments will reflect the strong views they will have about the companies they would run.
As it is more often the case that they are invested for the longer term, undoubtedly, they have a vision for the institution they have acquired. So, the proactive approach will include that they could bring in a change in management, they would push for restructuring the operations, they would be working on overhauling the backend and other physical infrastructure, and may eventually be selling the company for a profit, either privately or through an initial public offering in the markets.
ESG – The new arithmetic of value creation
Many investors, practitioners, and other important constituents in the private equity space have begun to view ESG not only as a risk management tool or a value protection strategy but they have also started to see it as a value creation driver. That is a big change, going from a ‘negative screening’ to a ‘positive filter’. ESG has started to occupy a significantly large part of the investor’s attention and decision-making.
There are other reasons as well. With banks and financial institutions getting increasingly aware of sustainability issues while lending to private equity firms by using ESG as a filter, the private equity firms thus find themselves having their hands tied to incorporate ESG. Sometimes, a change for good isn’t organic and it may require external inputs, or rather, it has to be curated.
Let’s see what the world’s largest private equity firms are doing in terms of ESG.
With USD 619 billion in Assets Under Management, Blackstone is one of the largest private equity firms in the world. It has investments across a variety of sectors such as energy, retail, and technology. In May of this year, Blackstone, for the very first time, in a letter to its portfolio company CEOs controlled by its private equity arm, asked them to regularly report on ESG matters to their boards. Blackstone appreciates the importance of ESG in decision making as Blackstone’s private equity business head wrote to their portfolio company CEOs, “Environmental, social and governance factors are attracting greater focus globally and demand careful attention on your part.”
Figure 1: Share price of Blackstone over the past five years
Private equity amounting to USD 103 billion constitutes Blackstone’s largest category of investments. In April, Blackstone hired big names to its ESG team including James Mandel (who led carbon-free building program at non-profit group Rocky Mountain Institute) and Caroline Hill (former head of responsible business at Lloyds Banking Group Plc).
Blackstone announced in July that it would be acquiring Sphera from Genstar Capital for approximately USD1.4 billion. Sphera is a market leader in ESG software and solutions space and the buyout would allow Blackstone access to Sphera’s proprietary SaaS software.
Before this, in 2020, Blackstone set a goal of reducing carbon emissions by 15% within the first three years of buying any asset or company across its portfolio beginning with where the firm controls the energy usage, with plans to expand it to all its portfolio holdings.
KKR & Co
Founded in 1976 and headquartered in New York, KKR with an AUM of USD 252 billion, is known for being one of the first firms to engage in large-scale leveraged buyouts (LBOs). Having been a signatory to the United Nations-backed Principles for Responsible Investment (PRI) since 2009, KKR also has its own “KKR’s Responsible Investment Policy”, which articulates the firm’s approach to integrating the consideration of ESG risks and value creation opportunities into investment processes across various asset classes globally. KKR has been focused on ESG and impact investing for more than a decade.
Figure 2: Share price of KKr & Co over the past five years
In February 2020, KKR raised USD 1.3 billion for a global impact fund called “KKR Global Impact Fund” with a focus on sectors providing commercial solutions to environmental or social problems including waste management. Following that, in August 2020, KKR acquired stakes in two South Korean companies: ESG Co Ltd, a medical waste treatment firm, and ESG Cheongwon Co.Ltd., an industrial waste management company for USD 739 million from Hong Kong-based PE firm Anchor Equity Partners.
In April of this year, KKR continued its growing ESG interests by getting into discussions to acquire another South Korean waste treatment firm Yido Co. KKR clearly sees South Korea as a hotbed of ESG value, especially on the environment front. The state of Governance in South Korea is an open secret.
Read More: What is cooking in South Korea on ESG?
Continuing with its ESG push, KKR poached former Blackstone’s global head of ESG, Alison Fenton-Willock as a senior leader of its ESG team in May 2021. She is currently the Director-Sustainable Investing at KKR. During the same time, Blackstone created five new positions and appointed new names to its ESG team. The competition between the top private equity firms to one-up each other on ESG is evident. KKR also announced in May that it had signed an agreement to acquire a majority position in ERM, the world’s largest pure-play sustainability consultancy.
