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Private Markets 360° | Episode 1: The role of ESG in Private Equity

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Listen: Private Markets 360° | Episode 1: The role of ESG in Private Equity

ESG, a mainstay in the public markets, has also become a key element within the private markets. In this episode, Brandon and Jocelyn discuss the drivers for strong ESG practices within private equity. We also touch on sound frameworks for creating an ESG strategy and how to determine whether your strategy is driving the desired results.

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Brandon Newland

Welcome, everyone, to the first show. My name is Brandon Newland. I lead our Private Markets Product Management team at S&P. I'm joined by Jocelyn Lewis. Jocelyn, how are you doing today?

Jocelyn Lewis

Hey, Brandon, doing great. Thanks. I'm Jocelyn Lewis, Managing Director at S&P Global Market Intelligence where I'm Head of Private Debt Commercial Strategy across software and services.

Brandon Newland

All right. So we're going to jump into some exciting guests and focus on the leading industry trends for private markets here on the podcast. Jocelyn, should we jump right into it?

Jocelyn Lewis

Yes, for sure. So this podcast is dedicated to enlightening you to the world of private markets from different views. So yes, Brandon, let's go.

Today, we are joined by a senior leader within Crowe LLP's environmental, social and governance practice, where she helps her clients navigate through sustainability-related diligence, strategy execution and regulatory reporting. She's also an environmental enthusiast with a love for cycling, community involvement and supporting grassroots efforts to make the world a better place.

I'm pleased to welcome ESG expert, Daniela Arias, to Private Markets 360°. Hi, Daniela, thank you so much for joining Brandon and me today.

Daniela Arias

Excited to be here at your first inaugural podcast.

Brandon Newland

When we do 1,000 episodes, you got to come back at least.

Daniela Arias

We'll do it. Where are they now? That would be great.

Jocelyn Lewis

All right. So first off, with the rise of the ESG framework in private markets and its impact on investment decisions, Daniela, would you please just start off by defining ESG?

Daniela Arias

Sure. Simply defined, ESG is environmental, social, governance, where environmental might be any issues related with how the company manages its impacts on the environment, whether it's through things like energy efficiency, managing water scarcity, managing biodiversity and so forth.

We're looking at social, again, it's really all those issues that have to do with human capital and how management not only -- or how a company not only manages human capital internally at the organization, so thinking through how employees are being recruited, how it's managing employee engagement, how it manages and thinks through things like diversity, equity and inclusion; and then some external impacts like how a company interacts with the community that it impacts or communities that it impacts. So those are social.

And then on the governance front, and I think this is an area that a lot of organizations are probably more familiar with really is throughout our governance is how does management, how does the Board, what programs and what strategies do they have in place to make sure that they're running a tight ship essentially in an organization and that they're thinking through compliance requirements and that they're thinking about ESG as a framework as a whole and how they're managing ESG too.

So that's the ESG in a nutshell. I think it's a framework for a lot of different things.

Brandon Newland

Are any of those levers have a more particular focus when clients are approaching you around a framework?

Daniela Arias

Yes, absolutely. I think the idea of managing environmental issues from the context of broader organizational strategy is something that no matter how long a company has been doing it, it's still new in the context of, hey, this might be something that feeds into your broader strategy that you might ultimately want to report on because we're getting more formalized frameworks for the way that investors and other stakeholders actually assess the value of a company.

So I'd say that environmental has been one of those areas that's a focus simply because there's such a knowledge gap from the business community. But of course, I mean, social, that's another area that can be so abstract and so difficult to try to figure out what's the playbook that we need to have here on a social strategy. What do we -- how do we need to think about diversity, equity and inclusion when it's something that's such an art and not necessarily a science.

Jocelyn Lewis

They are the feel-good initiatives. Who doesn't want to do something better for the environment, reduce carbon emissions, maybe even rely more on sustainable energy? I'm somewhat surprised they have taken so long to be a focus because we've been concerned about the environment for a while now.

Daniela Arias

We've been talking about environmental as a corporate reporting kind of imperative for a really long time. I mean I think since well even before the Obama administration, there were discussions around should governments be regulating more the way that organizations are not only reporting, but using natural resources. These are things that impact society as a whole.

