Introduction
ESG in private markets has gained increasing attention in recent years, amid a growing number of private companies. Investors, or limited partners (LPs), are demanding greater transparency and alignment with ESG values, pushing private equity (PE) firms to prioritise investments in companies with strong ESG strategies. In fact, investments of this nature are associated with lower risks and higher financial returns, demonstrating the vested interest of PE firms to seek ESG-complaint investments. However, challenges such as inconsistent reporting frameworks, the lack of a standardised approach, and limited resources have hindered the full potential of ESG in this field.
Why is the private market booming and why is ESG in this sector important?
The burgeoning rise of private markets has prompted many investors to increase their exposure to this sector, shifting away from public equities and fixed income assets. Empirical data shows that assets under private market management reached $13.1 trillion in 2023, growing at an annual rate of 20% since 2018. One of the key reasons for this shift in investors’ strategy stems from the much larger investment opportunity provided by private markets. Globally, there were 95,000 private companies with annual revenues of over $100 million compared to 10,000 public companies with the same metric in 2022. This presents a significant opportunity for PE firms and other institutional investors to scale their investments in this market. Additionally, investing in public equities poses considerably higher risk compared to past decades. Morgan Stanley shows that the number of publicly traded companies in the US has dropped by 50% between 1996 and 2020. This is accentuated by an increase in concentration of market value. As of 2020, the 10 largest stocks in the S&P 500 accounted for over 30% of the index’s total market capitalisation. This remarkable level of concentration raises market volatility, and the risks associated with public equity investments, causing many investors to seek more diversified opportunities in private markets.
A more general theme with investing in private companies is investors’ greater involvement with the decision-making of the company. PE firms often wield significant influence over the strategic direction of their portfolio companies, providing greater autonomy to implement changes, such as ESG strategies, into the core operations of the business. Furthermore, this avoids the principal-agent problem commonly observed in public companies. With these companies, there is a wider base of shareholders that may lead to conflicting priorities and reduced alignment between owners and board members. With this in mind, since it is in PE firms’ interest to invest in companies with robust ESG strategies (explained in the next section), they are incentivised to proactively embed ESG frameworks within the company. In fact, private investors have demonstrated that it is more effective to incorporate these frameworks early, prior to a company’s IPO, as this increases the likelihood that ESG principles will become deeply ingrained in the company’s culture and decision-making processes.
What are the key motivations for incorporating ESG strategies?
ESG reporting in companies has experienced a rapid rise over the past decade, with firms increasingly disclosing information on emissions, racial diversity, and supply chain practices. In particular, private companies, albeit not required, have also begun to publish this information in order to attract investment from PE firms. PE firms often view companies with robust ESG strategies as lower risk, avoiding any ESG controversies or regulatory penalties which may impact their reputation and financial stability. For instance, software company SolarWinds, backed by PE firm Thoma Bravo, was involved in a major cybersecurity breach in 2020, resulting in a 25% decrease in their stock. This has in turn caused a significant decrease in the value of Thoma Bravo’s holdings by $1bn, highlighting the importance of greater transparency and reporting in cybersecurity assessments.
However, PE firms are increasingly recognising ESG factors not just as risk management tools but as drivers of value creation, due to cheaper loans, greater financial performances, and attractiveness to LPs. A survey conducted by PwC shows that 70% of their PE firms surveyed view value creation as the primary drivers for considering ESG in their portfolio companies. This shift is driven by the recognition that strong ESG metrics can enhance financial returns and make investments more appealing to LPs. PE firms are also likely to see an increase in the valuation of their portfolio companies when exiting, prompting greater returns for LPs. A study by NYU Stern and Rockefeller Asset Management that looked at 1000 research papers corroborates with the survey. They found that 59% of studies on ESG in investment portfolios yield similar or better financial performance compared to conventional investment approaches. Banks are also able to offer cheaper loans when companies hit certain ESG thresholds, further underscoring the financial benefits of ESG integration for PE firms.
Additionally, various ESG-focused government policies introduced in the last few years have incentivised PE firms to look for opportunities where companies can obtain cheaper financing solutions. In the United States, the Inflation Reduction Act of 2022 has offered tax breaks for companies that operate in the renewable energy sector. For example, wind and solar energy companies are able to enjoy a 30% tax credit on their investments, which translates to a 30% cost-reduction from their tax liability. PE firms can leverage these incentives by incorporating such companies into their portfolio, improving return potential and aligning with broader sustainable goals. Furthermore, the emergence of GSS (green, social and sustainability) bonds have created a market where companies can access capital for projects with positive environmental or social impacts. This signals to investors that the companies are committed to these strategies, increasing their appeal to PE firms. Notably, these bonds also tend to exhibit lower volatility during tough markets. During uncertain market conditions, these bonds are seen as more resilient as they are associated with projects that benefit from long-term demand trends instead of short-term market fluctuations. Therefore, by incorporating these companies into their portfolio, PE firms are able to position themselves to perform well across market cycles.
