For private equity market investment managers, ESG is no longer optional.

Once a niche topic in the private equity industry, ESG (environmental, social, and governance) is now permeating across the investment landscape, spurring alternative asset managers to fundamentally change how they approach the investment process and their communication to investors.

COVID-19 pandemic has also accelerated the ESG considerations in the market. This allows companies that actively contribute to sustainable development to gain a competitive advantage at getting investors onboard.

Our recent survey of private equity and asset management executives underscores the extent to which this trend of adopting ESG is already impacting private equity (PE) firms' day-to-day operations. 93% of respondents said they have incorporated ESG analysis into their due diligence processes before making an investment decision, and 68% said that they have walked away from a deal because of information uncovered in that process.

The survey, which was conducted by Mergermarket on behalf of IHS Markit, showed that ESG factors are influencing dealmaker decision-making and valuations. Nearly 60% of respondents think that a negative ESG assessment will have a significantly adverse impact on valuation, while 53% say a positive assessment would significantly improve pricing.

There are a variety of factors that are impacting this growing focus on ESG. The survey, which focused on executives from investment management firms based in North America as well as Europe, Middle East, and Africa (EMEA) region with at least US$1 billion of assets under management (AUM), illustrated how PE firms are responding to several driving forces. Chief among them was pressure from private equity investors and policymakers.

Pressure from policymakers and their ESG regulations

All told, 87% of respondents pointed to regulation and political pressure as a reason why their firm takes ESG factors into account when making an investment; more than half said that regulation was the primary reason.

While Europe is leading the charge with the Sustainable Finance Disclosure Regulation (SFDR), new ESG regulatory reforms are emerging in every region, many of which are focused on disclosure and reporting requirements. While the United States (US) Regulators have not issued their own reporting framework, additional requirements are on the horizon.

Overall, policymakers increasingly are focusing attention on how financial services businesses can drive positive change. This pressure applies to both PE firms and asset managers, as well as to the portfolio businesses in which they invest.

Private equity investors' expansive expectations

PE investors are also a major influence. Overall, 63% of survey respondents pointed to investor pressure as playing a role in driving their ESG agendas. Among institutional investors, endowments/trusts, pension funds, and mutual funds are leading the charge, the survey showed, as executives flagged those entity types as placing the highest emphasis on ESG issues.

However, responding to these private equity investor concerns is a complex task. Investors are no longer solely focused on returns but on a wide range of issues across the ESG landscape, and different issues take greater prominence depending upon the region.

For instance, within the category of environmental factors, the survey showed that North American respondents were more concerned about biodiversity than their European counterparts, who were more likely to focus on energy efficiency and water and waste management. By the same token, respondents from Europe, Middle East, and Africa (EMEA) region were more likely to rank business ethics as their number one governance concern (67%) than their North American counterparts (40%).

More to come

While the ways in which private equity investors push on the ESG agenda may vary, investment managers are unified in anticipating that investor scrutiny on this topic will become greater. A full 90% of respondents said they expect increased pressure from investors on ESG issues over the next 12 to 24 months; nearly half of respondents expect that increase to be significant.

In other words, for as much as ESG factors are already influencing the investment process, their impact is likely to become even more substantial. Indeed, 63% of survey respondents said they expect ESG to become significantly more important in their investment decisions in the near term; another 17% said it will become somewhat more important.

This presents PE firms and asset managers with a key opportunity to embrace ESG more fully as a business-as-usual activity rather than a standalone specialty. Failing to do so will only make it more difficult in the years ahead for PE firms to meet regulatory obligations and respond to investor demands.

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Posted 24 September 2021 by Alex Merola, Executive Director of Commercial Strategies, ESG & Private Markets, S&P Global Market Intelligence

IHS Markit provides industry-leading data, software and technology platforms and managed services to tackle some of the most difficult challenges in financial markets. We help our customers better understand complicated markets, reduce risk, operate more efficiently and comply with financial regulation.

This article was published by S&P Global Market Intelligence and not by S&P Global Ratings, which is a separately managed division of S&P Global.