Why is ESG compliance so important for Private Equity firms?

4 minutes
November 9, 2022

The shake-ups of recent years have thrown economies around the world in turmoil and have been a wake-up call for humanity. It is clear that in order to prevent future calamities, we must engage in generating a sustainable ecosystem. Companies globally are gradually adapting to the new environmental, social, and governance (ESG) standards.

In this relatively new area, it is not always easy to meet business needs while managing compliance with increasingly evolving regulations. For example, Private equity firms struggle to achieve what seem to be incompatible objectives: generating a return for investors while also achieving the ESG objectives of its stakeholders. 

In a recent publication, PWC reported that 89% of Private Equity enterprises are especially preoccupied with ESG compliance requirements. Moving forward though, Private Equity firms must keep ESG compliance at the top of their list, as they operate in an increasingly competitive space. 

Addressing the current circumstances & ensuring compliance

Private Equity enterprises must monitor and assess complicated, ever-evolving factors in their operational and legal landscape. Understanding applicable rules & regulations and taking necessary steps to safeguard their interest is a key priority. 

Within ESG, these firms seek to answer a number of questions including:

  • How do private corporations perform on ESG (environmental, social, and governance) indicators that matter?
  • How has the ESG performance of these firms evolved over time?
  • And how does their ESG growth relate to their financial performance?
  • What are the relevant benchmarks and how to report their achievements?

These are essential concerns for all Private Equity firms, their present and potential limited partners, and the businesses in which they have invested. From being a footnote of compliance or a specialised offering for a small group of investors - ESG has evolved into an overarching framework that influences the strategic thinking of organisations across all regions and industries.

Exploring the impact of the EU’s recent stringent regulations       

Regulations mandating the incorporation of ESG information into financial statements are in the pipeline, and they are only one of the regulatory constraints Private Equity markets face. Compliance teams are constantly confronted with new challenges to keep up with ever-changing requirements.

Fund Managers in the EU are now, both directly and indirectly, subject to a multitude of ESG-related disclosure rules for themselves and the entities they manage. These are outlined in the Sustainable Financial Disclosure Regulation (SFDR), the EU Taxonomy Regulation (Taxonomy Regulation), the Non-Financial Reporting Directive (NFRD), and (once adopted) the Corporate Sustainability Reporting Directive (CSRD). Consequently, fund managers must comply with several regulatory frameworks that often overlap.

Overall, the rapid progression of the EU ESG legislative framework, along with investors' shifting needs and interests (particularly with the aspiration for broad sustainable investment and transparency), has presented fund managers with new challenges. 

What happens if ESG compliance is not preserved?

Before committing financial resources, Private Equity require and verify target enterprises’ relevant information, including the impact of their operations or conflicts of interest and ESG related KPIs. Compliance concerns in target enterprises, especially around their ESG credentials or impact, may create a substantial monetary burden to their acquisition and ongoing oversight. 

Ultimately, Private Equity firms want to know with whom they are doing business with in order to have the necessary assurance for their investment choices. To address this, Private Equity companies may consider including suitable protection within legal contracts and various guarantees. Most global organisations expect their business partners to state in their legal agreements how they intend to adhere to compliance standards in accordance with applicable laws and regulations, including those applicable for ESG.

Key Takeaways

  • ESG compliance is a critical metric for Private Equity firms considering the proliferation of regulatory initiatives in the EU.
  • To maintain ESG compliance, Private Equity firms must analyse how private organisations perform on ESG targets, the firms' evolution of ESG performance, and the relationship between ESG efforts and financial performance.
  • ESG compliance risks in target organisations may impose a significant financial burden on their acquisition and upkeep.

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