Environmental, Social and Governance (ESG) is now a key part of investment decisions in the private capital markets, sustainability consulting firm ERM concluded in a recent report.
ERM surveyed 54 private equity investment professionals from around the world about how ESG impacts their decision making when choosing companies in which to invest.
The results of the poll underscore the important and growing role ESG plays in investment choices and that it no longer is considered “just a risk management issue” but is now viewed as an important factor in “value enhancement potential.”
Among the survey’s key findings were that 50% of those surveyed said ESG credentials are a factor in winning deals and 70% believed that ESG ‘sell-side’ due diligence will be undertaken increasingly over the next three to five years. “Anticipating buyer questions is the primary reason for including ESG in vendor packs,” the study found. Eighty-six percent of the respondents said they have access to a dedicated ESG Lead/Team that offers this expertise.
The survey also found that 25% of firms have an ESG fund or strategy and actively seek out ESG-focused investments, while 60% of those surveyed said there needs to be regular and in-depth board engagement with companies to make sure that important ESG factors are addressed during ownership.
In addition, since ERM’s last survey in 2016, there has been a “three-fold increase in the perception of ESG as a positive contribution to the exit multiple in sales processes, which also explains the trend to have better ESG disclosures in exits.”
Finally, 93% of those polled “agreed that focusing on ESG themes, that is, companies offering solutions or services to address sustainability challenges and trends, will generate good investment opportunities” and 83% said they believe that Europe will lead the way as a “hotbed of ESG investment activity” and other regions “will soon follow.”
“Going forward, it is clear that business resilience will be highly valued over the coming years, with investors and buyers willing to pay a premium for companies that can demonstrate strong ESG credentials and a resilient business strategy,” ERM stated.
Louise Pearce, ERM’s global mining and metals lead, said the purpose of the survey was to provide insights into the shifting dynamics of ESG in private equity and what this means in terms of how capital is deployed.
“You can no longer just tell a great story about a significant discovery, you’ve got to build in the broader sustainability issues,” she said in a Zoom call from her home in Toronto. “It is important to show how you are working with the local communities, and the value provided to them, how your company contributes to the low carbon economy transition, and to the responsible sourcing of metals.”
To emphasize how things have changed, Pearce relayed an anecdote from five or six years ago when she participated in a panel at a mining conference with an executive from a private equity firm. When asked about ESG at that time, the executive said all they cared about was that a company wasn’t in the newspapers and had a sustainability report of some sort. “Today it’s completely different,” Pearce explained. “There has been a complete shift in what the money is looking for as investor awareness increases. They want to see the company’s performance on environmental and social metrics, how a company’s social and environmental performance is tied to executive remuneration; and they want to see key performance indicators.”
According to the ERM survey, as of March, the amount of assets under management among ESG funds totaled more than US$1 trillion – marking a 35% increase over the preceding three year period – and European funds make up about 75% of these assets under management. In addition, 85% of ESG equity indices outperformed non-ESG peers in the first quarter of 2020, and 80% of fixed income assets did the same in the second quarter of the year.
The survey also found that 86% of those polled expect the pipeline of ESG investment opportunities to increase over the next three to five years and 21% said there will be significantly more.
ERM quoted one respondent, a managing director of an investment team at a European company, as saying: “For two businesses with [the] same profitability, we would be willing to pay a premium on the one that is a sustainability leader in its segment … because when we sell it in four to six years, we will get an even higher premium if we can maintain and grow this position.”
“Many firms are now recognizing the lucrative opportunities behind ESG themes but the leaders will be those that have a systematic process to identify these prospects and take decisive measures to create competitive advantage,” according to the report.
ERM also noted an emerging link between executive compensation and ESG, with 36% of the respondents saying they would like to see management incentives aligned with ESG metrics.
Drilling down into the most important ESG themes, ERM said 55% of those surveyed identified climate change impacts, societal wellbeing, water/wastewater and the circular economy as the areas that present the biggest opportunities between now and 2025.
As for regions where ESG has emerged as a significant theme, Europe leads the pack, followed by Asia-Pacific and North America. ERM pointed out that those surveyed said Europe offered the greatest opportunity for ESG-related investment due to its goal of becoming the world’s first climate-neutral region by 2050 and its intention to reduce greenhouse gas emissions by 55% before 2030.
“Five or six years ago a number of mining executives didn’t embrace climate change as a business challenge and now it’s really hard to find anybody who would talk about it not being real,” Pearce said. “It presents both a threat and an opportunity to the mining sector.”
Pearce said ERM is seeing an increasing number of miners announce net zero targets and looking at options to reduce their direct and indirect, or value chain, carbon emissions. This is being drive by a combination of regulation around climate change disclosure, such as the Task Force on Climate-Related Financial Disclosure (TCFD), and mounting pressure from investors on ESG performance, she said. “It’s a complex challenge, especially when you consider the important role that mining and metals companies play in terms of providing critical metals for the transition to a low carbon economy. The de-carbonization challenge requires collective action from a broad range of stakeholders – miners, downstream metals producers, governments, financial institutions, low-carbon technology providers etc. More broadly, the transition to a low carbon economy is about societal contribution to climate change … everyone has a role to play.”
Pearce also pointed to growing shareholder activism and the fall-out unfortunate decisions can have, such as Rio Tinto’s move earlier this year to destroy 46,000 year-old-rock shelters in Australia. “Things have changed, the world has changed,” she said. “You have the rise in awareness of systemic racism and the need for reconciliation with Indigenous peoples, to name two. The landscape has fundamentally changed in the past few years.”
Pearce noted that if companies have agreements with regulators or local communities from five or six years ago, the onus is still on the company to challenge itself and make sure these past agreements, even if in writing, align with today’s higher standards.
“Broader societal values have shifted so much that simply having an agreement or even permits from five years ago doesn’t mean you have the right to do what you thought you could do,” she said. “It’s not that the agreement itself is null and void, just that the conditions between when it was signed and actually delivered have dramatically changed. Companies need to ask themselves: ‘Is what we did five years ago still valid today? … They need to continually check in on their social license to operate, and make sure it’s up-to-date.”