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 are, and why other PE 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 and are touted as 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 will usually 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 reviews factors involving the company’s relationships with its employees, local community, and other stakeholders. Social criteria considerations also include a company’s supply chain. It looks at whether the company’s suppliers and/or distributors also 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 there are some companies out there that perform quite well in each category, most commonly a company will focus most of its efforts on just one. It is up to the investor to decide which value is most important to them when making their investment decisions.
ESG investing is becoming more popular with PE firms for a few good 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 that have not quiet entered investment markets will continue to build this trend. Therefore, PE firms need to be prepared to align with the values and investment desires of their clients.
Firms are also 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 long-term, sustainable growth. It is also unlikely 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 has cost the company $62 billion in cleanup costs and penalties as of 2018. In 2014, a U.S. court found that BP was primarily responsible for the disaster due to negligence and reckless conduct. This could have been avoided if BP was more focused on good corporate governance and better environmental practices. There are many other examples of companies that have cost investors millions or billions due to the consequences of poor environmental, social, and governance values.
Finally, ESG investing can help boost firm culture, a key factor overall financial success. Employees are becoming more conscious about who they are working for, and the impact that work has on the world. Talented professionals want to have a positive impact and are increasingly seeking out 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 isn’t necessarily new, but it is becoming more imperative for investors to make a priority. Making investment decisions based 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, take a look at your firm’s investment portfolio and values to take stock of how your investors and firm could benefit from ESG investing.