The race to acquiring ESG analytics and data provider firms is heating up as many asset managers view acquisition to be an efficient option over building a homegrown ESG team organically. This also calls for caution to be exercised on part of the asset managers. Considering how lucrative the ESG space as a whole has become, there will certainly be players who will portray themselves as a quality source of ESG data, when in reality they would be not.
Founded in 1992 by David Bonderman and Jim Coulter and headquartered in San Francisco California, TPG Capital, formerly known as the Texas Pacific Group, has a total AUM of USD 96 billion. In 2016, TPG Capital launched its inaugural impact-investing fund—the USD 2 billion Rise Fund in partnership with the Irish rock star Bono and Jeff Skoll. According to its website (www.therisefund.com ), “The Rise Fund seeks to expand the reach of commercial capital in order to help a new generation of entrepreneurs build profitable businesses that deliver positive and sustainable impact”.
In early 2021, TPG raised USD 5.4 billion for its first climate fund “TPG Rise Climate” from institutional investors and over 20 companies. It received subscriptions from institutional investors including Allstate, AXA, The Hartford, Ontario Teachers’ Pension Plan Board, Public Investment Fund, Public Sector Pension Investment Board, School Employees Retirement System of Ohio, Silk Road Fund, State of Michigan Retirement System, Universities Superannuation Scheme (USS), and Washington State Investment Board, the firm’s media statement said.
TPG’s co-founder Jim Coulter has been a champion of climate investing and ESG. In May, Coulter stepped away from TPG Capital to focus on Rise and the new TPG Rise Climate Fund. According to Coulter, private equity is the best place to fix the G of governance in ESG. A good board should function “like a dinner party,” Coulter said.
Very recently, TPG’s USD 5.4 billion climate fund made its first investment in clean energy, while partnering with investors, including Bill Gates, to develop a low-cost battery that enables electricity networks to better integrate renewable energy.
Private Equity, Net Zero, PRI and other drivers.
But there is a long way to go. According to EY’s annual report, only 34% of firms it surveyed with more than USD 15bn in assets had a head of ESG, which fell to 12% for firms with assets between USD 2.5bn and USD 15bn and to 2% for firms with assets under USD 2.5bn. There is clearly a lack of ESG leadership which although may not be of significance now but could backfire later.
The consistently high performance of private equity puts it in the driver seat to promote sustainability and shaping a net-zero future. According to a report titled, “The Changing Climate for Private Equity”, carried out by Ceres and The SustainAbility Institute by ERM, it has been mentioned that that there is an urgency to act on climate within private equity, but that there is a clear need for direction, guidance, and peer engagement.
This is supported by the fact that signatories to the United Nations’ Principles for Responsible Investment (PRI) jumped 28% in 2020 and now number more than 3,000 institutional investors and PE firms, representing a staggering USD 103 trillion of assets under management. Before jumping the gun, it would be wiser to take a detailed look first. According to Institutional Investor while the PRI signatory list includes 431 PE firms from around the world, only 16 of them disclose ESG’s impact on financial returns, and only half use ESG principles in monitoring more than 90% of their portfolio companies.
There is evidently a big gap between preaching and practicing. It is not just among the Asset management firms where such discrepancies are noticed. It is also a case of geographical discrepancies. While it is well known that the European Union is pushing sustainability as a pillar of financial and societal well-being, America isn’t as proactive.
According to an insight by Bain & Company, “ While 80% of the top 20 EU-based institutional investors have committed to either the PRI, the UN’s Net-Zero Asset Owner Alliance or the Task Force on Climate-related Financial Disclosures, less than half of the top 20 North American institutions have done so, and many of those are based in Canada”.
ESG isn’t just a regulator tool. Neither is it a solely money-making venture. Rather it combines these two elements and sprinkles a lot of purpose into the mix. Aligning values with investment has become the slogan for investors today. And they are ensuring that fund managers listen to their appeal and take assuring steps to carry out the same. ESG has become central to a company much like any other financial risk.
