Environmental, social, and governance (ESG) investing is a relatively new approach that continues to evolve. ESG criteria developed gradually over the last few decades, and private fund managers must keep adapting their interpretations to meet changing investor demands. Above all, private fund managers must be aware that ESG criteria are likely to play a larger role in the future.
Origins of ESG Investing
Although ESG investing has only existed for about two decades, it grew out of the socially responsible investing (SRI) approach of the late 20th century. With the rise of highly diversified mutual funds, many investors became concerned that they were making money from businesses that contradicted their values. Investors wanted a way to enjoy the benefits of diversification without holding stock in tobacco companies, private prisons, or businesses that created excessive amounts of pollution.
The 21st century brought new opportunities to expand and refine the socially responsible investing approach into ESG investing. Significant advances in alternative energy technologies created new ways to invest in clean energy, such as cost-efficient solar power plants. This growth of sustainable energy supported the evolution of the environment into a separate factor.
Furthermore, increasing awareness of the importance of good governance in preventing other abuses and criminal behavior have also strengthened the ESG approach.
Creating the Framework for ESG
The practical problem of coming up with usable criteria for ESG investing has many facets. Private fund managers must decide which factors to consider, and they also have to decide on their relative weights. How important are environmental considerations, such as sustainability and global warming, compared to social issues like diversity?
Even within categories, there are conflicting priorities. For instance, natural gas generates considerably less pollution than coal, arguably making it a form of clean energy. On the other hand, natural gas is not a renewable resource.
Creating ESG criteria for private fund managers presents unique challenges and opportunities. Private fund managers often invest in smaller unlisted companies that are not bound by the same disclosure rules as public companies. That makes it more difficult for outsiders to determine whether they comply with specific criteria. This task is further complicated by investing in foreign countries, where business practices are often different.
On the other hand, private funds frequently hold substantial stakes in small companies, which gives them the ability to make changes. As a result, the best private fund managers regularly communicate with company management. That makes it easier to get questions answered and promote ESG considerations within the company.
The Evolution of ESG Criteria
Regardless of which criteria private fund managers adopt, they need to be aware that ESG factors are continually evolving and update their practices accordingly. That is most obvious when considering the environment, where new and better options frequently supersede yesterday's clean and efficient technologies.
Only ten or twenty years ago, compact florescent lights (CFLs) were the energy-efficient alternative to older incandescent bulbs. Yet, CFLs are already being replaced by more efficient LED light bulbs.
Early adopters of socially responsible investing must update their approaches to meet broader ESG criteria. It is also possible for private fund managers to take a more restrained approach. ESG criteria can still serve as a traditional screen against potentially risky investments from either a public relations or a fiscal point of view.
However, completely disregarding all ESG criteria is likely to become more hazardous, perhaps like ignoring credit rating considerations. Firms that fail to meet ESG criteria often face higher regulatory and public relations risks, for which investors should be well compensated.
The Future of ESG
Incorporating ESG criteria is increasingly crucial for private fund managers due to the concerns of their investors. High-net-worth individuals have the money to invest in causes they support and generally have little interest in taking unnecessary ethical risks. Furthermore, institutional investors are acutely aware of the trust that has been placed in them to uphold the values of the institutions that they represent.
At Ashton Global, we maintain close relationships with private fund managers that help to ensure that investor values are maintained while providing access to a world of private equity opportunities.
