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    ESG In Private Markets – Investing For The Long Term

    Richard Tyszkiewicz

    Summary

    Jonathan Bailey explores the evolution of ESG factors in private equity, examining the upwards trend in the number of impact funds, which is beginning to be met with a gradual adoption of ESG criteria more broadly. He considers the role ESG integration is taking on in helping to identify both risks and opportunities within the asset class, and looks at some of the sustainability-related and social themes that are gaining traction.

    Find out more about Neuberger Berman’s ESG and impact initiatives in our 2021 Private Markets ESG Report.

    Jonathan Bailey, CFA, Managing Director, Head of Environmental, Social and Governance (ESG) Investing at Neuberger Berman.

    ESG In Private Markets

    While impact investing has found private equity (PE) the perfect environment in which to grow, it has taken longer for the asset class to fully embrace the integration of environmental, social and governance (ESG) factors in the investment process.  Nevertheless, client demand, regulatory pressure, and the realisation of the contribution ESG analysis makes to effective due diligence mean that private markets investors are rapidly catching up with their listed markets peers in terms of sustainability.  Neuberger Berman (NB) was one of a select number of investment management firms named in the Principles for Responsible Investment’s (PRI) latest Leaders Group.  NordSIP caught up with Jonathan Bailey, Managing Director and Head of ESG Investing at NB to find out how they are approaching sustainability challenges and opportunities within PE.

    “There has been an explosion in the number of private equity impact funds, particularly in the period since about 2017,” Bailey explains, adding that “in the context of overall PE that number is relatively small, but it is coming from a low base, as impact was initially more of a niche.”  This growth in the number of impact funds has been accompanied by a more gradual adoption of ESG criteria throughout the asset class.  “ESG integration around the management of financially material risks has become a mainstream expectation of general partners (GPs) along with the corresponding increase in the quality of due diligence on these issues,” according to Bailey.  He also points to the PE industry’s widespread adoption of the PRI and other industry sustainability initiatives as further signs of the overall change of mood.

    Limited partners (LPs) are driving the change, but as Bailey points out the PE industry is also being influenced by trends in listed markets: “ESG integration for publicly listed companies has become standard, and regulators in those markets are requiring more disclosure here in Europe but also increasingly in the US.”  Crucially for a high expected return asset class like PE, ESG integration helps identify attractive investment opportunities: “the last 10 months aside, we have seen valuations of companies involved in the climate transition and other sustainability themes appreciating, so there are good reasons from a returns perspective to go in this direction.”  Neuberger Berman apply the same underwriting criteria and Investment Committee discipline across the board, irrespective of whether PE investments have an impact objective, as Bailey explains: “we don’t accept lower returns just because an investment has positive environmental or social outcomes.  The good news is that the number of investments that come through for consideration that both meet that financial objective and have the potential for positive outcomes is growing.”

    Neuberger Berman ‘s ESG integration framework divides investment strategies into four categories: Avoid, which involves company or sector exclusions, Assess, which signifies ESG integration, Amplify, focusing on ESG leader companies and finally Aim for Impact, which must deliver intentional positive outcomes towards meeting certain UN Sustainable Development Goals (SDGs).  So far Bailey has observed that most of NB’s clients expect to be in the Assess category.  “They are focused on financially material ESG risks in order to support strong investment returns, but there is a subset of our clients that is also looking for impact and positive outcomes on the climate transition or social issues such as health care and other themes.”

    This impact-focused subset of clients is growing.  Bailey explains the main drivers of this trend: “if you look at net-zero and the climate transition, we are looking at technology-enabled infrastructure and companies that are directly delivering solutions to the challenge, whether it’s in waste-to-energy, water services, energy efficiency or EV charging, these are all exciting business models where we can find a lot of attractive opportunities.”  Sustainability being such a broad array of themes, asset managers must generally narrow their focus somewhat to make sure they are not spreading themselves too thin.  Bailey describes how NB have made that selection: “like a lot of investors we have looked at the UN SDGs, and for our impact strategies we have selected two environmental themes and three social ones.  On the environmental side we are looking at combating climate change and enabling energy transitions, and a second one focused on nature that will pick up things like the circular economy and life below water.  The social themes include driving sustainable and equitable growth, which might involve companies in education or that enable fairer access to information.  We also have a theme around improving positive health and safety outcomes, which could involve medical device manufacturers, companies delivering healthcare or research and development into new treatments.  We also target hunger and improvements in water and sanitation.  The final social theme is about promoting gender and racial equality, where there are opportunities in companies targeting under-served groups, although these are somewhat harder to find.”