Ardian, one of Europe’s largest buyout houses, recently conducted a survey of its general partners (GPs, or private equity managers) focused on assessing ESG credentials. It found that 30% have at least one full-time corporate social responsibility officer, a significant increase from 14% two years ago. These managers are training more people and are using the UN’s Sustainable Development Goals (SDG).
The fact that nearly 90 private equity firms representing over USD 700 billion in AUM have signed up to the Initiative Climat International (iCI), a first of its kind climate initiative for private equity, supported by the Principles for Responsible Investment (PRI) is also a sign of positive progress.
Where EMAlpha can help
There is a profound ESG movement going all over the globe right now. From countries to asset managers, from millennial investors to the old school stalwarts, everybody’s counting on the ESG chip for a better future and a better return on investment. There is almost an undisputed global consensus that businesses must incorporate sustainability into their operations.
While the ESG deliberation is appreciable, one can’t deny the challenges facing the ESG movement. Be it lack of proper metrics, frameworks, or quality of ESG information, ESG still has plenty of hurdles to overcome for it to be a sustainable investment instrument. Then there is also the challenge of Greenwashing.
In general, EMAlpha with its proprietary AI-ML techniques becomes useful for investors to gauge companies on the ESG front. As we have discussed, the changes in perception on ESG track record of a company and reactions from institutional investors have become an important driver of stock prices and especially in cases where the volatility is high, it matters even more.
From individual stocks to a portfolio, the complexity increases even more and EMAlpha AI-ML is a helpful tool for Asset Managers in evaluating progress for their portfolios and take corrective measures, as and when required. The following are four major components wherein EMAlpha can aid investors.
- The local language along with English news analysis can be tracked for companies experiencing increased competition. Considering the sensitivities involved, these issues could escalate quickly, thus impacting the stock price performance.
- The unstructured data analysis in other geographies can also be used to assess the potential impact on some of the larger companies. A case in point being Amazon in Poland which is very similar to the impact it had on Flipkart in India.
- Predicting the behavior of large institutional investors can help forecast the stock price impact. This is one of the key features of the EMAlpha product as it combines technology with domain expertise. There are cases when fears are unfounded and that creates opportunity.
- The social media analysis provided by EMAlpha is useful in picking up the signals when the views change for retail investors as compared to the stand of institutional investors. In many cases across markets, this plays a crucial role.
- Blackstone aims to cut carbon emissions by 15% https://www.spglobal.com/marketintelligence/en/news-insights/latest-news-headlines/blackstone-aims-to-cut-carbon-emissions-by-15-60529104 (Accessed on 27th August 2021)
- Blackstone Sets Goal to Reduce Carbon Emissions https://www.wsj.com/articles/blackstone-sets-goal-to-reduce-carbon-emissions-11601377200 (Accessed on 27th August 2021)
- MOVES Blackstone makes sustainability push with slew of new hires https://www.reuters.com/business/sustainable-business/moves-blackstone-makes-sustainability-push-with-slew-new-hires-2021-04-27/ (Accessed on 27th August 2021)
- Blackstone to Acquire ESG Software Firm Sphera https://finance.yahoo.com/news/blackstone-acquire-esg-software-firm-072025906.html (Accessed on 27th August 2021)
- EXCLUSIVE Blackstone asks its companies to regularly report on sustainability https://www.reuters.com/business/sustainable-business/exclusive-blackstone-asks-its-companies-regularly-report-sustainability-2021-05-03/ (Accessed on 27th August 2021)
- World’s top 10 private equity firms https://www.investopedia.com/articles/markets/011116/worlds-top-10-private-equity-firms-apo-bx.asp (Accessed on 27th August 2021)
- Responsible Investment https://www.kkr.com/responsibility/responsible-investment (Accessed on 27th August 2021)
- KKR wraps up $ 739 million purchase of Korean waste management firms https://www.kedglobal.com/newsView/ked202008210004 (Accessed on 27th August 2021)