What are the challenges associated with incorporating ESG strategies?
Despite growing interest, ESG investment in the PE industry, especially in growth-stage companies, remains incredibly nascent. These companies are generally at an early stage of scaling and face high risk of failure if their resources are not allocated efficiently, hence they would prioritise product development over integrating ESG into their business models. For PE firms specialising in growth-stage companies, they typically hold smaller stakes than those focused on later-stage investments, limiting their influence over strategic decisions, including ESG initiatives. In fact, these firms often lack the technical expertise to conduct meticulous ESG reports and resources to implement comprehensive ESG strategies. In contrast, larger, later-stage PE firms have dedicated ESG departments to support their portfolio companies, offering guidance on sustainable practices and reporting.
There is yet to be a unified benchmark for PE firms to adopt, making it challenging for them to compare their portfolio company’s performance against competitors or the industry as a whole. Many PE firms rely on various third-party frameworks, which can result in inconsistent outcomes. Indeed, unlike publicly listed companies, private companies are not required to disclose information about their financial statements or alignment with ESG principles, although they are likely to do so in order to attract investors. Hence, wider support from PE firms will be needed to address the disclosure and data inconsistencies, such as engagement sessions with portfolio companies and collaboration with other PE firms to create standardised benchmark indices.
Conclusion
With the rise of private markets, the role of PE firms in incorporating companies with robust ESG strategies into their portfolios is inextricably linked to efforts to enhance ESG presence in the sector. Empirical evidence shows this drives value creation, with portfolio companies benefitting from tax reliefs and GSS bonds, while PE firms experience lower risks and greater attractiveness to LPs. However, this progress is not uniform. Many early-stage companies lack resources to implement ESG practices, often prioritising scaling over ESG. To bridge these gaps, the industry should foster collaboration and create standardised benchmarks to improve transparency and reliability. This ensures ESG integration becomes a consistent element in private markets.
References
McKinsey & Company (2024) ‘Private markets: a slower era’. McKinsey Global Private Markets Review 2024. Available at: https://www.mckinsey.com/~/media/2024/mckinsey-global-private-markets-review-2024.pdf (Accessed: 13th November, 2024).
Spencer, D. (2022) ‘Total portfolio approach, Part 1: Key reasons why investor interest in private markets continues to grow’. Russell Investments Blog. Available at: https://russellinvestments.com/uk/blog/why-private-markets-investments (Accessed: 13th November, 2024).
J.P. Morgan Asset Management (2022) ‘How green, social and sustainability bonds could change the world’. Financial Times Partner Content. Available at: https://jpmam.ft.com/how-green-social-and-sustainability-bonds-could-change-the-world (Accessed: 14th November, 2024)
Robson, B. and Savage, G. (2024). ‘The unique challenges of applying ESG in Venture Capital’. bvca. Available at: https://www.bvca.co.uk/Our-Industry/The-BVCA-and-ESG/Excellence-in-ESG/The-unique-challenges-of-applying-ESG-in-Venture-Capital (Accessed: 14th November, 2024).
Gara, A. (2021). ‘SolarWinds hack throws wrench in Private Equity’s most profitable market’. Forbes Investing. Available at: https://www.forbes.com/sites/antoinegara/2020/12/18/solarwinds-hack-throws-wrench-in-private-equitys-most-profitable-market/ (Accessed: 14th November, 2024).
PwC (2023). ‘Generating upside from ESG: opportunities for Private Equity’. Global Private Equity Responsible Investment Survey 2023. Available at: https://www.pwc.com/gx/en/services/sustainability/publications/private-equity-and-the-responsible-investment-survey.html (Accessed: 14th November, 2024).
Investec (2024). ‘Private equity sees ESG’s inherent value’. Financial Times Partner Content. Available at: https://investec.ft.com/private-equity-sees-esgs-inherent-value (Accessed: 15th November, 2024).
ESG News (2024). ‘85% of Investors to Prioritize Sustainability as Private Equity Accelerates Net Zero Efforts: BCG Report’. Available at:
https://esgnews.com/85-of-investors-to-prioritize-sustainability-as-private-equity-accelerates-net-zero-efforts-bcg-report/ (Accessed: 15th November, 2024).
CFA Institute (2024). ‘How private market funds are integrating ESG in investments’. Available at: https://www.cfainstitute.org/en/professional-insights-stories/how-private-market-funds-are-integrating-esg-in-investments (Accessed: 15th November, 2024).