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ESG in private equity

16-05-2012 | Visie | Jesse de Klerk Although responsible investing has gained a foothold in private equity, implementation of ESG criteria is often superficial. Jesse de Klerk, Investment Director at Robeco Private Equity, outlines a deeper approach.

The private equity industry is a very different place from 2004, when Robeco launched the first sustainable private-equity fund of funds. Nowadays, an increasing number of industry players have begun to factor ESG criteria into their investment processes.

Just how far has the process gone? A March 2012 survey[1] of the private equity industry by pwc suggested that 50% of the private equity houses it surveyed now have a policy on ESG issues and/or responsible investment. Moreover, a hefty 94% of respondents said they would be increasing their focus on responsible investment activities in the next five years.

One powerful indicator of the sea change in attitudes is that the mighty Carlyle Group now publishes an annual “Corporate Citizenship Report”. Not a development that many would have forecast in 2004.

Engagement overlay was launched 2004
Back then, the concept of responsible investing wasn’t even on the radar for the majority of the industry. Yet it was in that year that Robeco launched the world’s first sustainable private-equity fund of funds, Robeco Sustainable Private Equity (RSPE), a hybrid product that invested in both mainstream and clean-tech funds, and also featured an active ESG engagement overlay.

Why ESG & private equity are a good fit
Jesse de Klerk observes that the RSPE program met with a puzzled response, to say the least. Not surprising, perhaps, as private equity and ESG might not have seemed to be natural bed mates. At first glance, private equity’s emphasis on operational efficiency and value creation does not necessarily dovetail seamlessly with a focus on longer-term sustainability issues.

But the industry is increasingly appreciating that ESG and private equity are not in conflict. There’s been a realization that ESG awareness can protect investors from ESG-related reputational, commercial and regulatory risks that portfolio companies might encounter. Perhaps more important, the industry understands that factoring in ESG considerations can help to maximize value creation. Focusing on employee satisfaction, for instance, can lower sickness rates and increase productivity.

In reality, says De Klerk, they make a nice pair. “ESG is particularly suited to private equity because of its inherent long-term characteristics,’ he notes. After all, private equity investments are, by their nature, long term and investors are not shackled by the short-term focus required by listed companies’ quarterly reporting.

How authentic is this ESG?
Back in 2004, the challenge was to convince private equity funds that responsible investing was the way to go. Now, the market has evolved: investors know it makes sense both monetarily and in terms of longevity. In general, it is no longer a matter of questioning why it should be done but of selecting the most appropriate implementation option.

But although having some kind of responsible investing approach is no longer uncommon, often funds don’t implement it in as insightful a manner as they could. “We’re now in a phase when a lot of funds say they are investing in a responsible way but when you drill down, many of them are mostly focusing on environmental aspects,” says De Klerk. “They are often looking only at ESG aspects that have a direct impact on the bottom line.”

Looking ahead, he believes that a future development within private equity’s adoption of responsible investing will be a wider awareness of all three ESG elements.

Integrating ESG factors throughout the investment cycle
Robeco Private Equity takes a different approach. Using a methodology developed in partnership with Rabobank’s Cooperative & Sustainable Business department, it encourages the successful integration of ESG factors throughout the investment cycle. It is a rolling process that involves real engagement.

“We’re one of the few houses that engage with funds after the investment,” says De Klerk. “We measure ESG performance on an annual basis. We track funds over time and we come back with recommendations for the funds on how to improve their ESG performance. That’s unique.”

So when a fund agrees to Robeco’s Principles for Responsible Private Equity—in its responsible private equity programs, Robeco only invests in funds that adhere to these ESG principles—it is agreeing to take part in a multi-level engagement process that goes way beyond due diligence and ticking boxes on checklists.

Feedback is central element in Robeco’s engagement process
How does this engagement process work in practice? The starting point is the Responsible Entrepreneurship Questionnaire that is sent out to participating funds at the beginning of every year. The completed questionnaires are then analyzed by Rabobank and the results sent to the funds.

