Keeping an eye on private equity and ESG
Do private equity firms merely make ESG claims, or do claims translate into better portfolio company performance?
How do you measure the sustainability of the private equity industry? How can you determine if a multi-trillion-dollar economic powerhouse, which has little to no obligation to offer public disclosure of its practices, benefits the planet, its stakeholders, or its investors? Moreover, how can you discern whether the environmental, social, and governance (ESG) information that the industry voluntarily discloses is genuine or mere window dressing? Finally, how can you assess private equity's impact on the ESG performance of its portfolio companies?
One approach to addressing these questions is to examine the information that private equity firms choose to disclose on their websites. Valuable insights can be gained by analysing a representative sample of thousands of firms and comparing the practices of those that make extensive ESG disclosures with those that provide limited information.
In a newly published paper titled "ESG Disclosures in the Private Equity Industry," authored by Florin Vasvari, Marcel Olbert, and Jefferson Abraham of the London Business School, the authors aim to do just that.
Photo: Marcel Olbert, Jefferson Abraham and Florin Vasvari discuss their new research
The trio provide the first systematic empirical insights into ESG disclosures by private equity firms, drawing from a representative sample of over 5,400 private equity firms. Their research seeks to explore the primary factors influencing a private equity firm's decision to disclose ESG-related information and to determine whether portfolio companies' ESG performance shows greater improvement after investments by firms with a strong ESG disclosure track record, compared to firms that disclose less.
To conduct their research, the team developed a novel yet straightforward measure of ESG disclosure using data from private equity firms' websites spanning from 2000 to 2022. They combined this information with data from the specialist data provider Preqin and data on portfolio company performance from publicly available sources such as the U.S. Environmental Protection Agency's Toxic Release Inventory (EPA-TRI), U.S. Department of Labor Occupational Safety and Health Administration (OSHA), and other sources like S&P Global's Trucost database.
Their ESG measure was constructed through textual analysis, utilising a dictionary of ESG-related words sourced from various references, including the United Nations Principles of Responsible Investment. Additionally, the ESG measure's validity was confirmed using the ChatGPT large language model to provide context regarding the nature of ESG disclosures made by private equity firms.
The study reveals a significant increase in ESG disclosures over the past two decades. While overall content on private equity firms' websites has expanded, the prominence of ESG-related messaging has consistently risen. This stands in contrast to disclosures about financial value creation, which have gradually decreased in relative importance.
Geography and the primary industries of portfolio companies are significant factors influencing the variation in ESG disclosures among private equity firms. ESG disclosures have grown at a faster pace in Europe compared to the United States, particularly in industries with higher environmental risks.
Investor perspectives also play a crucial role. The study demonstrates that the presence of ESG-aligned investors, known as limited partners in the private equity industry, drives ESG disclosures by PE firms. Following an investment by a limited partner committed to the United Nations Principles of Responsible Investing, website-level ESG disclosures increased by approximately 12%. The study also explores the potential influence of spillover effects from ESG disclosure mandates in public markets, which motivates private equity firms to enhance their ESG disclosures, especially when their portfolio companies operate in jurisdictions with robust public ESG reporting requirements.
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Following an investment by a limited partner committed to the United Nations Principles of Responsible Investing, website-level ESG disclosures increased by approximately 12%
ESG commitments positively impact fundraising outcomes. A doubling of ESG disclosures is associated with a 15% faster fundraise, equivalent to approximately $100 million every six months, and increases the likelihood of attracting ESG-focused investors. Furthermore, the study reveals that private equity firms tend to improve their disclosures in the years leading up to their next fundraising event, as prospective limited partners scrutinise their websites.
However, the critical question remains: do private equity firms merely make ESG claims on their websites, or do these claims translate into improved portfolio company performance? The answer, for the most part, is affirmative. For instance, regarding environmental pollution, the study finds a strong correlation between the strength of a private equity firm's environmental disclosures and the performance of portfolio companies' facilities in the U.S. This correlation extends globally, with Scope 1 and 2 carbon emissions decreasing for portfolio firms owned by PE firms with robust ESG disclosures.
Improved performance is not limited to environmental aspects. The study reveals that enhanced social disclosures by private equity firms are associated with a lower incidence of inspections due to complaints after an investment. Furthermore, following investments by private equity firms with strong ESG disclosures, reputational risks related to ESG decrease by nearly 14%.
The research team emphasises that this innovative methodology, relying on website disclosures, is necessary due to the limited public information available. Investors typically negotiate access to more extensive information about the funds they invest in and receive regular performance updates. However, due to non-disclosure agreements, other stakeholders may remain uninformed.
In conclusion, despite the economic significance of the private equity industry, the literature has provided limited evidence regarding PE firms' disclosure practices, primarily because non-listed PE firms are not subject to public financial reporting mandates. This study bridges that gap by introducing a new measure of voluntary ESG disclosures made by PE firms on their websites.
*ESG Disclosures in the Private Equity Industry, by Florin Vasvari, Marcel Olbert and Jefferson Abraham of the London Business School. 2023. The paper is currently subject to second-round review.
Florin Vasvari is Professor of Accounting at London Business School. Marcel Olbert is Assistant Professor of Accounting. Jefferson Abraham is a PhD student.
