Private equity caught in the anti-ESG storm: LPs and retail investors increase demand for ESG despite the backlash.

 

The backlash against ESG is dominating media and legislatures in the US, and has trickled down to affect the strategies of private equity (PE) firms. But the anti-ESG storm fails to reflect the reality of the investment landscape. Recent surveys show that LPs and retail investors are becoming increasingly interested in sustainable investment products. Regulation will soon intensify the pressure to focus on ESG. To weather this tumultuous period, PEs may consider clearly defining their ESG approach, focusing on materiality and stopping short of exclusion.

The backlash began in mid-2020, initially consisting of a few voices protesting ESG investing to protect the interests of states and businesses vested in fossil fuel and firearms. Political players, largely affiliated with the Republican Party and including several 2024 presidential candidates, took on the anti-ESG cause shortly thereafter. ESG investing has become embroiled within the broader trend of polarization in US politics.

Legislation has been proposed (and in some cases, adopted) in six states that prohibits state pension funds from “discriminating” against fossil fuel and firearms, or that imposes outright bans on ESG-integrated strategies altogether. Last month, a resolution was introduced in the US Congress which aimed to bar retirement funds from considering ESG-related factors in the investment process, although President Biden vetoed the effort.

The backlash has turned into a vicious storm: some asset managers have cut ties with public decarbonization commitments and reiterated their allegiance to the fossil fuel industry in fear of legal or reputational consequences. 

But is the backlash truly reflecting a shift away from ESG among asset managers and their LPs? Is this the end of ESG investing? Once the reality of the investment landscape is uncovered, the answer becomes clear: however loud and ominous, the anti-ESG discourse is a rhetorical approach that fails to reflect the reality of the market.

ESG is trending up

The backlash may see ESG as a threat to overhaul business as usual, but many LPs across the globe already demand that GPs report ESG data.  Indeed, despite the loud minority of anti-ESG LPs, the majority of LPs and retail investors are requesting ESG integration at increasing rates. A recent survey from the Institutional Limited Partners Association (ILPA) of over 100 LPs revealed that 80% expect to increase their requests to GPs for ESG reporting in the next three years. Similarly, a 2022 survey by Charles Schwab showed that the majority of retail investors born after 1980 consider ESG when investing.

Regulation is imminent in the US and the EU, with the SEC’s climate-related disclosure requirements slated to be released in April 2023 and the Sustainable Finance Disclosure Regulation’s (SFDR) first reporting period starting in June. PEs will have to contend with the regulations, even if they are not directly affected.

 Although the SEC’s requirements apply only to publicly listed firms, PEs will have to gather climate-related data on the portfolio companies they take public upon exit. In regard to SFDR, PEs with less than 500 employees will be exempt from disclosing the principal adverse impacts (PAIs) of their investments; however, they will still be required to classify funds according to the regulation’s various categories and gather detailed data if the funds are classified under Articles 8 or 9. These regulations could also increase LP expectations for obtaining ESG data from GPs, as the LPs themselves may be subject to the requirements or aim to stay competitive with those who are regulated.

Weathering the storm

Due to the media frenzy and legislation the backlash has spurred, PE firms are getting caught in the cross hairs, as they are fielding conflicting demands from their LPs. They face restrictions on ESG integration from weary LPs in certain US states, initial encouragement from pro-ESG LPs in others, and ambitious requirements from veteran ESG adopters in Canada, the UK and the EU. PEs want to protect commercial opportunities in their ESG products and strategies but are weary of alienating stakeholders and appearing political.

To maintain footing while the anti-ESG storm rages on, PEs may consider a three-pronged approach to ESG, aimed at keeping LPs satisfied and preventing firms from getting caught up in the rhetoric.

  • Be precise: Define your approach to ESG clearly and align it with your firm’s interests and strategy.

  • Focus on materiality: Determine the material risks for your strategy, based on LP demands, relevant industry risks or market focus. Refrain from playing to the ESG trend du jour if it does not apply to your strategy.

  • Engage, don’t exclude: Where possible, engage with co-investors or targets to develop more robust mitigants against material ESG risks, rather than exclude the sectors ESG-weary LPs want to protect.