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Private Equity Continues To Adjust To ESG And Deal Environment Changes

Professional services firm Ernst & Young LLP’s (EY) latest PE pulse says that many private equity fund sponsors are actively working towards creating positive social change through their portfolios of companies, a paradigm shift from the ‘do no harm’ mentality of years gone by.

Private equity general partners taking an interest in ESG factors during the screening process for new investments isn’t new, of course, but it is now a primary consideration, explains Peter Witte, Associate Director, EY Private Equity.

“ESG and impact are powerful trends in private equity. I think PE firms – and investors more broadly – are waking up to the fact that we must collectively have a broader view; one where we care not only about returns, but also about the world that future generations will inherit. This means that integrating ESG factors into investment decision-making is rapidly moving from a niche area to a mainstream business imperative. Firms are working with portfolio companies to identify ESG risks and opportunities up and down the value chain, setting KPIs and developing a regular reporting cadence”, he said.

The hedge fund industry’s challenges around ESG reporting are well documented, and it’s no different for private equity. This represents a roadblock for the industry with regards to how it can effectively implement an ESG-compliant investment strategy – and consequently, justify that to the LPs.

“Reporting around ESG and impact remains a challenge for private equity. While risk and return have well-established guidelines and measurement protocols, ESG doesn’t”, says Witte. “Across the industry today, there are a lot of different standards, with no clear consensus – at least not yet – on what represents a best practice. Many firms use proprietary metrics, while others use third-party frameworks, and some leverage both. And even LPs within the same fund may have different needs and different areas of focus. But there is a clear need for some greater level of consensus on goal setting, ESG and impact management, measurement and reporting.”

EY’s report also references the firm’s belief that private equity fund sponsors were too conservative in the last downturn (the global financial crisis); too much sitting and waiting as opposed to deploying additional capital on add-on transactions when prices were lower.

“Firms are out there looking for opportunities, and they’re trying to buy attractive assets at reasonable valuations as best as they can. The challenge, of course is that it’s currently a very difficult market from a valuation standpoint, and that’s been the case for several years now. So, firms are making sure that they have dry powder ready to deploy in the event of a potential downturn. Many clients we speak with recognize that the GFC represented one of the best buying opportunities of all time and that, perhaps, both GPs and LPs were overly cautious.”

Since the GFC, the private equity industry has continued to grow apace. Recent data from Preqin suggests that the industry now manages more than $4trn in assets. This growth has been fulled by new entrants coming into the market as well as a higher average fund size. Witte says that this the industry has hit a fork in the road with regards to the type of deals being done.

“At the high end of the market, firms are leveraging their scale as a competitive differentiator, moving into deals that are generally too large and complex for others to replicate – complex carve-outs, for example”, he said. “At the other end, you see firms moving into growth capital. Dry powder for that space is growing much faster than buyout. For companies, they’re now able to spend more of their life cycle in private ownership because there’s a wider array of funding vehicles that are available to them. Everything from seed stage to growth capital to buyout, and now to the long-life funds and permanent capital vehicles that we’ve seen emerge in recent years.”

Another theme to emerge from EY’s report is that of the increased percentage of assets for new funds coming from high net worth individuals; the report states that NHWIs account for 15-20% of new money coming in. The reasons are both demand and supply-driven, according to Witte, and is a trend he sees continuing.

“High net worth individuals and family offices are looking at private equity and its track record relative to what’s available in the public markets and they’re deciding that it’s a compelling asset class for a portion of their portfolios. At the same time, several of the large firms have really focused on this market by building out the infrastructure required to access and serve these clients. And I think their sense is that they’re in the very early stages of this, and that the potential in the space is substantial” he said. “I think the trend is increasing people’s access to private market investments. And there’s a real imperative here, because increasingly, that’s where more of our economy’s growth is occurring. At this point, many people are aware that there are 50% fewer public companies than there were 20 years ago. I think a decade or two from now, PE’s investor base could look much different than it does today.”

In December 2019 the U.S. Securities and Exchange Commission voted to change the definitions of an accredited investor which, if passed, would significantly open up the universe of potential investors for alternative investment fund managers of all types and strategies. The proposal is currently subject to a 60-day public comment period, which ends this month. If passed, Witte’s crystal ball will likely prove correct.

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