Jocelyn Lewis

The public markets have certainly placed an emphasis on strong ESG practices. But now we're seeing more and more emphasis on strong ESG practices also within private equity groups. So what do you think is driving this overall shift?

Daniela Arias

Yes, so many things. Obviously, you'd be remiss not to mention we're living in a pretty inevitable truth. We're into an irreversible period of global warming. It's already impacting the climate in ways that we've never expected. It also has astounding impacts on biodiversity and the natural resources on which many of the products that we use in our everyday lives rely. And so it's natural to start seeing -- we're seeing a huge shift, right, in market demands.

I also probably don't need to restate the obvious fact that we're going through a significant generational shift, not just in the U.S., but worldwide. So we have millennials and even Gen Z-ers who are starting to move into more of those positions of decision-making roles. And so along with that comes a lot of shift, not only in the public markets, but in the private markets as well around what's the meaning of this organization? What organization am I working for? What's the purpose of what we're doing? Are we actually leaving the world in a better place than we found it? Are we having a real positive impact on society as a whole as part of our strategy in our operations, right?

Of course, you have significant advances in technologies that are making it much easier than ever probably for consumers to make very important decisions about what companies they choose to do business with just based on their environmental or social stance. And in that same vein, because of technology and social media, it's making it very easy for a bad decision to become very, very public very quickly, no matter whether you're a public entity or a private entity.

Of course, you have some indirect pressure coming from regulatory movements, right, that are coming along with all of this. So we have pressures coming from the European Union. They're overhauling their nonfinancial reporting directive. And they're increasing a lot of scrutiny over institutional investors and asset managers and the like around how they classify what's actually sustainable, what's a sustainable investment.

And we have similar pressures coming from the United States where the SEC regulates primarily public institutions, is issuing unprecedented proposals to regulate how companies report on their strategy to manage climate risk, how exposed they are and then, similarly, how asset managers are classifying sustainable investments.

So like I mentioned, these are things that necessarily have a direct impact on private companies, perhaps direct impact on some private equities that are maybe public and so forth, but the indirect impact is real. So besides that, there's also a great deal, I would say, a growing scrutiny in recent periods around what is the role of private equity in this climate crisis as well. Are we just pushing around the issue here?

And so interestingly enough, Amnesty International published a piece a few months ago that very specifically targeted the private equity industry for its role in human rights issues and its lack of accountability, especially when compared to public companies. So these are evolving issues that are affecting companies on all sides of the spectrum.

Jocelyn Lewis

So we've talked a lot about different types of ESG frameworks. But if I am a private equity group, maybe a new one, maybe I'm just kind of late to the game with nailing down my ESG framework, where would I start?

Daniela Arias

There's existing frameworks out there that make that judgment and thought process a little bit easier for companies. So you have Sustainability Accounting Standards Board, for example. They've done a great deal of work over the past several years. They've been around for quite a bit now since 2009 or well before. They've done a lot of research around, from a market perspective, I'm not even thinking about impact, what types of sustainability issues are those issues that are actually going to impact value of an entity over time.

And so SASB has a very, very robust conceptual framework that can help companies think about what sustainability issues are material for my specific industry. And so I'd say for a company that's just starting, thinking about it at least from that SASB framework perspective to start is a great way to start, at least sort of conceptualizing it and making ESG strategy something that can be kind of even one bite at a time, right? So I'd say look into the Sustainability Accounting Standards Board, right?

Of course, there's also other data initiatives out there. So ILPA has their Data Convergence Initiative, and it started about a couple of years ago. And really, it was a process or an initiative that started with LPs and a lot of data managers that came together and said, hey, there's a lot of frameworks on ESG out there. This ESG data is not useful to us right now. We're getting all kinds of measures. They're measured differently. We don't even know how to make decisions with this. There's too many frameworks. There's no real critical mass in any one of them. Companies are just managing this totally differently depending on just their own internal strategies. Rating agencies are not even focusing on the right metrics, maybe they're thinking about this too binary.

Brandon, to your point, they're maybe thinking too much about this on a yes or no perspective. We need to figure out a better way to get some standardized ESG metrics for private companies that we think are feasible, that we think are things that our sponsors and their companies can actually start working towards so that we can at least start getting a basic set of metrics we can compare across the board. And so that's really what the Data Convergence Initiative is all about.

