ESG Portfolio Monitoring
Challenges Facing Private Market Investors in a Changing Regulatory Environment
Perhaps more than any other group of investors, private market investors have been on the forefront of embracing sustainable investing and incorporating environmental, social, and governance (ESG) considerations into their decision-making processes. Today, approximately seven out of 10 limited partners (LPs) say that ESG factors play a role in their organization’s investment policies, according to a recent survey by ILPA and Bain & Company, and those policies impact more than three quarters of the assets held under management.1 By contrast, less than a quarter of institutional investors in general report incorporating ESG factors into such a large portion of their investment holdings.2
Private market investors are also in a far better position, in theory, to bring about positive ESG changes in the first place.3 Consider the fact that investors who undertake ESG strategies through publicly traded equities may not control many — if any — board seats of the companies in which they invest. Yet even private equity firms that don’t own 100% of a portfolio company are still likely to have adequate board representation and direct access to management to influence the company’s operations as they pertain to ESG goals and performance.
Ironically, the same private market investors who are embracing ESG and have real power to bring about positive changes also face challenges when it comes to obtaining good, relevant data on their holdings, monitoring that ESG performance over time, and being able to benchmark that performance in a way that sharpens their investment decision making.
This may be why more than twice as many asset managers (74%) use public equities to deploy their ESG strategies versus private equity and private debt (34%).4 It may also explain why only around half of private equity (PE) firms who are signatories to the U.N. Principles for Responsible Investment (PRI) utilize ESG considerations when monitoring the majority of their portfolio companies.5
While these challenges may work themselves out over time, there is a great sense of urgency today, as the regulatory landscape is shifting swiftly, likely requiring faster-than-expected action to get ESG performance data in order.
What’s driving the push for better portfolio monitoring now?
Part of the reason shortcomings in private market ESG data haven’t been addressed yet may have to do with two countervailing forces. At once, there seems to be too little standardized ESG performance data pertaining to the private companies these firms own.6 At the same time, there has been a proliferation of competing ESG frameworks, adding to a sense of confusion in the marketplace. Yet an even bigger force is now pressuring the private markets to improve their portfolio monitoring capabilities.
Nine out of 10 investors say the biggest reason they are considering implementing more ESG factors into their investment decision-making is due to the evolving regulatory backdrop and legal requirements.7 Until recently, many of those pressures have been coming from Europe, through rules such as the Sustainable Finance Disclosure Regulation (SFDR), which requires asset managers to disclose ESG-related data not just at a firm level, but at a product or investment level as well.
There is also the European Union’s Taxonomy Regulation, a complex and lengthy classification system that spells out what sustainable economic activities constitute. To fit the definition today, an economic activity must contribute to at least one of six objectives: climate change mitigation, climate change adaptation, sustainable use and protection of water and marine resources, transition to a circular economy, pollution prevention and control, and protection and restoration of biodiversity and ecosystems. Moreover, sustainable economic activities must do no significant harm to any of the other objectives, and they must also respect basic human rights and standard labor practices.
Now, investors must also be mindful of the U.S. Securities and Exchange Commission (SEC). In March 2022, the SEC proposed climate disclosure rules outlining the metrics by which public companies need to disclose data regarding their direct contribution to greenhouse gas (GHG) emissions, known as Scope 1 disclosures, along with indirect emissions generated through their purchase of electricity and other forms of energy, or Scope 2. Scope 3 disclosures would also require public companies to report on emissions generated throughout their value chain.
The proposed requirements could affect private companies in a couple of ways. For starters, PE firms looking to the initial public offering (IPO) market as a potential exit for their portfolio companies would have to monitor, track, and document GHG emissions ahead of any potential filing for an initial public offering. Private companies are also indirectly affected by Scope 3, which requires public companies to report on the upstream and downstream activities of their value chains, including each company’s suppliers and service providers, even if they are privately held businesses.
