Managing Private Equity Portfolio with ESG objectives

Private Equity Investments

In recent years institutional investors – e.g. pension funds, insurers, endowments, development banks and sovereign wealth funds – have been building up sizable allocations to private equity and real assets (mainly infrastructure, real estate, forestry and farmland, energy and commodities). Successfully entering, managing, and exiting direct investments requires a high level of expertise, experience and staff incentives that most institutional investors are unable to provide. Therefore, their preferred modus operandi is investing indirectly as so-called limited partners (LPs) through limited partnership funds.

Modern Portfolio Theory (MPT) suggests that the risk of investment loss can be diversified away by reducing the correlation between the returns from securities in their portfolio. This allows optimising the portfolio’s expected return against an accepted level of risk. For private equity and real assets these figures are not only difficult to access but also of limited reliability. As this market is private and legitimately exploits opportunities associated with opacity publicly available industry statistics is incomplete and thus subject to, for instance, survivors’ bias. Consequently, data on expected returns are not necessarily representative. Correlations between these returns can be measured but will change considerably over the long time-horizons these assets need to be held.

Additional ESG challenges for institutional investors

Over the last decade, the rise of Environmental, Social, and Governance (ESG) factors has been one of the major changes for private equity partners. ESG considerations have redesigned the standards of due diligence and add new objectives on top of financial statements and growth plans. From the regulatory point of view, the landscape of ESG may seem uncertain and is part of the challenges faced by private equity investors. ESG criteria are wide and depends strongly on the underlying private equity firms and their application domains. Rules and regulations fluctuate regularly from country to country and evolve quite rapidly with the release of new studies.

It is therefore not trivial to evaluate them with a single criterion adding another level of difficulties for investors who needs to deal with fuzziness and conflicting objectives. Currently, there is no automatic and optimised solutions to help investors to maximise their allocation to ESG.