Funds receive an ESG profile reflecting their absolute and relative ESG performance over time, as well as a set of specific recommendations on how their performance can be improved. The funds also receive Robeco’s full annual report based on the assessments, which includes examples of best practice in the industry.

De Klerk notes that the report’s unambiguous ranking methodology—each participating fund is awarded an ESG score (in percentage terms) as well as being placed in one of three groups (leaders, followers and laggards)—does spur funds on to better performance.

The annual process is completed by feedback sessions that provide an opportunity for the funds to clarify the results and exchange ideas with Rabobank’s CSR specialists and investment managers from Robeco and SAM, Robeco’s 100%-owned sustainability investing subsidiary, on possible next steps.

Engagement is a two-way process
This last stage is a genuine dialogue. And as well as being given advice, funds also ask for support in certain areas. De Klerk gives the example of one of the larger LBO firms that asked for input on best practice in implementing a system of key performance indicators (KPIs) for ESG.

It is an approach that adds value. “The Principles for Responsible Private Equity, the annual survey and the feedback sessions are tools that can help private equity funds in the formulation and implementation of their ESG strategy and in the integration of ESG policies into the operations of their portfolio companies,” says De Klerk.

Value of engagement is in rising annual ESG scores
He adds that the ultimate proof of the value of the process is when funds’ ESG scores improve over time. And, overall, the ESG scores for the funds that participate are improving year by year, though De Klerk notes that while better funds are getting better, some laggards are actually getting worse. That said, while the engagement process is a major element in this improvement, De Klerk concedes that the general movement in the industry towards ESG integration also plays a part.

Still, one group that has acknowledged the benefits of the process is the French/Italian private equity firm 21 Centrale Partners. Not only has 21 CP signed up to the UNPRI and taken an active role in professional private equity associations, it has also developed an advanced monitoring system for ESG performance indicators across portfolio companies that are active in different industries.

Such developments have helped to push up 21 CP’s ESG score from 79.0% in 2007 to 88.5% in 2010. Moreover, the firm was also awarded Private Equity magazine’s 2011 grand prize for responsible investment in the LBO fund category.

Of course, 21 CP is a pacesetter—or, in in terms of the Robeco/Rabobank rankings, an “ESG leader”. “The most advanced funds are forward looking and perceive the integration of ESG factors as good business practice and not something extra that general partners and their portfolio companies have to deal with. They see opportunities in ESG integration, not the limitations,” says De Klerk.

But other should follow as the positives become more widely understood. As such, he expects responsible investing’s progress into the mainstream of private equity to continue. “In ten years, this will not be called responsible investing. It will just be how we invest.”

Expanding ESG assessments to mainstream funds
Yet this is not something that will happen automatically. As part of Robeco Private Equity’s ongoing efforts to promote responsible investing—and to stay in the forefront of innovation—in 2012 it extended its basic ESG assessment to include all the funds that were not included in one of the responsible investing programs.

This analysis showed—perhaps unsurprisingly—there was substantial room for improvement. “Although many funds have already made steps towards becoming responsible investors, most of them have one or more areas in which improvements are necessary or desired,” says De Klerk. “A good start would be to set up specific plans for the coming year and timelines for the goals that ought to be realized. Good practices of the best scoring funds indicate how this can be attained.”

That’s not the only area where Robeco Private Equity is seeing a role for investors such as itself. One of the challenges that the private equity industry is facing is that the concept of responsible investing is still quite new and, as a result, many different initiatives are being undertaken. For example, investors are developing their own way of collecting ESG information. Aligning the various initiatives and standardizing ESG reporting would be a major support to the development of responsible investment in private equity and the team is thus looking at ways to contribute to this effort. Watch this space…

[1] “Responsible investment: creating value from environmental, social and governance issues”, pwc
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