Responsible investing has clearly become a hot topic, and for good reason. Over the past few years, capital flows into ESG funds have surged, with the global market reaching $2.5 trillion this year, according to Morningstar. However, much of this is concentrated in listed equities and fixed income instruments, while the unlisted market often takes a back seat.
From an investor's perspective, the problem may be that responsible investing practices and standards are heavily weighted towards the public market given the lack of standardized reporting practices and lack of ESG data in private markets.
So how should one approach the unlisted market, and especially small and medium-sized growth companies? Why is focusing on ESG and impact ever so important for growth companies albeit the absence of common standards? And what then is the role of the investor in this equation?
The attention of private equity investors has historically focused on two things - people and growth. A company needs to be able to anticipate longer-term changes in the market, as companies normally take years to reach their full market potential. They also need to be able to build and grow a team of talented people in order to turn ideas into a profitable business.
Today, consumer demand for sustainable products and services has become mainstream and this trend is gaining further momentum. In evaluating growth potential and product-market fit, private equity investors will increasingly need to factor in this trend. Add to this the heightened awareness of corporate values and ethical business practices guiding employer selection, and it becomes clear why focus on sustainability should be set as a priority.
As companies grow, things like corporate culture and governance will evolve too. It is specifically this growth phase where investor support reaches a critical point and also provides an opportunity for genuine value creation.
So, what is the role of a private equity investor today? How has it evolved and what challenges still lie ahead?
If we start with the investor’s role, the term active ownership is often emphasised. Compared to the listed market, in unlisted equities investor influence is commonly greater. This is generally tied to the significant shareholding in target companies, the narrow investor base and, as the name implies, the growth phase of companies. Given this growth phase and the potentially limited resources and experience in sustainable development, it should be in the investors interest to drive the work forward.
Looking at active ownership then and how it is manifested, one concrete way is through the work of the Board of Directors. According to a recent study by PwC (2021), 56 percent of boards of global private equity-backed companies include sustainability on the boards’ agenda on an annual basis. Just three years ago, this figure was 35 percent. Given the critical role of boards in growth support, developing personal competencies in areas such as sustainability has become vital. And such competence should be found widely throughout the entire investment team.
In addition to board work, these days responsibility is also more strongly integrated into companies' growth plans, for example through the establishment of 100- and 1000-day value creation plans and setting ESG KPIs. The drafting of ESG policies is also being implemented in more than 65 percent of cases (PwC). Integrating responsibility and impact into growth plans is often not an easy task and requires a degree of tailoring on the part of the investors to ensure genuine value creation. Finally, given the often wide portfolios of private equity investors, being able to leverage on sharing best practices across companies may provide further competitive advantage.
Although efforts have been made in recent years to promote responsibility throughout the industry, there are still challenges for the sector as a whole. The most critical, according to research commissioned by Pitchbook (2021), are the measurability of responsibility and the availability and comparability of data.
However, there is some light at the end of the tunnel, as business models are evolving at an accelerating pace and, for example, the number of data providers is clearly increasing. One Finnish example is the Upright Project, which is doing pioneering work in the field of impact data. The development of ESG metrics and best practices for private equity have also been actively promoted among industry players. A recent example is the Finnish Venture Capital Association’s ESG toolkit, co-developed by Evli together with six other investors in June 2022.
Looking ahead, as responsible investing gains foothold within private markets, it is certain that the pace of change will continue to grow exponentially. Paired with increasing regulatory pressure and consumer demand, it is certain that the whole industry is facing clear transformation towards a more responsible direction.
Original text (in Finnish) published on the Finsif website.