Alternative Asset Managers Heads Up! An ESG Wave is Headed to Your Mid-Market

Despite Donald Trump’s climate change skepticism and deregulation promises, one of our major predictions for 2017 is that mid-market private fund managers are going to have to pay much more attention to environmental, social and corporate governance (ESG) issues.

Let me explain why. For one, ESG is a trend with a ton of inertia behind it. These types of things tend to start at the top of the market, where resources and specialists are in plentiful supply, and work their way down. KKR for instance publishes a detailed ESG report annually, and has a section on its website dedicated to responsible investment. You would be hard pressed to find anything similar at a firm managing south of $1 billion, but it’s becoming a point of conversation in mid-market circles. In fact, a new PwC study found that more than two-thirds (70 percent) of managers have now made a public commitment to investing responsibly. In 2013, the comparative figure was 57 percent. But elevating responsible investment from a do-good side show into a core element of your firm culture means putting action behind those words.

On that point, we think we can help. Last November Invest Europe, the trade body, published a due diligence questionnaire (DDQ) for managers to use to assess ESG factors at the companies they own or plan to invest in. The DDQ is important because many managers express a genuine desire to weave ESG into their investment ethos, but are unsure where to start. That’s why we recently sat down with three members of the Invest Europe taskforce – Blaise Duault of PAI Partners, Marta Jankovic of APG Asset Management and James Holley of KPMG – that played a key role in the creation of the DDQ as part of a virtual roundtable. We discussed not only the purpose of the questionnaire, but provided managers practical advice on how they can use it out in the field, as well as integrate the DDQ into their due diligence processes, which Navatar Private Equity can manage.

Back to my prediction, the second point is that responsible investment is turning from an investor want into an investor demand. It used to be the case that only European investors ever turned down a star manager for not being green enough. But late last year, Coller Capital found that one in five North American LPs are now willing to do the same. The last time Coller polled LPs on ESG was two years ago, when they named it the least important skill a manager can have to drive returns, so clearly investor sentiment on the issue has evolved.

Thirdly, even if managers don’t appreciate ESG as smart investor relations, they should recognize responsible investment as an effective risk management tool and lever of value creation. Cutting portfolio company waste, keeping workers happy and rooting out corruption doesn’t just put a smile on investors’ faces, it’s just smart business practice. Happily, the industry is starting to appreciate that. When asked what’s driving responsible investment, nearly half (44 percent) of managers in the PwC study put risk management up top.

Lastly, if not convinced yet, regulators may force the issue on mid-market managers. Yes Trump may pull America out of the Paris Climate deal, but the longer-term global trend is a government clampdown on carbon emissions. So fund managers would be wise to anticipate policy changes and act accordingly. To that end, some market observers have already published guidance on what the Paris deal will mean for private equity firms and other financial sectors specifically.

And need it be said, it isn’t just private equity that should take notice of the above trends. Every private fund manager, including for instance hedge funds, should anticipate a ESG wave moving down market. Many, indeed, are doing just that.

To be clear, fund managers taking a more active interest in the environment and human issues is a totally good thing. We applaud any sign of the mid-market embracing ESG just as much as their counterparts up top. But the trend will produce winners and losers. Managers that incorporate ESG considerations at each stage of the deal cycle, from due diligence to finally exit, get a head start on mid-market managers who wait for investors, poor returns or regulators to force their hand. For more on this, check out our roundtable with Invest Europe below: