In recent years, Environmental, Social and Governance (ESG) factors have rapidly moved from the fringes of the investing world to become an important focus for firms and investors, particularly in Europe, and increasingly in the Asia-Pacific.
While ESG and responsible investing are undoubtedly relevant from an ethical perspective, there is also a growing body of research that correlates ESG performance with financial performance, providing a major motive for change that is likely to help stimulate ESG data demand in the Asian markets.
OUTPERFORMANCE THROUGH ESG ALIGNMENT IN CHINESE SMES
The University of Cambridge recently published a China-based study tracking ESG metrics for employee and board diversity against individual firms’ financial performance. The research focused on 122 Chinese high technology small and medium enterprises (SMEs), comparing performance in adverse and favourable conditions.
The report discovered a striking 19.5 per cent increase in profitability in firms with management teams that are highly balanced in terms of gender composition in times of adverse conditions. The study also highlighted a 24.8 per cent increase in the return on assets for firms with high gender balance during highly challenging times.
This analysis can be substantially important to private investors when evaluating an investment into an SME and as a potential value driving lever during an investment hold. Investors can use the continual monitoring of management team pedigree and composition to evaluate performance while aligning with investment objectives over time. Without monitoring such metrics quantitively, this impact may not otherwise be recognised from a risk management or value creation perspective.
As individual investors increasingly focus on quantifying ESG metrics and their impact on financial performance, there is growing emphasis within the global private markets investment sphere to move towards standardised reporting and disclosure practices.
In 2018, IHS Markit studied the impact of ESG across private market investments and fund types, including multi-strategy groups, institutional advisers and fund of funds. By conducting a series of interviews, meetings and roundtables with global investors and international organisations such as the UN’s Principles for Responsible Investing (PRI), we assessed how private market participants view the challenges and opportunities in ESG.
Our research revealed three clear trends in global private markets:
ESG reporting is on the rise
IHS Markit’s report, The LP Footprint Project, found that 63 per cent of limited partners (LPs) researched have public ESG policies, 59 per cent have self-selected to be signatories with PRI and 40 per cent publicly publish annual ESG reports, with the number rapidly growing.
Additionally, research we conducted with general partners (GPs) also found that a growing number are beginning to close that gap by choosing to track and report ESG metrics on their portfolio companies’ operations. At a recent client conference, 67 per cent of attendees confirmed that they collect ESG data.
ESG reporting is seen as a way for firms to differentiate themselves from others with similar investment theses pre-investment and to increase transparency to investors post-investment. Of our GP conference attendees, 28 per cent reported the drive to collect ESG data was a responsible investor initiative, 10 per cent in preparation for a fund raise and 57 per cent for both, paired with existing investor requests.
As a result, portfolio companies face growing requests from GPs to provide ESG metrics during the due diligence process and throughout the investment period.
All participants see value in ESG reporting
Through roundtable discussions in 2018 with 17 private market firms, we confirmed that LPs and GPs alike derive three major benefits from ESG reporting.
- Managing risk: As materiality concerns go beyond financial data, ESG metrics enable a more in-depth assessment of risk. Assessing ESG factors during due diligence flags potential risks to monitor throughout the investment period.
- Drive value: The practice of ESG reporting can be an indicator of strong corporate oversight, controls and a commitment to transparency, which combined with assessment of ESG metrics themselves have been correlated in many studies with potential for excess return.
- Differentiation: As LPs prioritise ESG, GPs tracking and reporting on portfolio company ESG metrics can produce reports to demonstrate to investors their commitment to driving better financial performance as well as supporting social or environmental improvement benchmarks.
Other research corroborates our findings. A Morgan Stanley survey of 118 large institutions showed that 78 per cent of investors identified risk management as an important application for ESG data and 77 per cent of investors identified return potential as an important factor in ESG-driven investing.
Better tools and guidelines are needed
In recent years, the private markets have made great strides in improving transparency and reporting capabilities, but more is needed to support ESG objectives for investors and investment managers alike. Our research shows that new tools and guidelines are two areas where leadership is most required:
Guidelines on ESG metrics will help LPs and GPs determine the data that needs to be requested and reported on throughout the investment life cycle. GPs and LPs reported there are multiple consortiums and organisations aspiring to outline standard processes and metrics. Nevertheless, no set reporting standard for portfolio companies has come to the forefront globally for private capital markets.
Tools for collecting and analysing ESG data are needed to help GPs and LPs be efficient in collecting and integrating these additional data into their existing portfolio monitoring and reporting processes.
With the growing body of data and reporting revealing notable benefits for both investors and firms alike, ESG factors look set to increasingly become a central pillar within both private and public markets globally.