On many episodes of Middle Market Musings, the podcast I co-host with Charlie Gifford, the conversation turns to environmental, social and governance (ESG) considerations in business operations and investments. ESG is also a topic with my investment banking clients, both as it relates to their own firms and to their investable wealth outside of business holdings.
These conversations lead me to wonder, what does ESG actually mean in the world of private capital today – how is it being applied as an investment practice, as opposed to being touted as an organizational aspiration?
Here are a few takeaways from the podcast discussions with private equity fund leaders: (a) The extent to which they are being motivated by genuine concerns about issues like income disparity and climate change; (b) Their protectiveness of the fiduciary obligation to optimize investor returns; (c) Their mindfulness of the importance of these issues in attracting and sustaining younger professionals; (d) The stark difference between the relative straightforwardness of acting on these concerns in one’s own organization and the complexities of applying them as a weighting factor in investment decisions.
“Initial results of this analysis suggests underperformance
of PRI signatory funds.
On the last point, I can’t improve on the comment made on the podcast last year by Gene Fama, the Nobel-Prize winning economist and pioneer in efficient market theory:
“If you say I’m going to invest only in companies doing things that I like, which is a form of consumption rather than investment, that’s fine. You’ve got a perfect right to do that. Where I think people managing these products are not totally truthful is in not saying, ‘Of course that [decision] should be associated with lower expected returns because we’re only considering a subset of the market.’ You can’t do better. At worst you can do about as well, but probably you’re going to do worse.”
Pitchbook recently published an excellent report assessing the impact of ESG objectives in private capital asset classes. The Pitchbook team grounded its analysis in the decision of investment firms to sign or not sign the United Nations’ Principles for Responsible Investment (PRI). These principles, first implemented in 2005, crystallized the concept of ESG investing.
There are six PRI principles with just about all the force in Principle 1 – “We will incorporate ESG issues into ESG investment analysis and decision-making processes.” If a firm is comfortable doing that, the other five principles amount to administration and marketing.
Pitchbook found 2,351 private market general partners as of May 2023 that are mapped to the PRI signatory list. Within that group, performance data was available for 714. Their analysts compare the performance of signatory and non-signatory funds for the vintage years 2010-2018.
Pitchbook concluded: “Initial results of this analysis suggests underperformance of PRI signatory funds. For overall private capital, between 2010 and 2018, there were six vintages for which the median IRR of the PRI signatories underperformed compared with their non-signatory counterparts and only two vintages for which the reverse was true. PRI signatories also under-performed relative to the benchmark, with a median return .81% below it, while non-signatories had a median return .38% above it.”
However, they go on to place several caveats on this conclusion, noting that “these results suffer from several limitations, including that they did not control for geography or fund size.” To take the former as an example, European G Ps tend to under-perform the average and preponderantly signed on to the PRI. In the end, they conclude: “It is evident that other factors controlled for in the regression, including geography, fund size and vintage year, have a much greater influence on returns than PRI signatory status.”
What do I make of this?
Gene Fama’s observation that the addition of non-financial objectives can only reduce financial return stands undisturbed, because actual investment behavior in general is not challenging it.
Most firms committed to the concept of social investing are not following the literal prescription of PRI Principle 1 and including ESG issues “as a weighting factor in investment analysis and decision-making processes.”
It is increasingly common, however, for private equity firms and other investors to target industry sub-sectors compatible with energy efficiency and other social dynamics – but they tend to focus on those with powerful growth drivers behind them.
Two guests of the Middle Market Musings podcast discussed investments their firms have made related to the lithium-ion battery and its use in electric vehicles (EV). In both cases, the investors were adamant that there was no diminution in return expectations. An investment driven by EV technology is not conceptually different from one driven by healthy living diet trends. In Fama’s parlance, both investments are being driven by the consumption preferences of a company’s customers, not by those of the company or its owner.
That is where the center of gravity stands today, but things change.
When Charlie and I talk to our contemporaries, there is respect for social objectives, but also a conviction that people who entrust their money to pension funds and other institutional investors are not looking to have their returns dampened by the pursuit of social objectives, even ones they share. But we all work with younger people who care about these values and may guide financial institutions to look differently at investor obligations and return over time, particularly if there is a widespread sense of government dysfunction in addressing these problems.
About the Author
Andy Greenberg is CEO of Greenberg Variations Capital, a mergers & acquisitions advisory firm based in suburban Philadelphia devoted to one-off or targeted transactions. He is founder and former CEO of GF Data©, the M&A data tracking service acquired by ACG in 2022. For more information, visit www.greenbergvariations.com.
© 2023 Private Equity Professional | June 21, 2023
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- Source: https://peprofessional.com/blog/2023/06/21/cool-intentions-the-actual-state-of-esg/