- KKR chasing another Korean waste management firm Yido, betting big on ESG https://pulsenews.co.kr/view.php?year=2021&no=338486 (Accessed on 27th August 2021)
- KKR hires Blackstone’s global head of ESG https://www.newprivatemarkets.com/kkr-hires-blackstones-global-head-of-esg/ (Accessed on 27th August 2021)
- KKR to Acquire Majority Position in ERM https://www.businesswire.com/news/home/20210517005309/en/KKR-to-Acquire-Majority-Position-in-ERM (Accessed on 27th August 2021)
- TPG raises $5.4 bn for inaugural climate fund https://www.vccircle.com/tpg-raises-5-4-bn-for-inaugural-climate-fund (Accessed on 27th August 2021)
- Iron-air long-duration battery startup Form Energy closes US$240 million funding round https://www.energy-storage.news/iron-air-long-duration-battery-startup-form-energy-closes-us240-million-funding-round/ (Accessed on 27th August 2021)
- The education of Jim Coulter, or: How private equity learned to stop worrying and love ESG https://impactalpha.com/the-education-of-jim-coulter-or-how-private-equity-learned-to-stop-worrying-and-love-esg/ (Accessed on 27th August 2021)
- Institutional Investors Report That ESG Will Be a Future Focus https://www.plansponsor.com/institutional-investors-report-esg-future-focus/ (Accessed on 27th August 2021)
- Private equity’s journey: from compliance to value creation https://www.pwc.com/gx/en/services/sustainability/publications/private-equity-and-the-responsible-investment-survey.html (Accessed on 27th August 2021)
- Hedge funds and private equity improve ESG focus yet face differing reporting and monitoring challenges https://www.privateequitywire.co.uk/2021/08/25/305333/hedge-funds-and-private-equity-improve-esg-focus-yet-face-differing-reporting-and (Accessed on 27th August 2021)
- New report explores private equity’s role in addressing climate threats to the global economy https://www.ceres.org/news-center/press-releases/new-report-explores-private-equitys-role-addressing-climate-threats (Accessed on 27th August 2021)
- Nearly 90 private equity firms representing $ 700 billion AUM have signed up to a global climate initiative ahead of COP26 https://www.unpri.org/news-and-press/nearly-90-private-equity-firms-representing-700-billion-aum-have-signed-up-to-a-global-climate-initiative-ahead-of-cop26/7383.article (Accessed on 27th August 2021)
- Private equity makes ESG promises. But their impact is often superficial https://www.institutionalinvestor.com/article/b1m8spzx5bp6g7/Private-Equity-Makes-ESG-Promises-But-Their-Impact-Is-Often-Superficial (Accessed on 27th August 2021)
- Hedge fund vs Private Equity: What’s the difference https://www.investopedia.com/ask/answers/121614/what-difference-between-hedge-fund-and-private-equity-fund.asp (Accessed on 27th August 2021)
- Why private equity has started taking ESG seriously https://capitalmonitor.ai/asset-class/equity/why-private-equity-is-finally-taking-esg-seriously/ (Accessed on 27th August 2021)
- The expanding case for ESG in private equity https://www.bain.com/insights/esg-investing-global-private-equity-report-2021/# (Accessed on 27th August 2021)
- Private equity goes on ESG recruitment drive https://citywireselector.com/news/private-equity-goes-on-esg-recruitment-drive/a1512632 (Accessed on 27th August 2021)
EMAlpha Products and Services
In most Emerging Markets, information discovery is a major challenge. For example, even if global investors do show interest, how do they solve the problem of timely access to information? The world’s largest capital allocators hold USD 60 trillion and they include GPIF (Japan), GPF (Norway), ADIA (Abu Dhabi), GIC (Singapore) etc. However, only 10% of the capital gets allocated to EMs and ~90% goes to G10. The big hurdle for EMs is: Foreign investors cannot access relevant local information in a timely fashion.
Most market participants and investors from across the world realise that the low rates in G10 makes EM attractive for investors. But, a) Information access is usually a cost and time intensive process for investors, and b) In many EMs, language is a big barrier and because of multiple regional languages, there is a significant delay before news makes it to the mainstream English language. To address these issues, you need solutions like, a) Real time news collection from multiple languages and, b) Instantaneous machine translation and text analytics leading to actionable recommendations for investors.
There are further challenges such as ensuring that companies behave responsibly and that they adopt sustainable business practices. There is a need to ensure that the investors are contributing towards making the world a better place by making investment decisions which reward responsible behaviour of companies. Case in point, ESG (Environmental, Social & Governance) which is increasingly being used as a filter for investment decisions. There are other issues as well such as which data to use and a lack of a standardized framework for evaluation.
Some of these issues are too important to be postponed to a later date and it is in this regard that EMAlpha is making its contribution. EMAlpha has developed a Flexible ESG Framework Management System which is a proprietary technology that makes ESG scores framework agnostic, thus allowing for quick adaptation. In addition, the users decide what matters to them and the EMAlpha system does a classification into E, S, G and more granular categories.
EMAlpha also has solutions for Multilingual data collection and real time targeted information which are based on proprietary processes to collect relevant data across multiple markets. The coverage expands across emerging market equity, currencies and commodities and the work has also been very successful in testing the signals in some key markets for live trading strategies. This is a continuous cycle and a virtuous loop that allows for iterative improvement through AI-human feedback.
With developments in AI and technology in areas like NLP, there are considerable new possibilities to bridge the gap in information between Emerging Markets and the more Developed Markets. This is an area which is turning out to be very exciting because some of the tools mentioned were not available even a couple of years ago. This implies that the evolution in the field will only get faster as time goes on. While the Emerging Markets and the Capital Flow Conundrum is a complex one, there is now much more hope and optimism that with the usage of technology, things will only get better.
At EMAlpha, the ESG team is doing further research on why some issues like Social get more prominence as compared to others like Environmental or Governance issues. To look at specific cases in the context of ESG is a very intense yet interesting exercise and this has been an incredible learning experience for the EMAlpha Research team. The data, information and ratings are a humongous challenge for ESG and it takes time to reach to the depth of the issues as the field is evolving very quickly.
EMAlpha is making a solid contribution in tackling these challenges. EMAlpha has solutions for ESG which are practical, user friendly and although not too simplistic yet easy to use. EMAlpha has developed a Flexible ESG Framework Management System which is a proprietary technology that makes ESG scores framework agnostic, thus allowing for quick adaptation. In addition, the users decide what matters to them and the EMAlpha system does a classification into E, S, G and more granular categories.
We strongly believe that the entire ESG ecosystem requires multiple stakeholders to pull in the right direction in order to make it operational and that will be the most critically determining factor for ESG’s success in making the corporate responsibility actually work. Most importantly, the investors should view ‘E’, ‘S’ and ‘G’ individually and should not confound issues when it comes to the comprehensive ESG evaluation. It is important to understand the right reasons behind ESG investing because this bias could hurt their investment decision making and portfolio performance.
EM Alpha LLC
For more EMAlpha Insights on Emerging Markets, please visit https://emalpha.com/insights/. To know how you can use EMAlpha’s unstructured data and ESG (Environmental, Social and Governance) solutions for better investment decisions, please email us at [email protected].
EMAlpha, a data analytics and investment management firm focused on making Emerging Markets (EMs) more accessible to global investors and unlocking EM investing using machines. EMAlpha’s focus is on Unstructured Data as the EMs are particularly susceptible to swings in news flow driven investor sentiment. EMAlpha works on information discovery and ESG solutions for Investors in Emerging Markets, using AI and NLP tech. Our mission is: “To help increase capital flow, in terms of FDI and FPI, to Emerging Markets by lowering information barriers using AI/NLP”. EMAlpha Products help achieve both alpha and ESG solutions and the idea is to help asset allocators, asset managers, banks and hedge funds along with companies with cost and time efficient access to relevant information. We use thoroughly researched machine learning tools to track evolving sentiment specifically towards EMs and EMAlpha pays special attention to the timely measurement of news sentiment for investors as these markets can be finicky and sentiment can be capricious. Our team members have deep expertise in research and trading in multiple Emerging Markets and EMAlpha’s collaborative approach to combining machine learning tools with a fundamental approach help us understand these markets better.
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