ESG – definition and criteria
ESG is the abbreviation for Environmental, Social and (Corporate) Governance. The term ESG is associated in the financial world with the role of a socially responsible investor, where the inclusion of the above aspects in investments is essential.
In the world of private equity, public awareness and investor preference for a more sustainable and long-term investment strategy has increasingly driven the focus on ESG factors and ethical investments. Private Equity International’s 2021 LP Perspectives study shows that investors place critical importance on ESG factors in the due diligence process. The Financial Times reported in 2020 that the majority of ESG funds outperformed the broad market over a ten-year period. Although ESG factors are not currently a required part of financial reporting for listed companies, more and more companies are choosing to include them.
The concept of sustainability was first mentioned by Hans Carl von Carlowitz (born 1645) in his book on forestry. Nowadays, sustainability is on everyone’s lips and it is hard to imagine everyday investment without it. Almost every fund provider now has a sustainable fund on offer and thus advertises compliance with its defined ESG standards. However, there are several centuries between the invention of the sustainability idea and the ubiquity of sustainability today.
The first investment vehicle with a socially responsible orientation was the so-called US Pioneer Fund in 1928, which refrained from investments in the alcohol and tobacco industry. This decision was justified by the negative effects of alcohol and tobacco on human health. The first global conference on the environment was held by the United Nations in 1972. Here 26 principles were developed, which placed the interactions between economic growth and consequences for the environment on an international level. In 1990, the “Domini 400 Social Index” was created, the first stock index for “social investing”, thus enabling investors to invest on the basis of sustainable aspects for the first time.
The investor initiative “Principles for Responsible Investment” (PRI) was founded in 2006 with the support of the UN Environment Programme. This international investor network has set itself the goal of supporting investors in incorporating aspects of sustainability into their investment decisions. In 2015, the 193 countries of the UN General Assembly adopted the Sustainable Development Goals (SDGs) with the aim of reducing greenhouse gases. In 2018, $30.6 trillion worth of assets (AuM – assets under management) were managed with ESG orientation and are expected to grow to $140.5 trillion in 2025, according to global provider Bloomberg. At that point, ESG AuM would account for more than one-third of global AuM.
ESG criteria – how many are there?
ESG does not only include the financial aspects of an investment. The ESG criteria are intended to reflect the sustainability of a company and its contribution to society.
Environment refers to the interaction between companies and nature. Companies can have both a positive and a negative impact on climate, resources, water and biodiversity through their products or value chains. The following points fall under the first category of ESG criteria:
- Dealing with climate change
- Efficient and responsible use of limited resources
- Sustainable energy management
- Reduction of the ecological footprint
- Disposal of raw materials and wastewater
The second category of ESG criteria addresses the importance of companies in a social context. Here, the added value that the company brings to society is considered. The following points are relevant here:
- Working conditions and worker protection
- Respect for human rights and human dignity
- Social impact of products on society
- Socially responsible conditions along the entire value chain
3. Governance (corporate governance)
The third and final condition of the ESG criteria addresses the issue of sustainable and responsible corporate governance, which promotes internal processes and values in order to prevent risks. The following aspects are meant here:
- Working conditions and employee protection
- Anti-corruption measures
- Tax honesty
- Combating anti-competitive practices
ESG criteria at a glance:
ESG funds are vehicles in which ESG criteria are included in the investment process. For example, such funds exclude shares in companies that do not meet certain environmental requirements. In addition, no bonds are purchased from states in which human rights are violated.
Private Equity and ESG
In the private equity sector, too, the three letters E, S and G are becoming increasingly important and have shaped the investment landscape in recent years. In principle, private equity companies strive for a balanced risk-reward ratio, which can be very well combined with ESG principles. Nevertheless, in practice there are some problems and hurdles to overcome. For example, there are no, or only a few, fully established KPIs (key performance indicators) that deal with the ESG issue. Therefore, it is necessary that these are developed individually and, if necessary, sector-specifically. In this respect, private equity companies have to spend a lot of time and resources on finding, collecting and evaluating the appropriate KPIs.
The ESG issue in the private equity sector covers two areas in particular: On the one hand, it must be ensured that the private equity company itself acts according to ESG standards, and on the other hand, the companies in which investments are acquired must comply with the requirements.
With regard to the company itself, this can be done, for example, by an ESG officer who takes care of compliance with the guidelines. Furthermore, the areas of responsibility also include public relations and the further development of measures within the private equity company. Compliance with the guidelines is ensured by the fact that the ESG officer of the private equity fund keeps the sustainability-oriented fund investors continuously informed about the ESG activities. However, in order to ensure a holistic view, it must be ensured that the portfolio companies of the private equity fund also address this issue.
At SHS, the topic of ESG, socially responsible and ethically oriented investing has long been a high priority in the strategic orientation. The ESG Officer, Dr André Zimmermann, is responsible for implementing the measures and ensuring compliance with the standards set. At the same time, SHS fund investors receive ESG reports that show the relevant developments at SHS and the portfolio companies.
ESG monitoring – What is it?
An important element in the implementation of a sustainable investment strategy in the private equity sector is the application of the ESG strategy over the entire life cycle of the funds and their portfolio companies.
At the portfolio level, the first step is the investment review prior to a new investment, which already looks for critical ESG points or ethical aspects (red flags) that would exclude an investment. If insurmountable aspects emerge, no investment is made. However, the initial review is only the first step in the monitoring of the portfolio companies with regards to the implementation of ESG issues by SHS. Together with the management, SHS develops a roadmap to gradually improve the ESG status of the respective company.
The ESG Officer at SHS tracks and reviews progress on an annual basis. The further development of the portfolio companies is recorded and graphically depicted using a standardised ESG score. This is done up to the time of the acquisition of a portfolio company, during which the ESG development as well as the implemented improvements can be presented to the buyer. In this way, SHS ensures that investments in the healthcare sector are professionally monitored at the ESG level throughout the entire life cycle of the investment.
In summary, it can be said that the topic of ESG is firmly implemented in today’s private equity landscape and will presumably continue to play an increasingly important role in the future. Due to the broad public attention and the willingness of investors to commit to this topic, private equity funds that practice ESG-compliant investing are becoming more and more popular.
At the same time, analytical data show that ESG-oriented economic activity is not associated with a loss of returns; on the contrary, ESG-compliant companies increase their value more significantly than others and will probably be able to profit disproportionately from this in the future.