Unpacking the ESG complexity for alternative investment vehicles

By Angela Jhanji; Renee Stock; Michael C. Patanella, Grant Thornton

Published: 30 November 2021


A need for authentic commitment, clear strategies, and a grasp of context 

The environmental, social governance (ESG) space for alternative investments, including hedge funds and private equity, and for registered investment companies, such as mutual funds and ETFs, can be difficult to navigate. The landscape is populated by both authentic practitioners who have built their investment approaches on coherent strategies and entrants who are responding to trends and exploring marketing opportunities.

As the market has grown, increasingly sophisticated approaches have evolved. Like all investment strategies, ESG requires strategic coherence, ongoing management, attention to the detail, context, and objectives of opportunities; and a pool of investment professionals who understand its unique challenges. Regulations already exist in Europe, and SEC action appears to be on the horizon in the United States. To strategically pre-empt market trends and forthcoming requirements, companies are beginning to embed strategies informed by expertise and rooted in data and best practices.   

An evolving approach to ESG  

The current ESG investment approach has evolved from an earlier model which emphasized divestiture and negative screens. Many approaches now consider whether an investee is addressing the important ESG issues impacting its business. Such an assessment might include the following considerations of the investee:

  • Directionality: Are they moving toward their goals?
  • Optionality: Is there opportunity for engagement and change?
  • Intentionality: Have they articulated a strategy and a mandate to change?
  • Materiality: Are financial material topics understood and disclosed?
  • Impact: If they change their behavior, will a larger issue, such as climate change, be significantly closer to being solved? 
  • Leadership: Are they setting benchmarks for ESG success?

This multi-factor approach seeks to replace rigid hurdles with rigorous analysis. It allows investors to engage with imperfect companies which show potential for improvement. 

In private equity, general partners are shifting quickly to address limited partner pressures to further ESG insight and performance. The combination of changing demographics, regulatory uncertainty, and general risk mitigation postures continue to drive ESG into the agenda. From due diligence, to unpacking financial materiality gain and return on investment insight, the race to translate ESG intervention into quantitative reports is on. As they unpack the vast number of ESG topics material to their portfolio companies, many firms look to one another and to outside support in creating, and customising, templates and frameworks.

Central to a rigorous ESG engagement and reporting approach is the ability to track and report underlying metrics. They inform investment decisions, determinations about  KPIs, which methodologies are followed, how proxies are voted, and what engagement strategies are deployed. Furthermore, the transparency pillar of ESG investing demands a level of reporting and sharing to ensure no one is caught out and there is no suggestion of fraud.

ESG investing has evolved past its early days of often concessionary returns. Building a portfolio on strong strategic foundations is now one and the same as building an ESG- aligned portfolio.  

The role of Climate Action 100+

One of the emerging drivers of ESG momentum is collective action enabled by deep research and agreed-upon approaches. Climate Action 100+ is an investor-led initiative to drive climate change from a group of focus companies. It grew out of the Intergovernmental Panel on Climate Change (IPCC) which, after reviewing decades of climate research, concluded that climate risk is threatening humans, supply chains, food supplies, global infrastructure, and global economy—and predicted trillions of dollars of loss if changes aren’t made.

Research suggesting that 167 companies have contributed to more than 80% of all global industrial emissions further informed the initiative’s distinctive approach: engage those specific companies on behalf of hundreds of global investors representing trillions in investable assets and challenge them to set science-based targets, align with the Paris agreements, and conform to TCFD (Task Force on Climate-Related Disclosures) reporting requirements.   

Managing responsible funds in an imperfect world

ESG funds pose ongoing and complex management challenges. So, it is important to start with a coherent approach. From a responsible universal investor applying larger ESG considerations across its portfolio to a sector-specific fund with a deep understanding of the metrics, business models, and local regulatory environment. Each strategy should consider varying levels of available reporting and insight into performance, opportunities and challenges, and the agility of the players in pivoting within volatile environments. Other strategies that may be more pragmatic include funds that shape a strategy around holdings, proxy voting, or engagement.

Each opportunity needs to be closely scrutinized, requiring both experience and talent for rigorous evaluation. For example, a natural gas company may have significantly reduced their carbon emissions but still reflect them on their balance sheet. Alternately, two cell phone tower providers may have similar top line metrics for carbon data. But, after considering different business models and geographical locations – which have unique reporting requirements – a careful, in-depth comparison may reveal significant differences. In general, top-level comparison is easy, but meaningful granular comparisons are challenging. The ability to get them right, though, can help further real change. 

Given the low correlation between major data reporting services, reporting which indicates top line ESG performance for two companies shouldn’t be taken at face value.  It’s important to assess whether two reports share the same methodology, as well as how robust, up to date, complete, and rigorous they may be. Furthermore, do they explain their assumptions and reflect their context? In fact, many argue that you can look at two companies with similar top line metrics and arrive at a different carbon number. Careful analysis and attention to data quality help distinguish substantive reporting from smoke and mirrors.

By its nature, ESG is emotional, and so experts are often trying to focus on the facts. Investors may be too invested in a given metric. With the current desperation for data, companies may portray themselves as market leading with a small amount of transparency which is carefully authored and articulated. What’s missing from the equation is proactive management of material topics that often make the headlines. Looking at societal trends, and mega-trends, how are companies keeping up and who is the leadership behind the decision making? There is a balance between anticipation and execution, and those able to do both will survive the waters and continually adapt for the coming tides.

Given this complexity and the different way of thinking about ESG impact, there are two useful rules of thumb.

  1. Has a company made ESG a part of its strategy? Are responsible investing concerns reflected in their decision-making?
  2. Have they established an ESG mandate? Do they hold themselves accountable for progress? 

If so, they may be a good candidate for consideration for inclusion in an ESG portfolio. The decision to include depends on what matters to you, what aligns with your strategy, and whether the information you have supports your evaluation. 

Useful tools for navigating the ESG investment industry

  • SASB (Sustainable Accounting Standards Board):  SASB “connects businesses and investors on the financial impacts of sustainability.”
  • UN Sustainable Development Goals: Seventeen goals which address poverty, health and education, inequality, economic growth, climate change, and conservation of oceans and forests.
  • UN PRI (Principles for Responsible Investing): Signed by the vast majority of global investment managers—works to understand the investment implications of ESG factors; and to support its international network of investor signatories in incorporating these factors into their investment and ownership decisions
  • Morningstar ‘Sustainable’ Stock Designations: Allows investors to understand how the companies in their portfolios are managing their ESG risks relative to their peers.