Private equity investors face stranded assets without ESG transition

Institutional investors that make private equity deals should also consider change-based targets to complement levels-based targets because of shorter-term horizons, according to a WEF whitepaper.
Private equity investors face stranded assets without ESG transition

Private equity (PE) investments might not be subject to mandatory disclosures the way public assets are, but PE investors have other strong motivations to ensure sustainable integration and will have to adopt unique strategies at that, a new World Economic Forum (WEF) whitepaper said.

“Increasingly, because of regulations, and also societal pressure and LP (limited partners) pressure, [private equity investors] have to focus on sustainability improvements as well,” said Shrinal Sheth, project lead for financial innovation at the WEF said.

“Because unless they can show that, within the time period that they held on to that asset, they have, let's say improved workers’ lives or legacy, or they've improved on carbon emissions, then they cannot charge any premium when they exit,” she said.

The WEF whitepaper titled ‘Creating Value through Sustainability in Private Markets’ published in collaboration with Boston Consulting Group highlighted private equity’s role in transforming grey to green assets as well as barriers that keep PE investors from achieving their environmental, social and governance (ESG) goals.

PE investors face challenges that all other investors do, such as a lack of sustainability expertise and measurement uniformity, but they also face barriers specific to PE assets such as insufficient time to capture value, levels-based targets compared with change-based targets, and the risk of assets becoming stranded if no progress towards sustainability is made, wrote the report.

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“If [an investor] is going to sell an unsustainable asset, ‘to whom?’ is going to be an increasingly difficult question to answer,” Sheth said, “At this point, after stating their targets, any institutional investor would probably want to make any type of commitment to those types of assets directly.”


Investors generally hold on to PE assets for five to seven years before making an exit, which means that their PE portfolios change often, making it difficult for investors to reach their portfolio-wide levels-based targets such as net-zero.

“Hypothetically, if you acquire a high emitting asset, your portfolio's emissions are going to go up,” Sheth said. “If you only look at it from a portfolio level, then a private equity portfolio changes every five to seven years. So it's going to be very difficult to meet a net-zero commitment.”

“So what we've tried to propose in the paper is to focus on a change-based approach, as well as a levels-based approach. So if I'm a private equity fund acquiring an asset today, if in seven years from now, I've been able to reduce the emissions of that particular asset by 30%, or 40%, that should also count towards something,” she said.

A change-based approach also involves having different milestones within the holding period and being able to explain how a coal power plant, for example, is moving towards a hybrid plant and eventually phasing out coal.

She also cautions against blind divestments from ‘grey’ assets because there will always be irresponsible investors waiting to swoop in to harvest cash flows from coal power plants for instance.

“The change-based emissions approach would help the industry move forward when it comes to making more, bolder transformations, as opposed to just divesting because it looks good on your balance sheet,” she said.

Some asset owners have argued that private investments provide more opportunities for  engagement as compared with public assets. NZ Super and LGIA Super for instance told AsianInvestor that private markets even offer superior ESG opportunities.

“Private equity investors often have the advantage of more direct engagement compared with public markets investors that have minority stakes,” Brian Kernohan, chief sustainability officer for Manulife Investment Management’s private markets told AsianInvestor.

Manulife IM releases its second annual stewardship report on May 3 that emphasised key aspects for sustainable investment outcomes, stating that within private markets such as equity, credit and infrastructure, relationships were key to the firm asserting its influence over assets and portfolio companies.

“As an example, Manulife Investment Management partnered and sponsored Albamen, an industrial investment firm… Currently, the Albamen team has been retained to continue managing 10 renewable energy assets in China,” he said.


One of the main challenges unique to Asia is that the continent has more high emitting assets than any other developed market, but Sheth said that this meant that this provides more of an opportunity “because the range of potential sustainability investments that any private equity investor or an LP can make is also broader because some of these assets need to be decarbonised.”

“Of course, it's a unique challenge because there's more to do, which means it's more difficult to show progress,” she said.

Kernohan added that data is a problem particularly pertinent for PE investors. “A lack of data is often cited as a challenge for investors, but for private equity investors there is often little data available except for that which is provided by the investee company. Consistency within the sector regarding what data to request is also a challenge, resulting in difficulty in comparing ESG performance across investments.”

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Several institutional investors have taken steps to address the data problem. For instance, the California Public Employees' Retirement System (CalPERS) and private equity firm Carlyle launched an industry initiative known as the ESG Data Convergence Project in September 2021 to streamline private equity’s fragmented approach to sustainability reporting.

The group has since grown to include more than 140 GPs and LPs, representing $12 trillion in AUM and more than 1,600 portfolio companies. It is centred on six key metrics: Scope 1 and Scope 2 greenhouse gas emissions; renewable energy; board diversity; work-related injuries; net new hires; and employee engagement.

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