Howard Eisen, Head of Sales for Fund Services at TMF Group, talks to Private Equity Wire about the challenges of gathering and reporting ESG information.
In his 2020 letter to CEOs, BlackRock CEO Larry Fink wrote that the investment risks presented by climate change are set to accelerate a significant reallocation of capital, which will in turn have a profound impact on the pricing of risk and assets around the world.
ESG risks are now becoming as important to the way managers think about their portfolios as traditional market-related investment risks, prompting many PE firms to consider what is most important to them, from an ESG perspective, and how best to codify it within their ESG policy.
In his letter, Fink goes on to say that resilient and well-constructed portfolios are essential to achieving long-term investment goals: "Our investment conviction is that sustainability-integrated portfolios can provide better risk-adjusted returns to investors. And with the impact of sustainability on investment returns increasing, we believe that sustainable investment will be a critical foundation for client portfolios going forward," he wrote.
It is hard to disagree with the fact that today, ESG factors represent a secular trend that is only going to continue to evolve over the next decade. In times past, there have been various moments of interest, in an investing context, such as portable alpha and 130/30 strategies, which became all the rage among investors, only to then fizzle out.
But ESG investing, and the myriad implications associated with it, is no fad. This is now a bona fide core element of how institutional allocators assess private market managers.
"ESG really is the question of the hour," says Howard Eisen, Head of Fund Services Sales for North America, TMF Group. "I would say this feels more durable and more structural and that it is not simply a fad. Rather, it is an ethical and existential issue for a growing number of people."
Major financial institutions like BlackRock are taking a lead on ESG, paying careful attention to how they integrate ESG factors into their fund portfolios and focusing intently on ESG. They have to, given that they expect companies they invest with to do the very same thing.
And whereas in the early days of ESG investing, say 15 years ago, there was a fair degree of scepticism over why fund managers would seek to prioritise sustainability, potentially diluting the financial returns on offer, this mindset has increasingly faded into the background.
"When ESG first came to the forefront, the biggest argument against it was whether the components of ESG were compatible with return expectations sought out by investors. There were many people who did not see the consistency and that if you put ESG factors ahead of fundamental factors when investing, you would reduce returns. How could you elevate virtue over profit and have that be commercially viable?
"The world is now broad and diverse enough such that there are opportunities to make money if you keep ESG factors high, if not at the top, of one's list of priorities," says Howard Eisen, Head of Sales for Fund Service at TMF Group
One of the unique challenges, however, is that while there is a surfeit of information in the public markets, with technology providers able to create a consistent framework to rank ESG factors, there is no uniform way of gathering and reporting ESG data within private markets.
Nobody yet agrees on what is the right set of ESG factors and even if they did, there is still no consistent way to efficiently gather, rate and rank ESG information.
"Both on the GP side and the allocator side there is a continuing and steepening slope of attention and resources being applied to ESG. People are attempting to engineer solutions so that a PE or VC manager might be able to gather and apply ESG data in a consistent manner across their portfolio. The best approach is to have an independent body - similar to say ILPA - rather than a commercially driven organisation, to develop an ESG reporting standard, with input from industry participants," argues Eisen.
Of course, there are ways for GPs to demonstrate to investors that they are taking ESG risks seriously in their portfolios, such as by asking companies to adhere to SASB reporting, or by demonstrating to investors which UN Sustainable Development Goals their strategies are aligned with. Indeed, the Task Force on Climate-related Financial Disclosures (TCFD) is helping to drive adoption of ESG reporting among corporates, both in public and private markets.
This is certainly helping to bring ESG transparency to a higher plane, but private markets remain at some distance from arriving at a uniformly agreed-upon ESG reporting standard.
As Eisen is quick to point out, this is a fast-evolving concept and the goalposts will inevitably move.
"Like so many other things, the best way to tell how this is going to play out is to follow the money. The managers are focused on expanding their client base. And if a growing amount of money, and a growing number of allocators, are elevating ESG considerations within their investment programmes, there is no question that the economic incentives to managers mean that they have to commit resources to this.
"If you go to the websites of large allocators who really embrace ESG, such as some of the large university endowments and public pension plans, they themselves are fairly vague with respect to this issue of an ESG standard.
"It starts at the top of the food chain with national governments. The Paris Climate Accord is the closest we've come. You have different regulatory regimes in the EU, the US, Latin America, Asia and if we can't agree on regulatory issues, which tend to be fairly black and white, how are we going to arrive at a uniformly accepted standard on ESG issues, which are not black and white?
"We will make progress but I doubt that we will ever achieve global harmony on ESG that every country, and every investment firm, accepts. We're going to have to accept the fact that we shouldn't let pretty good be the enemy of perfect."
TMF Group's global clients have started taking ESG issues more seriously, across all shapes and sizes of manager, according to Eisen. If investors want more ESG transparency, managers have to respond in kind.
"Investors want to see these issues advance and if you're an emerging manager in growth mode, or a mid-sized manager aspiring to the next level, you're going to want to make sure you can respond to investors' needs," he says.
And even though private market managers have to work hard to overcome the issues of how best to gather and rank ESG data in a consistent manner, it is not as if there is a lack of data. Indeed, ESG data provided by both public and private companies continues to improve.
One of the questions managers need to ask themselves is how best to apply ESG data across their fund portfolios, which might hold a diverse number of assets spanning industrial, software, healthcare sectors and so on.
"The data is available but it will depend on the following: a) how efficiently it can be extracted; b) what are the standards that you determine to be the most important? and c) how is the data applied consistently to get an ESG ranking that makes sense across the entire portfolio, and from Fund I through to Fund XX?
For managers and allocators alike to make sense of ESG reporting, and to meaningfully apply benchmarking, it will be necessary to rank different parts of the portfolio, at the individual sector level, using an ESG taxonomy; especially for generalist PE funds. For a specialist healthcare-focused fund, for example, the same ESG ranking could apply at the wider portfolio level.
"For me, it really comes down to addressing the disparate opinions of what is important under the ESG umbrella, and how to apply ESG rankings to different companies operating across industry sectors," states Eisen.
He adds: "You could make a bold statement in your ESG policy that you only invest in companies using supply chains that have no association with human rights abuses. But how does that apply to an advertising agency, for example, where there is no supply chain?
"There can't be a one-size-fits-all approach. I think there will need to be a taxonomy that can be applied by GPs in different ways to different companies, based upon sector, product.things like that. But the question will always remain: 'What is important to you?' Is it more important to have gender diversity in senior positions? Is it more important to lower your carbon footprint, or to ensure there are no human rights issues related to corporate supply chains?
There are so many facets to how managers need to think about ESG factors. But one thing is for sure: this is a trend that shows no sign of stopping. With climate risk, diversity and inclusion, and closer scrutiny on supply chains, all coming to the fore in recent times, managers cannot afford to take their eye off this increasingly relevant, secular theme.
This article was written in collaboration with Private Equity Wire.
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