More than three-quarters of private fund leaders surveyed by affiliate title Private Funds CFO believed that a stronger ESG vision and culture would ultimately drive value in their business. “It is very clear to us that responsible corporate behaviour and the consideration of ESG factors have a positive influence on long-term financial performance,” says Jeff Pentland, managing director at Northleaf Capital Partners.

However, it was LP pressure that remained the most significant driver behind greater ESG monitoring and reporting, with an overwhelming 86 percent of respondents saying that LP questions on ESG became more detailed over the previous 12 months. The most cited reason for enhancing ESG practices was investors’ demands, followed by a firm’s own social responsibility goals, competitive forces and valuation creation objectives. Regulation was seen as the least significant factor.

In the inaugural Private Funds Leaders Survey 2021, conducted in partnership with MUFG Investor Services., ESG considerations played an equal role in due diligence and value creation. Just under half of respondents described ESG as either critical or very important when assessing potential transactions. The same proportion said ESG was critical or very important for adding value in the businesses they bought.

“We have already seen positive correlation between ESG progress and the performance of our companies across a number of different metrics, such as improved costs, efficiencies and an improved, more engaged workforce,” says Ruth Lane, head of investor relations and ESG officer at ATL Partners.

Littlejohn & Co president Brian Ramsay states: “We believe that robust ESG programmes at our portfolio companies inherently lead to better outcomes in the form of safe, healthy and motivated employees.”

Yet although private markets leaders recognised the importance of getting ESG right, the operating models to support those practices frequently remained immature. Almost three-quarters of respondents exclusively received their ESG data from their portfolio companies, but close to 90 percent described the process of collecting information as at least slightly challenging. This was unsurprising when 64 percent employed a fully manual process.

And even where some degree of automation was achieved, a lack of industry-wide uniformity remained a problem. Ramsay says: “Metrics that are easily quantifiable are automated and those that are more qualitative are tracked via ongoing dialogue with our portfolio companies.

“But the lack of standardisation around reporting metrics and ratings make it challenging for GPs to benchmark themselves against their industry, as well as for LPs to compare ESG programmes across their portfolios.”

Although nearly two-thirds of respondents relied on an internal ESG team entirely, 34 percent expected to move towards an outsourced model over the next three years.

Northleaf is one firm that believes in leveraging external expertise. Pentland says: “We have sought to enhance our ESG risk assessment capabilities across our due diligence and portfolio management processes through a partnership with RepRisk. [It] provides a software platform that allows us to systematically identify and assess material ESG risks. The system also allows us to set up watchlists on a mandate-by-mandate basis and then to track how every individual investment is performing from an ESG perspective.”

In the expectation that climate-related considerations will become increasingly important, Northleaf has also entered a partnership with Climanomics, the SaaS platform by The Climate Service. This enables climate risk reporting and disclosure that is aligned with the Task Force on Climate-Related Financial Disclosures framework.

What metrics to monitor?

Company diversity was the most commonly monitored ESG metric, followed by board and management composition. The least tracked metric was waste, followed by carbon.

“We track a number of ESG metrics, both as a firm and across our portfolio companies,” says Lane. “Some metrics are consistent across our companies, and some are company-specific.”

Ramsay says: “We track a variety of health and safety metrics, diversity statistics and some environmental metrics. We track the most relevant metrics that will have an impact on the health and wellbeing of our companies, their employees, surrounding environments and communities. Over time, we expect the mid-market to catch up with its larger peers in measuring carbon footprint.”

And yet, despite a clear increase in focus on ESG at all levels, less than half of respondents could definitively prove a positive correlation between ESG and investment performance at a portfolio company level. This was, in part, a question of maturity. Longer and deeper track records were required to provide empirical evidence of ESG’s impact on value creation.

But Gareth Whiley, managing partner at Silverfleet Capital, believes that, in any case, equating ESG with returns misses the point. “We don’t look for a correlation between returns and ESG – and continue to argue that this is a slightly odd way of looking at things,” he says. “We believe we need to be responsible investors; not ignoring the financial costs, but certainly not only [being responsible] because we can justify that there is a financial benefit.”