    Access to accurate non-financial data is the lifeblood of ESG investing, and Neuberger Berman has joined more than 200 other private markets participants in the ESG Data Convergence Initiative, which is seeking to improve the information flow in these asset classes by creating a standardised set of ESG metrics.  Bailey explains what led to this initiative: “we have been working for many years with GPS that we invest in and alongside to try to encourage more ESG data to be tracked and reported on.  What is nice about the ESG Data Convergence project is that it attempts to bring LPs and GPs together to agree on a minimum set of common indicators.  The commitment is to provide yearly reporting around social topics like diversity, net new hires, or work-related accidents but also addressing the environmental side with carbon footprint or renewables use.  It’s a relatively limited set of metrics that some GPs are already collecting, but it will help others do the same.  It aims to set baselines, for instance with scope 1 and 2, and potentially scope 3 greenhouse gas emissions.  That will allow one to look at the intensity change over the course of the investment and perhaps identify key areas along with ideas of how to bring those emissions down over the value creation period.”  Bailey adds that there is a conscious effort to maintain consistency with the metrics used in public markets, where regulators across the world are requiring more environmental reporting each year.  Getting PE portfolio companies reporting on sustainability at an early stage sets them up well for an eventual public listing.

    Data gaps persist, but there are solutions, as Bailey explains: “there are a lot of resources out there, consultants and tech companies that have been building solutions to make it much easier for smaller private companies and GPs to collect this data and report it.”  The final resort for persistent data gaps is to use peer group numbers to form a proxy while supporting the establishment of permanent solutions.  NB is also involved in industry working groups organised by the likes of the Initiative Climate International (iCI) and the Science Based Targets initiative (SBTi) that are looking at portfolio level net-zero frameworks for private markets.  “Private equity is different in that you come in and out of companies during the life of the fund, so trying to work out what a net zero transition looks like is quite different from buying a single listed stock.”

    As a sustainability-minded PE investor, NB must establish early on whether GPs or investee companies are genuinely working towards making the necessary changes to their strategy: “we run every GP that we invest in or alongside through our ESG risk assessment framework.  Having a policy in place is one part, but it’s often very clear if it has been churned out by a third party versus something that’s really embedded and thought through and specific to the GP’s style.  We wouldn’t invest in a GP without examining the history and performance of its financial transactions, so we do the same from an ESG and impact perspective.”  Co-investment structures provide the best environment to communicate and collaborate on sustainability, and Bailey stresses that one must avoid underestimating smaller partners that might not have as much marketing clout as their larger peers: “with co-investments you are seeing in real time the work that’s being done and the resources that are being put in place, rather than just a corporate statement.  We often find that GPs that a bit smaller and more focused on a particular sector may not have a lot of well-crafted marketing collateral around ESG, but because they are specialists in their field, they are actually very focused on the ESG risks as it’s a fundamental part of how they evaluate companies.”

    Bailey concludes with an optimistic outlook on global ESG investing, despite the occasional politically motivated backlashes against the concept: “I think there has been a bit of confusion around terminology.  In our framework, the Assess category is all about looking at financially material risks that happen to be E, S or G, just like you would otherwise look at appropriate leverage levels or management team competence.  ESG is just part of good investing.  We now have better tools and data, and the external environment has also changed in that these issues are more material to regulators and customers.  It’s therefore entirely appropriate to consider ESG, but we also recognise that not all clients want impact.  Our job is to adapt and create solutions to meet these differing needs.  I think part of the challenge has been the conflation of ESG integration and impact investing.  The world is a complex place, and many people don’t want to have to spend the time understanding the nuances of ESG terminology.  The good news is when you look back at where we have come over the last decade, there is huge demand for ESG integration and growing demand for impact around the world, and I don’t think that’s going to reverse even if there’s occasionally a bit more noise coming from certain places.”

    Jonathan Bailey

    Jonathan Bailey, CFA, Managing Director, is Head of Environmental, Social and Governance (ESG) Investing at Neuberger Berman. Jonathan joined the firm in 2017 and has overall responsibility for the consideration of material ESG factors in investment processes firm-wide. He leads the firm’s ESG Investing team and works with portfolio managers and analysts across our equities, fixed income and private investment portfolios. The team enhance existing strategies and launch new sustainable and impact investing strategies. Jonathan chairs the firm’s ESG Committee and sits on the firm’s Governance and Proxy Voting Committee. He also leads client engagement and thought leadership on ESG topics. Previously, Jonathan was the founding Director of Research at Focusing Capital on the Long Term (FCLT Global) a think tank established by BlackRock, the Canada Pension Plan Investment Board and McKinsey & Co. FCLT Global developed quantitatively robust research on short-termism along the investment value chain as well as practical solutions. He spent the bulk of his prior career at McKinsey & Co where he was an Associate Partner working with asset owners and asset managers on investment strategy and ESG investing topics. Jonathan has also worked for Generation Investment Management, the sustainable investment firm co-founded by former Vice President Al Gore, and as a governance advisor for former British Prime Minister Tony Blair. Jonathan holds an MBA (with high distinction) from Harvard Business School, an MPP from the Harvard Kennedy School of Government, and an MA (Oxon) from the University of Oxford. He has been awarded the Chartered Financial Analyst designation. Jonathan is Chair of the Board of Instiglio, a developing market social impact bond advisory non-profit.

    For more information, please contact

    Mark Oestergaard
    Managing Director
    Neuberger Berman
    T: +44 20 3214 9014
    E: [email protected]

    For more information, please contact

    Emelie Albeck
    Vice President
    Neuberger Berman
    T: +46 85 052 7861
    E: [email protected]

    For more information, please contact

    Harry Sivarajah
    Senior Vice President
    Neuberger Berman
    T: +44 20 3214 9085
    E: [email protected]

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