Key Takeaways from ESG and PE—The Missing Pieces

Board oversight of Environment, Social and Governance (ESG) issues has come to the fore as public and private companies evolve their stakeholder communications to include company-specific ESG metrics and targets, designed to identify risk and long-term value creation. Unlike public companies, private entities are not obliged to make specific ESG disclosures to satisfy regulators and the ratings agencies that monitor actions on the ESG front. Because private firms have the latitude to either ignore or embrace ESG, it’s worth noting that so many are dedicating time and energy to ESG issues.

One driving force for greater ESG engagement is the limited partners (LPs) insisting that ESG issues take center stage for no other reason than that ESG issues are critical to most companies’ future success. In particular, the COVID-19 pandemic has shone a spotlight on ESG and illuminated the importance of paying attention to employee health and safety, supply chain resilience, and corporate culture more broadly. Human Capital Management is increasingly an ESG issue no company can ignore.

Michael Cappucci, managing director at Harvard Management Company, which manages the endowment for Harvard University, focuses on sustainable investment because he finds doing so prudent: “We believe that considering all data—including relevant ESG data—is not only in line with our fiduciary duty but simply something that smart investors should be doing.” 

Warren Valdmanis, investment partner at Two Sigma Impact, agrees: “If you want to build a company for the future, it is critical that you are on the front foot for ESG issues.” 

How ESG became so critical to PE discussions and what types of ESG issues are most worth attention were the central topics at a recent webcast sponsored by Donnelley Financial Solutions (DFIN). Following are some highlights of the discussion.

What PE Investors Want to Know

When private companies do report on ESG issues, they are doing so voluntarily and so the information they deliver tends to be truly “decision useful,” says John Truzzolino, director of business solutions services for DFIN and moderator of the panel. Decision-useful ESG data is different at all companies; companies are now conducting ESG materiality assessments to identify what is material risk and longtime value creation across a broad range of ESG issues. For some guidance, the Sustainability Accounting Standards Board (SASB) provides a list of 23 core elements across 11 sectors and 77 industries that are deemed “financially material” to a company. 

Cappucci points out that PE has an enormous leg-up when it comes to driving better ESG practices in portfolio companies. That’s because, he says, “The governing structure of private equity is conducive to both ESG-style analysis and also provides the tools for effecting change at the portfolio company level.” He continues: “One challenge in the pubic equity space is that no matter how good you are at identifying ESG issues, it can often be quite a challenge to get management or the board of directors to recognize where they might be able to improve… In private equity the sponsor often has control at the board level and can much more directly influence the business outcomes.” 

Leela Ramnath, director of ESG at Warburg Pincus, agrees, noting that she can have “tactical conversations about issues” in ways that are simply unavailable to most investors at public companies. She notes that at a private company, she can engage with the CEO or CFO on ESG issues, and her firm usually has at least one board seat on the companies that it owns.

Timothy Koller, partner at McKinsey & Company, is also convinced that PE firms have an enormous opportunity to be proactive and should use this opportunity wisely: “They should be confident and say, ‘This is what matters to us.’”

While Koller emphasizes the importance of honing in on ESG issues critical to the business (beverage companies should, for instance, focus on water consumption), Valdmanis believes that two issues are emerging as critical for companies more broadly. These are 1) the environment and emissions, and 2) the workforce. COVID, he says, has “catalyzed the issue of the workforce.” He notes that companies today need to consider “how to make positive, ROI investments in workers.”

Global ESG Regulation Is Evolving

On August 26, 2020, the SEC adopted amendments to modernize the description of business (Item 101), legal proceedings (Item 103), and risk factor disclosures (Item 105) that public companies are required to file pursuant to Regulation S-K. While there are many facets to the new SEC rule, one of particular interest is the requirement to disclose company information pertaining to Human Capital Resources to the extent this information is material to an understanding of a registrant’s business. 

With the effective date of this new SEC rule November 9th, 2020, the 2021 public company 10-K and proxy SEC filings will likely evolve and include human capital resources information such as, but not limited to:

  • Number of employees in well-being programs
  • Number of safety incidents
  • Revenues or profits by employee
  • Employee retention or turnover rates
  • Ethics and compliance training
  • Total workforce costs and labor costs per full-time employee
  • Diversity (age, ethnicity, gender)

Private companies need to watch ESG trends more broadly, according to Alexandra Farmer, partner, sustainable investment and global impact practice, at Kirkland & Ellis. She notes that the EU has been more proactive in its ESG approach and has given “firms the tools that they need to describe themselves as ESG positive without focusing on enforcement.” Farmer believes that the EU trend of creating ESG reporting taxonomies is one well worth watching.

Finally, Ramnath notes that the importance of ESG for PE firms and investors is not only firmly established but is accelerating, too. “This is rapidly evolving,” she concludes. “The ecosystem has changed dramatically, even within the last year.”