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Friday Letter: Time to step it up

Responsible investment and ESG is becoming increasingly important to LPs. While the industry has made some headway, there’s still room for improvement

Question: when it comes to considering the relevance of environmental, social and governance issues would you describe yourself as one of the more sceptical GPs? If the answer is yes, then it’s probably time to give the matter some serious thought.

A report published this week by Switzerland-based alternatives firm LGT Capital Partners and consultancy firm Mercer, found that ESG really does matter to investors. The report highlighted that 76 percent of the 97 institutional investors in 22 countries that LGT and Merger surveyed, said they incorporate ESG criteria when investing in alternative asset classes.

Significantly, 57 percent of respondents believed that incorporating ESG criteria has a positive impact on risk-adjusted returns, while only nine think that it has a detrimental effect on performance. Issues that have the potential to impact a company’s long-term risk, reputation or overall performance were also an important consideration for LPs, the study also found. Topics such as carbon intensity, controversial weapons, bribery and corruption have moved up the list of important factors for LPs, while exclusion criteria such as alcohol or tobacco were rarely considered.

As far as LGT is concerned, the results prove that ESG analysis has moved beyond ethical concerns and has firmly taken its place as a risk and management topic. It also believes that given the marked uptick in firms’ adoption of ESG and a general broadening of interest in the topic, ESG integration will continue its upward trajectory.

Having said that, according to the report, a penchant for responsible investment is a relatively new phenomenon for most LPs, with 54 percent of institutional investors who incorporate ESG criteria within their investment decisions having done so for three years or less.

Nevertheless the report also noted that most GPs haven’t yet adapted to this change in appetite among LPs. According to the report some 65 percent of institutional investors who consider ESG criteria in manager selection said that the majority of the managers they reviewed do not incorporate ESG-factors into their decision-making.

In fairness, there are of course plenty of managers out there that do take ESG into account. Many GPs – especially in Europe – have hired ESG-focused professionals in recent years and have signed up to the United Nations’ Principals for Responsible Investment. US-based managers also – especially when they have a European investor base – have made headway in recent years; take for example KKR’s Green Portfolio Program, an operational improvement programme that assesses the environmental impact of the firm’s private equity portfolio companies. Last October, the US-listed firm said it recorded nearly $1.2 billion in avoided costs and added revenues as a result of its ESG measures.

What’s more, GPs across the board continue to improve their ESG approach, the Mercer and LGT study also found. Fund managers displayed “significant improvement” on ESG-related policies from 2014 to 2015 it found, but alongside that trend, LP expectations about ESG will continue to rise, the report warned.

So the message to GPs is this: it won’t do you any harm to brush up on your ESG policy if you haven’t already done so. After all, in an increasingly bifurcated fundraising market, having a sound responsible investment approach could well give you a clear edge over a similar GP that hasn’t.

If you want to hear more about ESG and investing responsibly, attend PEI's 6th Responsible Investment Forum on June 23rd. Click here for further details.