This has the potential to complicate data requirements in several ways:
- Scope 3 requirements come into play if material — in other words, “if there is a substantial likelihood that a reasonable investor would consider them important when making an investment or voting decision.”8 But what is that likelihood? And what would a reasonable investor consider?
- Scope 3 emissions may also constitute the lion’s share of a company’s overall emissions, as it includes all emissions generated from the raw materials a company purchases, the suppliers and partners a company works with, as well as the disposal of the company’s products after they are used and discarded.
- Scope 3 data is also largely outside the direct control of the investor and relies on information generated by each company’s suppliers, distributors, and service providers. This data may be harder to monitor, measure, and accurately report if the value chain includes private companies with less capacity to monitor and report such data accurately.
Other factors driving demand for better monitoring
Nearly eight out of 10 investors who are already incorporating ESG factors in their decision-making process, or considering it, say that managing risk is a chief reason why.9 The connection between ESG and operational risks is particularly pronounced in private credit, given the correlation between credit ratings and how companies manage their climate risks.
When it comes to sovereign debt, for instance, recent research by the International Monetary Fund has determined that a country’s exposure to climate change, or management of and resilience to it, can directly impact its creditworthiness and likelihood of default. Among private lenders, climate risk management is increasingly viewed as an early warning indicator for credit rating risks down the road. Therefore banks and lenders, led by many outside the United States, are increasingly looking at integrating climate risk data into their own credit risk management operations.
Underscoring the need for better and more accurate monitoring is the fundamental desire to protect and increase value. Around half of all LPs believe ESG considerations are additive to their investment performance.10 Among European investors, this is even more pronounced, with around two thirds of LPs believing that ESG drives valuation premiums.11 This is why ESG monitoring is a particularly important consideration when a potential exit option for a portfolio company is an IPO, where public market scrutiny will demand visibility and competency surrounding ESG performance.
Even for investors who aren’t convinced that ESG is additive to returns, there is a defensive motivation for more effectively monitoring and measuring ESG performance. Increasingly, investors understand that if they don’t act on ESG — and back it up with data — this could negatively impact the assets on their balance sheet over the coming five, 10, or 20 years. This is particularly true when managing exits. The vast majority of North American and European LPs, for example, say they would walk away from a deal for a variety of reasons associated with ESG shortcomings, such as lack of ESG alignment and poor ESG reporting practices.12 By contrast, only 7% of LPs say they would not walk away from a deal for ESG reasons.
Increasingly, the push for greater and better data is being driven by LPs themselves. Among the questions they are increasingly asking:
- How are you measuring progress in portfolio companies?
- How are you benchmarking that progress?
- What evidence is there that you are helping companies improve on ESG?
- What kind of progress can you demonstrate on key issues such as climate risk, biodiversity, DEI (diversity, equity, and inclusion), social impact, and matters that are specific to your firm and industry?
These are the questions investors frequently want answered as they have moved beyond being satisfied with the mere existence of an ESG policy. They now want to see evidence that the ESG policies that are in place are working and that the right factors are established to satisfy the board and regulators.
Challenges facing private market investors
While there are plenty of incentives for better and more accurate ESG monitoring in the private markets, there are also several challenges in place. For instance:
Which framework to choose?
Though assets held in sustainable investing strategies have taken off within the past decade, platforms and frameworks for organizing and standardizing ESG data have been in existence for much longer. The Global Reporting Initiative (GRI), for example, was established in 1997 as part of the U.N.’s Environment Programme (UNEP), and the platform now tracks performance on the U.N. SDGs as part of its basic framework.
Over the years, other initiatives have been launched either to sharpen the data being gathered or improve the system of measurement. In 2011, Ceres and the Tellus Institute created The Global Initiative for Sustainability Ratings (GISR), arguing that “stakeholders of all types — investors, companies, non-governmental organizations (NGOs), government, consumers — are weary of continued confusion, uneven quality, and opacity in sustainability ratings.” At around the same time, the Sustainability Accounting Standards Board (SASB) was established in hopes of becoming a standard-setting body, much like the Financial Accounting Standards Board (FASB). SASB has been particularly vocal in identifying sustainability issues that are most relevant to each industry in an effort to create standardized reporting that is most material and germane to asset managers and owners.