So even more simplified than SASB, it's just 6 topics that they've started with, 15 different metrics across a number of environmental, social, governance topics. So emissions, for example, is one of them, diversity is another, health and safety is another. They came together and kind of formed this initiative. It's now being managed by ILPA. And what it essentially asks is, hey, sponsors, come and join us in this initiative, agree to start collecting these data points from your companies every year, at least once a year, and then send it over to them or to us.

And what we're going to do is we're going to process all this data, and we're going to give you the opportunity to be able to actually benchmark so that you can see how are different companies performing across these different metrics and across the board so that we can then start using this as a framework for better management over time, right? So part of managing your issues is so much of it is kind of reliant on benchmarking.

Jocelyn Lewis

I bet, too, that if you are a private company and all of a sudden, you have to report on all of these metrics, maybe you got a new investment or maybe you're looking to get a new investment, you probably can't even report on all of them. So do you have to think there's a certain number, I don't know, 50, 100, that everyone should be able to report on? And then from there, there's a goal of increasing by, I don't know, a certain percentage every year?

Daniela Arias

And so many of the scoring mechanisms too are, to your point, precisely based on does this company disclose or not. So moving from no, we don't disclose to yes, we're now disclosing is a metric in and of its own in a show of progress. So SASB, ILPA Data Convergence Initiative are 2 that I always kind of go back to.

But then, of course, over time, companies might be more interested in starting to think more about, okay, well, do we need to start thinking about impact? Do we need to start thinking about aligning ourselves to something like the Sustainable Development Goals that are issued by the United Nations and thinking more about how do our operations improve or detract from the quality of life of others. And those are things that end up happening kind of towards as companies move forward in more maturity. And that would be the expectation is that over time, you start moving up in maturity in your ESG programs and you start being able to really demonstrate, look at where we are now compared to where we started.

Jocelyn Lewis

It sounds like it's a transition risk, right? How are you going to manage the transition when you decide that you want to maybe divest oil and gas assets or not put additional investment into those areas, but how are you then going to take care of your investments that are in the portfolio today? Are you going to decide that maybe you're going to divest of them via secondaries? Or are you going to just manage the risk and more of a long-term strategy of trying to look at what the score is and whether that ESG score that you're tracking is improving over time and making a decision to manage the risk that way? Maybe you could do it in a binary way, and maybe it's a little more of a thought process in terms of managing risk.

Daniela Arias

Yes. And I think more often than not, these things aren't black and white. And so more often than not, you will see companies having dialogue and sponsors having dialogue with portfolio companies, for example, in trying to think where can we move the needle? What are the things that you're doing well? What are the things you're not doing well? And how can we help you make sure that you're moving to a place where you're doing better in some of those gap areas?

Jocelyn Lewis

Right. So pivoting a bit, what are you seeing as solid foundations of an ESG strategy for private equity?

Daniela Arias

As a private equity company, you certainly want to make sure that you've had some internal conversations around decision-makers. What do we want our investment mandate to be, right? Do we want to be focusing more on impact-investing strategy? Do we want to focus more on just integrating ESG issues into the way that we help and manage our portfolio? So having an understanding of that mandate first is really important, right?

Which then kind of leads you into, well, what processes do we have in place, not only internally, but then at the portfolio companies? So having processed in place pre-investment, so whether it's implementing some formalized due diligence process that helps look and really frame all of these ESG issues that might be material, having a process in place to do that pre-investment, but then also having a really nice and good way to kind of link what have you found during that pre-investment period. How do you link that to the hold period? And how do you link that to some real progress and improvement over the whole period all the way to exit?

So having that process from beginning to end in place and at least conceptualized, I think, is good. This is still new. And even companies that have been doing, incorporating ESG as part of their investment strategy, they are still trying to define what does it mean for our organization, what does it mean for how we interact with our portfolio companies, but at least having a framework in place is important.

But the truth is that when the rubber hits the road and it's time to really think about, well, how do we actually try to impact and make some change in some of these areas, that can be difficult to step into and can be overwhelming. There's a lot of different things that a company might be able to focus on. And so having that right support system for the portfolio companies is definitely a solid and very, very sound foundation for good ESG strategy.

