"ESG": A new ethical lens on private equity

In the wake of global crises and changing investor demographics, investment decisions are moving away from the traditionally exclusive focus on financial gain. Instead, the topic of Environment, Social, and Governance or "ESG" has been a fast-growing trend in the Private Equity space in recent years. ESG refers to various ethical considerations that companies are implementing in their operations in order to become more socially responsible.

Some key examples of ESG are as follows:

Environmental

• Climate Change
• Pollution/Dumping
• Conservation of Resources (energy, trees, water etc.)
• Animal welfare

Social

• Employee/human rights
• Local community interaction
• Workforce Diversity and Inclusion
• Labour sourcing

Governance

• Executive pay
• Board structure
• Code of conduct
• Transparency of internal controls

ESG considerations have become increasingly popular due, in part, to the commitment to "Socially Responsible Investing" (SRI) by many major investment funds.

SRI in Private Equity

SRI, also known as Sustainable Investing or Ethical Investing, is the making of investment decisions by engaging ESG factors. According to a survey of 162 Private Equity firms conducted by PricewaterhouseCoopers, 81% of respondents have a responsible investment policy more than a third have an in-house team dedicated to responsible investment.^[1] SRI initiatives can include the following:

1. ESG-integrated financial analysis: The estimated financial impacts of ESG factors are directly included in financial models when calculating expected financial performance.
2. Positive Screening: Investment candidates are selected based on a minimum threshold of ESG standards.
3. Negative Screening: Investment candidates that participate in certain negative ESG activities are excluded from investment selection.
4. Impact Investing: Investments are selected strategically for furthering a particular ESG objective.
5. Shareholder Engagement/Activism: Existing investments are influenced to improve ESG performance through shareholder activity such as shareholder votes in favor of ESG-friendly corporate actions.^[2]

While simple in concept, these strategies are often difficult to execute. ESG values differ across industries and evaluation models are notoriously inaccurate. Case-in-point: shortly before its emissions scandal, Volkswagen was held up "Company of the Month" in a certain ESG newsletter for its contributions to Environment.^[3] Investment funds thus need to frequently update and rebalance ESG models in order to track performance indicators accurately.

Current Market Practice

Today, all five major Canadian banks are signatories to the UN Principles for Responsible Investment, which requires each of them to publicly report on responsible investment activity. Examples of engagement in SRI at the banks and other investment entities include the following:

• positive screening and impact investing (structural environment-focus);
• dedicated responsible investment teams offering ESG-specific funds;
• SRI portfolios that exclude tobacco, alcohol, weaponry and countries that disregard human rights;
• employment of a "Chief Sustainability Officer" that advises investment due diligence;
• ensuring all offices are carbon-neutral; and
• offering ETFs and mutual funds that are exclusively focused on sustainable investments.

Future Considerations

As interest in ESG and SRI continues to grow, the ESG landscape is shifting. Fund managers should be aware of the following trends:

Enhanced ESG Reporting

An increasing number of investment funds are releasing ESG-specific annual reports to update clients on positive developments and some industry participants are indicating a desire for government regulation in the ESG space. In future, ESG reporting could become standardized across the investment industry. Fund managers may be able to benefit by keeping a close eye on ESG standards and engaging regulators in discussion early.

Innovative Investment Tools

Analyzing and screening investments for ESG criteria can be a resource intensive task. Utilization of artificial intelligence (AI) in investment has been gaining traction outside of ESG for some time and this will likely attract imitation inside ESG as well. Fund managers will be looking for new tools to cut costs and increase accuracy of investment research and the answer could lie in AI.

Rise of Ancillary ESG Services

Following the popularity of ESG, many independent service providers have begun offering ancillary services such as ESG ratings and ESG research and analysis. The investment industry could see a convergence of services if incumbent ESG funds decide to take these services in-house or form strategic partnerships.

These trends each represent a challenge and an opportunity for private equity in 2020. Gowling WLG's expert private equity team has broad fund formation and investment expertise; we deliver bespoke advice at every phase of the private equity life cycle. For more information on how we can help, contact Edward Johnston, National Leader, Investment Funds and Private Equity.

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