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Environmental, Social, and Governance Criteria in the alternatives industry is driving more transparent investing

29 May 2019

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With private equity, hedge and other alternative investment funds beginning to think about their path towards Environmental, Social, and Governance (ESG) awareness, investors are beginning to define their own ideas on ESG.

At a recent Alternative Investment Management Association (AIMA) Global Policy & Regulatory Forum in New York, 49% of delegates reported that they were already facing questions from investors and prospective investors regarding sustainable investment strategies. 70% said that they are either currently or expect, within the next 12 months, to have to develop ESG strategies.

ESG criteria is based on an institution’s self-defined values and can differ based on industry and the business itself, but examines elements like environmental impact, business relationships, employee welfare, philanthropy and good governance. Within the alternatives industry, managers are beginning to define specifically what ESG means for their entities, and the impact this has on business and investors. Consequently, investors are seeking to better understand the composition of portfolios, with increasing focus on understanding an ESG strategy’s impact. The need for transparency is increasing.

Investors are now consistently acknowledging opportunities in ESG-focused businesses. For example, environmentally conscious products and systems have been finding more funding. At a panel discussion during the Palm Beach Global Finance Forum in April, there was a consensus among the speakers that investors are, for the most part, comfortable with investing in environmental sustainability in the renewable energy sector, like the recycling of raw and processed materials and carbon emission reductions or limits.

With the recognition of these modern opportunities, as well as the inherent subjective nature of ESG, investors are being forced into defining their own criteria of ESG and whether or not particular investments are consistent with these new-founded standards. Historically investment strategies were largely prescriptive or restrictive. This new approach of transparency into ESG, and thus portfolios, is largely born out of the growth of managed accounts and Funds of One, and it’s becoming the investor’s onus to define their place in this new way of doing business.

This participation of the investor adds a layer of complexity for managers. The social component, the piece that examines an entity’s business relationships and the ethics of those entities, is proving to be the most challenging aspect.  As investors are now bringing their own interpretation of ESG, matching vast or varied demands can be difficult. With the implementation of ESG criteria, there’s more diversity in senior management and board composition on the governance front too. These updates often bring a contemporary approach to ESG, but can further make meeting expectations and requirements challenging for managers.

Direct transparency doesn’t address the potential impact of regulation on ESG. European regulators, for example, are demanding that listed issuers define ESG KPIs within publicly available materials, such as annual reports. While some may view the regulatory hand helpful in managing investor expectations, the lack of consistency among regulators and the very fact ESG standards and criteria are subjective means that nailing down regulated ESG KPIs requires greater coordination and consensus among regulators to be of real value to investors.

Looking deeper into ESG impacts is opening up doors to new ways of investing, putting new people and views on boards and in executive seats, but is ultimately driving ever increasing transparency into the decisions institutions are making. Definition by regulation may remain to be seen, but the conversations among managers and investors are being had.

If you’re an investor or a manager, get in contact to learn more about how ESG will impact the way you do business.