ESG investment drivers are creating unstoppable momentum

Several mutually reinforcing factors explain the rapid acceleration of the ESG trend.

The motivations behind environmental, social and governance (ESG) investing can be complex. And there is debate among private equity specialists about the relative importance of the various drivers.

Is the accelerating popularity of ESG funds down to fund managers scrambling to stay ahead of global regulation? Is it a way to drive value? Or simply a desire to do the right thing?

In fact, it is all these things and more. Interestingly, the factors behind private equity’s embrace of ESG criteria are mutually reinforcing. They work together to create a momentum for ESG that may be impossible to reverse.

The jury is in: private equity is embracing ESG

One thing is certain. ESG is now a key consideration for private equity investing. Research from consultants Bain and Company has found that 88% of Limited Partners (LPs) say they use ESG criteria in investment decisions.

Robeco, BNP Paribas Asset Management and Legal & General Investment Management are among those leading the way according to Shareaction’s ranking of the world’s 75 largest asset managers based on their approach to responsible investment.

Speaking on a recent Intertrust Group podcast, Marc Lino, a senior partner at Bain & Company, said he expected ESG adoption to be much faster in private equity than in public markets.

ESG regulation tightens

Why? Partly, it is down to regulation.

The popular idea that value creation has now replaced regulation as the main driver for ESG investing is an oversimplification. In fact, regulation is still in its infancy and new laws are on the way.

In Europe, for example, the proposed Corporate Sustainability Reporting Directive (CSRD) will significantly extend the scope of the Non-Financial Reporting Directive (NFRD), capturing far more companies. It is due to take effect in January 2023.

CSRD will be coupled with the EU taxonomy and Sustainable Finance Disclosure Regulation (SFDR) which focuses on investors and takes effect in January 2022 and January 2023 respectively. It will provide a strong regulatory framework for non-financial reporting.

Europe is ahead in setting ESG commitments, but globally, too, the direction of travel is set. Recent initiatives in Singapore, Hong Kong, India and the US speak of a growing regulatory appetite for ESG enforcement. We outlined some of these new ESG developments in previous articles.

ESG is part of the investment value equation

At the same time, fund managers increasingly recognise that ESG investment is no detriment to performance. A NYU-Stern study on ESG and financial performance  which covered more than 1,000 research papers from 2015-2020 explains. “We found a positive relationship between ESG and financial performance for 58% of the “corporate” studies focused on operational metrics such as ROE, ROA, or stock price with 13% showing neutral impact, 21% mixed results… and only 8% showing a negative relationship.”

A recent Morningstar study found that some categories of sustainable fund – though not all – outperformed the market over the last decade.

It also found that sustainable funds significantly outlived traditional funds over the same period. Over three quarters of sustainable funds available to investors ten years ago are still around today. Less than half of traditional funds are.

Even so, the carrot of increased returns on investment is clearly driving ESG uptake by fund managers to some extent, though the stick of regulation is at work too. Managers know value increases when risk is reduced.

Investor attitudes to ESG are crucial

A third factor is at play. Private equity investors are driving the creation of more ESG investment products and opportunities, particularly around sustainability.

Simply, it’s down to market demand. A study for wealth manager Quilter found that while investors have major concerns about the increasing costs associated with responsible investing, their top concern was greenwashing and investments not being what they claim to be.

Investors know that regulation presents an increasing risk to non-compliant companies or those who misrepresent their ESG credentials. And a growing number want to invest in a way that genuinely makes a difference.

Rise of the impact investor

Then there are the impact investors who aim to generate financial returns while also creating a positive social or environmental impact.

As Tikehau Capital group climate director Pierre Abadie explains on our podcast, there is risk in that, but also huge opportunity.

Pierre uses the example of a logistics company with a polluting vehicle fleet. When impact investors subsidise the purchase of green vehicle technology, the business becomes more attractive to large retail groups. That is because they too want to clean up their supply chains ahead of stiffer environmental regulations.

As a happy side-effect, employees of all the companies in this virtuous chain become more productive, and churn is reduced. People like working for responsible businesses.

In this example, well-directed investing makes a tangible difference to sustainability. It also drives value in several ways.

This is the ESG investment boom in microcosm. The interplay of regulation, value and a genuine desire for change is creating winning propositions, and looks like an unstoppable force.

Why Intertrust Group?

• Expert guidance in how to take control of ESG data in your portfolio with 24/7 access to performance data
• Online dashboards and reports allow clients to compare the performance of portfolio companies and funds
• Our solutions allow your portfolio companies to calculate greenhouse gas emissions based on up-to-date national and local coefficients