Environmental, social, and governance (ESG) investing is becoming more popular among individual investors and investment firms alike. There are several reasons why ESG is gaining in popularity. But what can ESG investing mean for your firm?
Let’s take a look at what ESG criteria there is, and why private equity firms are taking it seriously for their own portfolios.
What Are Environmental, Social, and Governance (ESG) Criteria?
Companies that meet ESG criteria are evaluated based on a number of factors. These attributes are a great way for investors to find companies that match their values.
Most companies don’t meet the criteria in all three categories. Rather, they typically focus on one or two areas within the broader scope of ESG.
- Environmental criteria can include factors such as a company’s energy use and where the energy comes from (renewable vs. fossil fuels), pollution, conservation, and their treatment of animals.
- Social criteria involve the company’s relationships with its employees, local community, and other stakeholders. Social criteria considerations also include a company’s supply chain—whether the company’s suppliers and/or distributors hold the same standard of social values as the company itself.
- Governance criteria relates to how transparent and fair a company is in governing itself. Reviews include factors such as transparent accounting and HR methods, stockholder enablement, and avoidance of conflicts of interest. And, of course, that the company doesn’t do anything illegal.
While some companies perform quite well in each ESG category, most commonly a company will excel in a particular area that is most important to them and where they direct more of their attention.
It is up to the investor to decide which value is most meaningful to them when making investment decisions.
The Rise of ESG Investing
ESG investing is becoming more popular with PE firms for multiple reasons. First, investors themselves are becoming more interested in investing in their values (read Why Firm Culture is Important for Limited Partners).
This is particularly true as Millennials begin to make up a bigger portion of investors, and Gen Z adults, who have not entered investment markets quietly, continue to build this trend. Therefore, PE firms need to be prepared to align with the values and investment desires of their clients.
Secondly, firms are increasingly viewing ESG investing as a way to avoid a variety of risk factors that impact company profitability and investor return. A company that consciously works to decrease its impact on the environment will, in theory, produce sustainable, long-term growth. This type of organization is also less likely to have to deal with a significant environmental disaster, which can cost billions of dollars.
Take the BP oil spill as an example. The Deepwater Horizon disaster occurred in 2010. In 2014, a U.S. court found that BP was primarily responsible for the disaster due to negligence and reckless conduct. By 2018, the incident had already cost the company $62 billion in cleanup costs and penalties.
Both the environmental and financial toll could have been avoided if BP had been more focused on good corporate governance and better environmental practices. There are many other examples of companies that have cost themselves and investors millions or billions due to poor environmental, social, and governance values.
Finally, ESG investing can help improve firm culture, a key factor in overall financial success. Employees are becoming more concerned with who they are working for and the impact that the company’s work has on the world.
Talented professionals want to have a positive impact on the planet and are increasingly pursuing employment with companies whose values align with their own. Developing a strong, values-based culture in your own firm will help you hire and retain top talent in the long run.
ESG Investing: A Higher Priority for Today’s Investor
ESG investing isn’t necessarily new, but it is becoming more imperative for investors to make it a priority. Basing investment decisions on ESG requirements is a good move for PE firms that are looking to attract new investors to their firm. It’s also a great way to mitigate risks and build a strong company culture.
At a minimum, you should take a look at your firm’s investment portfolio and values to take stock of how your investors and firm could benefit from starting or increasing ESG investing.