With environmental, social and governance concerns becoming ever more influential across the business world, LPs and GPs face the thorny challenge of how to tie ESG to compensation. Although there are no easy solutions, ESG-linked compensation is likely to become commonplace sooner rather than later.
As a sign of how influential ESG has already become, consider that almost half of FTSE 100 companies have ESG targets in their annual bonuses and long-term incentive plans. In a recent Capstone Partners survey, 27 percent of global private equity LPs said they would be happy to “trade lower performance for excellent ESG credentials”.
LPs are increasingly looking to achieve their returns through investment in businesses with strong ESG credentials. As a result, funds lacking such credentials will find it difficult to raise capital.
For impact and sustainable funds, it makes sense to tie fees and compensation to the sustainability performance of their assets. Some of them are already doing this, but other infrastructure and real estate players may question if it is even worth trying. GPs will need to build meaningful ESG-linked KPIs, decide how to best apply them and work out how to measure the results.
Impact on recruitment
Despite the difficulties involved, the writing is on the wall. It is only a matter of time before tying compensation to ESG performance becomes mainstream – whether the market likes it or not. So, how is this likely to affect recruitment in the sector?
“GPs will need to build meaningful ESG-linked KPIs, decide how to best apply them and work out how to measure the results”
Although many candidates are passionate about ESG, at present these appear to represent a small sub-section of the overall talent pool. This means firms that most closely link compensation to ESG may struggle to hire top talent, at least in the short term. Having said that, the firms that are pioneers in the space are those that truly believe in the benefits of sustainable investing and are likely to attract talent with a similar mindset.
Anything that affects compensation is always going to be divisive and will take some time to get used to. If ESG performance is outside their control, candidates are likely to find this more frustrating. However, the more it happens, the more candidates will become used to the idea. Many of them will realise that now is the time to adopt a new mindset around compensation for the good of their long-term career and that being at a fund with strong ESG credentials will make it easier to raise capital and therefore generate returns and carry.
While the short-term impact for firms may be somewhat negative, we are likely to see LPs favouring first-mover firms that experiment with compensation models and that gain reputations for strong ESG performance. This in turn will make them magnets for the best talent in the long run. It’s time to grasp the nettle.