When it comes to their investment policy, pension funds take a keen interest in how responsibly a company handles ESG (environment, social and governance) aspects. As well as keeping a close eye on their own social responsibility and reputation, pension funds are also acutely aware that sustainability can help create value in their portfolio. Private equity investors, who frequently deal with pension capital, are also required to pursue an ESG policy.
This is what PGGM's Responsible Investment Advisor Tim van der Weide and Eric-Jan Vink, who heads up the Private Equity Team, write in their contribution to the recently published book ‘New Strategies for Risk Management in Private Equity’.
ESG policy adds value
When private equity players develop a proper ESG policy, they are not only giving their clients the transparency they demand, but also laying the foundations for managing the risks in their portfolio and reducing those risks wherever possible. In the ideal scenario, this adds value: if, for instance, a company decides to press ahead and reduce its energy consumption rather than waiting for the government to tighten up emission standards, it will lower its costs and be less vulnerable to higher energy prices. What's more, the lower CO2 emissions will be good for its image. This is a compelling example, but how do you measure ESG risks and how can you then influence them? Van der Weide and Vink bypass the well-worn theories surrounding ESG policy, presenting instead a series of concrete examples and recommendations.
Take stock of risks
They believe a sound ESG policy starts with taking stock of the risks run by portfolio companies in the spheres in which they operate. Ideally, this should be a standard feature of the due diligence that precedes an investment. Unfortunately this is not a fill-in-the-blanks exercise, not least because the operational and strategic risks differ vastly between countries and between sectors. Do the companies abide by all the local and international standards and rules? How big is their carbon footprint, do they work with dangerous substances and how dependent are they on water?
The next task is to quantify, weigh and classify the risks as accurately as possible. Benchmarks and guidelines issued by international organisations such as the Organisation for Economic Co-operation and Development OECD and IFC, part of the World Bank, can be helpful here. The risk analysis tools used by banks can also provide inspiration.
Influence the partner
Eventually, a private equity investor will have to set to work with the identified risks. For companies with a high risk profile, investors could influence policy by making concrete agreements at the start of their investment, advise Van de Weide and Vink. Private equity investors are wise to keep their clients well informed about their ESG policy and the progress they are making. This is also in their enlightened self-interest: if they succeed in steering their portfolio companies to new heights with a good ESG policy, they are proving their added value.