The Role of ESG in Private Market Investing

In the current world of investment, ESG—Environmental, Social, and Governance—is no longer a trend or a fad; it has become a core component of how investments are deployed and managed, reshaping strategies in private equity (PE) and venture capital (VC) to address climate change, social justice, and governance issues. But what exactly does ESG mean for private markets? How is it reshaping investment strategies, and how does it drive value creation?

So come on, here is a quick introduction to the realm of ESG in private markets and why the endgame is no longer just about the money but the tides.

Understanding ESG

ESG means environmental, social, and governance factors, defined by the acronym responsible investing.

The E in ESG, environmental criteria, is related to a company’s use of various inputs such as carbon usage, energy, materials, water, land space, etc, and its effect on the surrounding environment in areas such as pollution and generation of wastes, among others. Corporate environmentally responsible policies entail controlling the emission of gases contributing to the greenhouse effect, avoiding wastage of water, using power from renewable sources and raising awareness of the increased extinction of species.

The S in ESG, social criteria, involves determining how an organisation interacts with employees, consumers, vendors, stakeholders, and the general populace. This covers employees’ rights and remuneration, human rights, DEI (Diversity, Equity, and Inclusion), its relationship with the community, and how the firm’s products or services affect society. Businesses that focus on social responsibility issues enhance better working standards among employees and more loyalty among business consumers.

The G in ESG, governance, deals with how business organizations are managed and the range of mechanisms by which a company is regulated. These aspects are the board of directors’ diversity and independence, executives’ compensations, shareholders’ privileges, clarity and business integrity. Accountability is necessary for proper governance because of risk factors such as corruption, fraud, or conflict of interest.

Principles for Responsible Investment (PRI)

The implementation of ESG started in June 2005 when the United Nations launched the Principles for Responsible Investment Initiative, the world’s leading proponent of responsible investment. Beginning with 63 signatories in 2006, the number became 3826 in 2021. Indeed, nine out of the ten largest global GPs have become members of this organisation, which points to the causation of ESG in private markets. PRI suggests six principles of integrating ecological and social factors into investment processes developed by investors for investors:

1. We will incorporate ESG issues into investment analysis and decision-making processes. Investors correctly understand the impacts of environmental, social, and governance factors and support responsible investments.
2. We will be active owners and incorporate ESG issues into our ownership policies and practices. Some of these actions can involve interaction with the companies’ management teams, voting for or against proposals to address ESG problems put to shareholders, and urging corporations to be more environmentally friendly.
3. We will seek appropriate disclosure on ESG issues by the entities in which we invest. Investors engage companies to obtain necessary ESG information to help stakeholders evaluate a company’s ESG performance.
4. We will promote acceptance and implementation of the Principles within the investment industry. Greater focus is placed on cooperation as a critical component of sustainable system transformation.
5. We will work together to enhance our effectiveness in implementing the Principles. Investors and their stakeholders pool their efforts and experience to increase the efficiency of ESG integration.
6. We will each report on our activities and progress towards implementing the Principles. Investors publicly document their progress toward implementing and integrating ESG criteria, which will benefit investors and stakeholders.

How was ESG previously viewed in private markets?

Traditionally, PE specialized in financial performance and management control, but their activities were criticized during the 1980s as “corporate raiders”. Categorized here are the areas of concern related to corporate governance, while the environmental and social elements of ESG were secondary. The key motivating factor, therefore, turned into a quick win, and minimal regard was left for the measures it would take in the long run, financial, social, or environmental. A void emerged in the industry's sustainable investing strategy by viewing environmental and social considerations- contingent on the essential objectives that are perceived to unlock worth and immediate revenues.

Today, this point of view has changed as the private market focuses on adding ESG principles into the framework for sustainable and long-term growth. From the early days of loose implementation, where ESG principles were often treated as a box to tick to avoid problems, we have entered a new era where ESG has become the key to unlocking growth opportunities and identifying emerging global trends. For example, China’s interest in enhancing air quality can generate significant ESG investment opportunities, more than $3 trillion by 2030. Today, private equity and venture capital firms follow the culture of ESG; with their help, these funds are becoming powerful agents of economic transformation, creating value and benefit for a broader society and excellent financial results.

The growing importance of ESG in PE

While ESG has gained prominence across all investment types, it holds particular significance for PE firms due to their longer investment horizons and more direct influence over portfolio companies. PE is one of the fastest-growing industries, and investors should focus on achieving a more sustainable economy. Recent research shows that 60% of asset managers now think private markets have superior ESG prospects than public ones. This view reflects a burgeoning tendency toward sustainable investment techniques in PE.

Graph source: State Street - Future of Private Markets Study: How Private Markets Are Embracing ESG

Unique influence of private equity on ESG

PE firms are particularly positioned to push for ESG changes within the target enterprises. By their very design, PE firms gain substantial ownership over portfolio firms. Thus, they can implement improvements in sustainable practices at the company level and across all ESG dimensions. This practical strategy benefits ESG integration because PE firms can lead firms to change to green operations, including energy consumption, supply chain management, corporate structure, and employee conditions.

Several key trends and statistics support the growing influence of private equity on ESG:

• ESG momentum in PE: Investors' ever-growing attention to ESG has led to a routine practice of integrating sustainable investments into PE. Indeed, some ESG activities and policies have already taken root within PE firms. According to a recent survey, 65% of PE firms have already implemented ESG policies or solutions in their operational frameworks, while 72% conduct ESG risk analysis for potential acquisitions.
• Regulatory catalysts: New laws such as the IRA or Inflation Reduction Act in the United States are putting pressure on private capital and directing it towards cleaner energy and climate-smart investments. Such changes bring significant incentives for PE firms to pay attention to ESG and their compliance with societal goals, which supports the thesis.