Jocelyn Lewis

What I've noticed is that ESG and sustainable investing kind of in general, it's become a key differentiator for our investors. So it seems that it's because it's a tool that can highlight differences, like you mentioned in the diligence process, between otherwise similarly positioned companies. And conversely, it can help to prop up an otherwise disadvantaged prospect that you might not want to invest in at first glance, but digging in a little, it might have an ESG benefit.

So I also think that companies and investors alike are just taking interest in ESG and the insights that the ESG data can provide into investment opportunities and using that as they look for a solid foundation.

Daniela Arias

Assuming the data is there, which is a whole another challenge around sort of implementing ESG strategy, right? But to your point, I mean, what ESG -- adopting an ESG framework is really trying to do, it's not more than just trying to formalize how do you actually account for intangible value, then the intangible value that management teams are creating over time. And how do you formalize that a little more so that you can really demonstrate, hey, here's all the areas that we are excelling, and we're doing things differently and we're differentiating and we're thinking about and having foresight around.

Brandon Newland

So Daniela, when you think about the investment thesis and then tying it to that ESG framework, do you think private equity firms are actually looking at ROI when they're making some of those investment decisions into these different opportunities? I think Jocelyn highlighted a good one where there could be an opportunity where the ESG framework that the GP provides could turn an asset that may be somewhat less desirable into one that's quite successful.

Daniela Arias

Yes, definitely. I think that the ways that they're looking at ROI may be different from what your traditional sense of financial connected ROI might be. It's a little bit more qualitative, I think, components to it, right? Part of the reason why something like an ESG framework is having impact and is increasing in popularity is because it's tracking qualitative issues that ultimately do link to better performance.

They're abstracts, sometimes hard to pin, partly because ESG deals with a different time line than I think many of us in the financial world are really used to. So when you look at ROI, you're not necessarily looking at what's happening a year from now or maybe even 2 years. So I think people expect to see sometimes a very clear linkage between ESG and increased income for this particular year.

But to sort of try to answer the question that I think you're asking here, there are studies. And I think the companies that are -- that have been doing this for a little bit are aware of this. There are studies out there that have been issued over the past several years that make linkages to strong ESG strategy and better company performance over the long run, better valuations and so forth. Some of those reasons are very straightforward, right?

So take, for example, a company wants to start focusing on performing better from an environmental perspective, they might be thinking about resource efficiency, reducing their overall environmental impact. Well, naturally, any effort to reduce consumption of resources and to maybe encourage things like reuse or circular economy type of theories or maybe better management of raw materials and production process, that's all going to be highly linked to better operational efficiency. And so therefore, you're going to see better financial performance over time if you're doing that right.

And so that's one of those kind of easy examples where there's a clear linkage there between better performance and implementing kind of ESG-related strategies. There are studies that have shown that there's a clear positive correlation between employee satisfaction and shareholder returns. So I know back in 2012, London Business School had a research study that essentially said that companies that were listed in the 100 best companies to work for in America tended to generate, and this is an estimation and I'm approximating it, around 2% to 4% higher stock returns than their peers. This is sort of an indication that the stock market doesn't really know how to fully value intangible assets, right, like the social components.

Then you kind of start moving into what other opportunities or impacts to value can you have, if you really start thinking about ESG as an opportunity driver, what happens when a company is actually fine-tuned to the needs of a market that's shifting? So you open up opportunities to innovate. McKinsey had an article a while back where they talked about Unilever, for example. They went through this process to develop a new brand of dishwashing liquid that supposedly use less water than other brands. And in doing so, they actually discovered that sales of that specific brand and other water-saving products for them actually ended up outpacing the growth of their product categories by like more than 20%, I think, is what McKinsey said in specific markets that were water scarce.

Jocelyn Lewis

Wow. I think the point on the Unilever soap is so interesting because that's one area in the grocery store or even if I'm shopping online, where if there's an option for something that's green or a healthy environment, I'll generally choose that one. So I wonder how many other people just think that way. That was a very interesting statistic, I thought.

