The evolution of ESG disclosures
What leads PE firms to disclose more ESG information and does it reflect their investment activities? We find out
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There is no doubt that ESG has become an indispensable part of the financial sector. Private equity (PE) firms obviously cannot ignore this intensified focus on climate change and social issues, as investors increasingly demand ESG-related information. Nevertheless, the wide perception is that PE firms provide only limited disclosures in general and face relatively little regulatory scrutiny, giving rise to the concern that PE firms invest in assets with low ESG performance but attractive financial returns. Referring to some PE buyouts in the heavy-polluting energy sector, articles in the media, such as the Economist, even suggest that PE firms could be undermining the overarching goal of ESG regulation.
As assets under management, and thus the size of the PE fund industry, have grown over the past decade and will continue to grow in the future, the influence of PE firms has also strengthened. With their significant stakes in acquired companies, PE funds have a strong impact on the decisions of portfolio companies, and thus on their ESG responsibility. At the same time, ESG has become increasingly relevant to PE firms, offering potential for value creation and attracting capital from investors who focus on ESG objectives.
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'Social issues are growing particularly fast compared to governance issues'
To shed light on ESG disclosures in the PE industry in general, and to examine whether PE firms take actions consistent with their ESG “talk”, we set out to create a novel database on voluntary ESG disclosures for a global sample of PE firms. Using this novel database, we examine what factors lead PE firms to disclose more ESG information and whether these disclosures are reflected in PE firms' investment activities.
Measurement of PE firms’ ESG disclosures using historical website data
To measure PE firms’ ESG disclosures, we use information from PE firms’ historical websites which are available through the Wayback Machine over the 2000-2021 time period. We create an algorithm that scrapes PE firms’ websites’ snapshots in each year, and then construct an annual measure of PE firms’ ESG disclosures by scaling the number of ESG-related keywords mentioned on a PE firms’ historical website by the total website word count. The ESG-related keywords come from established ESG dictionaries, such as the from United Nations Principles of Responsible Investment. Our empirical measure thus proxies for a PE firms’ focus on ESG, as it measures the information disclosed around ESG activities, relative to the overall information disclosed on the websites.
Increased disclosures, especially of ESG-related information
In general, the information content of PE firm websites, as indicated by the total word count, has increased over the last 20 years. This trend is even stronger for ESG disclosures, which have become relatively more important, especially since 2012. Interestingly, social issues are growing particularly fast compared to governance issues, which the PE industry has traditionally focused on, and the historically more important and salient environmental topics.
The analysis of the evolution of ESG disclosures on PE firms’ websites shown in the figure above confirms the general change that has taken place in the PE industry in recent years: PE firms increasingly focus on sustainable investments rather than just financial returns.
'Does financial performance suffer, as investors might be willing to sacrifice financial returns for the sake of sustainability?'
Breaking down ESG information by country and industry of PE firms' investments in their portfolios suggests that PE firms disclose more ESG information when they invest in countries where ESG and CSR information is more prevalent as these countries mandate respective disclosures, such as the United Kingdom or in the European Union in general. We confirm this interpretation based on a large sample regression analysis. Thus, we conclude that the trend towards ESG disclosure requirements for listed companies is also spilling over to non-regulated PE firms, which then report voluntarily.
PE firms “walk the environmental talk”
A key finding of our study is that PE firms which disclose more environmental information invest in companies with significantly lower levels of environmental pollution. Specifically, a 10% higher environmental disclosure ratio is associated with a 2-3% lower level of chemical releases of acquired facilities.
We find that independent of their environmental disclosures, chemical releases at facilities decrease by an average of 10% after the PE deal compared to the year before the PE deal. However, this pattern might also reflect an ongoing trend in the companies chosen as PE targets. Consistent with this notion, we document that PE firms with high environmental disclosures strategically invest in portfolio companies with ex-ante better environmental performance and these companies continue to display superior environmental performance after the investment. To conclude, ESG disclosures are reflected in PE firms' investment activities, suggesting that "greenwashing" is not an issue in our setting and PE firms are indeed following the global agenda of environmental responsibility.
ESG disclosures’ impact on financial returns
But does financial performance suffer, as investors might be willing to sacrifice financial returns for the sake of sustainability? Apparently not! We find that a stronger focus on ESG aspects in PE firms' investment strategies is associated with relatively successful exits, and thus better fund performance.
Overall, our study provides the first large sample evidence on ESG disclosures, and thus the focus on sustainable investment activities, of PE firms. Several analyses suggest that PE firms’ ESG disclosures are a response to an increasing investor and regulatory demand for ESG information. Further, we document that PE firms apparently take actions consistent with their ESG talk, in particular in the area of environmental performance. Finally, in contrast to several other academic studies that have documented evidence of greenwashing in the mutual fund and public equity industry, we show that PE firms disclosing a lot of ESG information are apparently also the more successful financial investors.
This article is provided by the Institute of Entrepreneurship and Private Capital. To receive our bi-monthly DeBrief newsletter please sign up here.