Rising investor demand

Consumers’ propensity to embrace ESG also continues to fuel the uptake of the solution across private equity as investors seek more sustainably-minded investment opportunities. Fund investors and the primary source of PE funds – limited partners – pay attention to the ESG factors in their investments. According to the survey conducted by INSEAD’s Global Private Equity Initiative, 89% of LPs consider ESG as a consideration while investing, and 77% consider ESG when choosing their GPs. Due to this increasing pressure from the LPs, GPs are now upping their ESG commitment standards across the entire investment cycle, starting with acquisition research and ending with operational and financial management.

Graph source: INSEAD - Green Shoots: Can Private Equity Firms meet the Responsible Investing expectations of their investors?

• Investor influence on retail demand: ESG is also becoming more recognized as an essential value creation factor, not just a way to make the business sound good. 61.1% of private market asset managers agreed that incorporating ESG elements would increase retail demand, reflecting the inclusiveness of sustainable investments.
• Growing market for ESG assets: Due to the increasing need for ESG, private market ESG assets under management quadrupled within the last five years, reaching $11.7 trillion. The pandemic’s impact on the phasing out of fossil-fuel-oriented financing solutions should also not be overlooked: Private market ESG funds, for instance, secured $92bn in 2022 alone, up from $45bn in 2019, figures compiled by the authors show.

ESG as a value driver

ESG has emerged as a new factor that responds to the stakeholders' demands and aims to improve financial results. Another study shows that environmental, social, and governance integration enhances long-term performance in private equity fund activities. High ESG-ranked companies will likely have lower risks and operational effectiveness than competitors, making them excellent prospects for savvy investors who want quality, safe investments.

Several factors underscore ESG’s value creation potential:

• Risk mitigation and financial outperformance: ESG proficiency, in essence, reduces operational risks like regulatory, environmental, or employee relations risks. Also, attaining some ESG goals, such as cutting carbon footprint, may enable portfolio companies to access sustainable-linked financing, which attracts lower interest rates.
• Long-term value creation: Because of their high level of engagement with the operations of their portfolio companies and long investment time horizons, PE firms are very well suited to incorporate ESG factors into the transition or value-generating strategies. Today, over 70% of companies include ESG in value creation, and 66% of PE companies consider value creation the most important reason for ESG operations.
• Leveraging sustainability for growth: Based on our analysis of global sustainability trends on PE, firms are advised to embrace new growth opportunities as ESG remain key ‘year-enders’. For instance, China’s initiative to control emissions will open up more than $3tn of investment opportunities by 2030 in areas as diverse as air quality measurement and eco-friendly construction resources.

Thus, ESG is gradually transitioning from an additional criterion for choosing companies for investments to a mandatory one for private equity firms. Drawing from concerns from investors, regulatory authorities, and the financial benefits that ESG delivers, it is evident why ESG has become a strategic success factor for value creation in PE as we advance. Injecting ESG into private equity practice will enhance sustainable returns for the investors and thus lead to a sustainable economy.

The future of ESG in private markets

The application of ESG strategies is expected to increase with the growth of private markets, with aggressive investors rising and impacting PE and VC sustainability. The global ESG investing market also undergoes a similar upward trajectory, from the projected market size of $29.86 trillion in 2024 to $167.49 trillion in 2034, at a CAGR of 18.82 %. This impressive growth is due to the rising business concern about environmental and social actions and government core indicators known as SDs, which are intended to promote sustainable development. While these markets have not developed ‘best practices’ as rapidly as the public sector, several trends are expected to become prominent.

• Standardized ESG reporting: Considering increasing investor interest in ESG disclosure, private market firms must transition to normalised ESG disclosure standards. This will improve the quality of the data provided and boost investors' confidence due to the enhanced reliability of Delaney’s ESG reports across the portfolios. It also helps to decentralize the task of preparing reports and increase organisational compliance requirements with new global reporting standards.
• Net-zero commitments: As climate change becomes more addressable as an international priority, private market investors will continue to declare net-zero goals that determine goals for cutting the carbon intensity of their portfolios. These commitments will most interest institutional investors concerned with climate-change milestones and LPs interested in investment outcomes with socially quantifiable values.
• Diversity and wealth distribution: Besides environmental aspects, socially responsible factors such as diversity, equity, and inclusion (DE&I) will be critical. PE and VC firms are expected to have started supporting plans to lead to a diverse PE and VC industry and companies backed by investors. Also, the approach to economic impact, such as providing financing for development in areas lacking adequate capital or providing support to local people, will be emphasized; here, the ‘S’ in ESG will be stressed.

Graph source: Precedence Research - ESG Investing Market Size, Share and Trends 2024 to 2034

Changes in the investors’ demands and legal framework

Protested-wise, market expectations are for investors’ focus to remain fixed on responsible investing, with LPs demanding more private market funds to integrate ESG. Such priorities shift, the nature of which means that PE and VC firms need to align to thrive, does as well. The same applies to regulations, or, more precisely, the governments and regulatory authorities of various countries are creating new rules that either require ESG reports or establish sustainability norms. Keeping up with these changes will be essential for private market firms due to the uncertainty of the future for ESG compliance.

The time to act is now.

Where will you stand in the ESG revolution? With ESG becoming more popular across asset classes, private equity and venture capital markets suggest that this trend is set to linger. They show that firms focusing on ESG will improve their financial situation and help improve the world. Now is the time for firms to embrace ESG as a critical driver of financial success and global impact.