Daniela Arias

Yes, absolutely. Just think about the fact that millennials, Gen Z, these are sort of the -- becoming, right, the prime consumers, prime decision-makers. Environmental issues and sustainability and social issues are at the foreground of decision-making for millennials and Gen Z, and all of this market demand is kind of moving. Now we have regulatory pressures coming at us from this. Well, it only makes sense to make sure that we're using and allocating our resources in the right way. If we're going to spend money on R&D, why aren't we thinking about it from an ESG lens?

Jocelyn Lewis

Yes, for sure.

Brandon Newland

I mean you made an interesting point around like the generational shift. So assuming that ESG is important to Gen X, Gen Y, Gen Z and these are the folks that are going to be the next CEOs creating companies, I think you're point is exactly right, like that would intentionally be the DNA of how we develop private companies and public companies moving forward.

I guess I'm curious, well, you mentioned the piece around, okay, well, let's say, GP gets into SASB and kind of some of the ILPA frameworks or reporting standards, how long does that typically take for a GP to kind of flesh that through the very fiber of their businesses? Is that a short process? Is that 1 to 3 months? 6 to 12 months? What have you seen out there?

Daniela Arias

Sure. I'd say I'd be surprised to see if companies actually implement this in less than 3 months just because there can be so many considerations and decision points to go through. More than maybe qualifying it as a this-is-a-year-implementation project, I see it as a -- it's a phased project. It's a phased approach is you start first with the basics, start looking at how are we looking at ESG issues in our investment committees. Do we have -- is our portfolio support team equipped with the right ESG knowledge? Do we -- have we established that investment mandate? Do we have agreement on what we mean when we say ESG?

And then moving into, okay, so we have general agreement, let's look at SASB. What are some of the topics that we think are going to be most critical for us to hit on, whether it's do we look at totally different topics for different companies in different industries? Or are there topics that we are going to want to make sure we absolutely touch on for every industry because perhaps maybe they're part of the ILPA data or something else?

So there's some discussions that need to happen to make some decisions around how exactly do you want to implement an ESG strategy. And then there's going to be some discussions around, well, what's our process for actually, a, evaluating investments, whether it's through due diligence; or b, managing the performance and helping and supporting portfolio companies. So those things can take a little bit of time, too.

But I'd say, stepping back, is it a year process? Yes, maybe. Maybe that's a good sort of ballpark estimate of how do you stand up an initial framework. Could it be a little shorter? Depending on how simple you want to make it, how far out you want to think about it, maybe as well. But more so, I think about it as it's got to be a phased approach.

Jocelyn Lewis

We're almost out of time for this episode. But it does sound like if you are not starting to think about your ESG framework, whether you are a company, whether you are a private equity firm, the time is now to get started, so you don't fall too far behind.

Daniela Arias

Absolutely. And certainly, there's a carrot in the stick, right, is you can do it because you want to make sure you don't fall behind. But the way I like to see this and the way I like to position it is start thinking about it now because it's going to be much easier, and it's going to be much more efficient and much more effective for you to be thinking about these things with an ESG lens.

Now as you are helping companies establish new strategy around whether it's operational excellence or anything along those lines, start thinking about it now and you implement it now, and then it's not going to be a pain later down the line when you have to go back and rethink your processes and think, geez, we just didn't think about this from the right lens at all.

So I see it more of as an opportunity to just get yourself ahead right off the get-go. And so from a time line perspective, it's all about what's the end goal, right? Are you looking to have your portfolio companies exit into public markets? Are you looking to have them exit into some type of investment or impact-related fund based on that build strategy now, just based on that, what you're expecting to see at exit?

Jocelyn Lewis

Yes. And it seems like you mentioned, even just collecting ESG-related metrics is impactful itself. So you start from nothing, and then all of a sudden, you've got a positive check mark. So I think we will -- and on that note, Daniela, thank you so much for your insights. This has been really, really great.

Daniela Arias

Yes. Thank you so much for having me. And I look forward, Brandon, to that invitation at the 1,000th episode.

Brandon Newland

30 in the mail. Really appreciate you coming by.

Well, thanks, Jocelyn. Thanks to our wonderful guests. We had a lovely chat today. Really appreciate everyone for listening in. And if you're looking for more private markets content, go to spglobal.com/research-insights, and you can stay tuned to find our next episode. Cheers, everyone.

Jocelyn Lewis

Thank you so much. You can also connect with us on LinkedIn. Have a great day.

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