More recently, a group of prominent PE investors has taken steps to improve how fragmented ESG data is collected and reported in the private markets. The idea behind the ESG Data Convergence Initiative is that if private market investors can coalesce around a small set of key performance indicators that are broadly relevant and that could be reported at the same time with standard definitions and normalization factors, the industry could build out meaningful ESG performance data that could be benchmarked. This would reduce the amount of time required of LPs and investment managers to research investments from a sustainability standpoint. The initiative is still relatively new, with 139 General Partners and 77 Limited Partners and investment managers participating.
Things get even more confusing when sustainable investors venture into impact investing, which has a host of other platforms to consider, such as the IRIS metrics administered by the Global Impact Investing Network (the GIIN).
What if you want to tailor your monitoring?
Adding to the challenges for private markets investors are key performance indicators (KPIs) that may be more specific to their industries or companies. Some of these goals may revolve around new initiatives surrounding DEI, biodiversity, financial inclusion, and the transition to a lower carbon world. Some of those targets may not be readily available within standardized frameworks, at least in a way that is applicable to that company.
What if you want to tailor your benchmarking?
Even if data surrounding tailored KPIs can be tracked, there’s another issue to address: How can you compare and contrast your performance against your peers in a way that benchmarks appropriately across industries and geographics? Among the big questions:
- Can the same measurements and metrics be used in developed and emerging market settings?
- Can the same measurements and metrics be used for mature vs. emerging growth companies?
- Can the same measurements and metrics be used across industries, particularly when there are wide variations in demographic representation for DEI purposes or industry operations for climate-related issues?
- Is there reliable data that allows for comparing private and public companies within the same industries?
Private market investors find themselves at a crossroads. Despite being early adopters to ESG, PE and private credit investors remain at a disadvantage when it comes to the availability of good and accurate ESG performance data. Yet despite this disadvantage, the regulatory environment is quickly changing, creating a real sense of urgency to address these monitoring gaps.
Private market investors need better perspective. Many of the issues surrounding ESG data shortcomings in the private markets are centered on the incomplete information that portfolio companies report. An outside-in perspective may be needed to supplement the data being supplied from the portfolio company level, providing a 360-degree perspective that gives all investors, including prospective buyers at exit, confidence that the company meets all the regulatory and due diligence needs to maximize value.
In addition, the private markets require guidance to make sure the right information is being demanded internally, that this information is being properly updated and evolves over time, and that the right questions are being asked and information sought to make sure monitoring and measurement protocols improve over time and remain relevant.
How we help
Our team of ESG experts helps firms of all sizes develop and refine comprehensive ESG programs. We work directly with portfolio companies to build industry-specific ESG programs.
Our ESG Portfolio Oversight supports the full life cycle of private market investments from diligence to on-going monitoring. We engage directly with portfolio companies to gather and report data at the pace determined by the firm, relieving much of the burden of portfolio oversight. Get timely, relevant, qualitative, and quantitative detail to tell your ESG story to stakeholders.
For questions about this article, or to find out how we can assist with your ESG data, please reach out to your ACA consultant or contact us.
2 The ESG Global Survey 2021, BNP Paribas.
3 “Private Equity Should Take the Lead in Sustainability,” Harvard Business Review, July-Aug. 2022.
4 The ESG Global Survey 2021, BNP Paribas.
5 “Private Equity Makes ESG Promises. But Their Impact Is Often Superficial,” Institutional Investor. June 2020
6 “Where Next for ESG Reporting?” New Private Markets, April 2022
7 Sustainable Investor Insights Survey, Barnett Waddingham. March 2022
8 “The Enhancement and Standardization of Climate-Related Disclosures for Investors.” The Federal Register.
10 “Limited Partners and Private Equity Firms Embrace ESG,” ILPA-Bain & Company Survey, Feb. 2022.