In 2015, Professor Cornelli and her colleagues at London Business School (LBS) presented the results of a comprehensive survey into environmental, social and governance (ESG) investment practices in private equity firms.  The evidence suggested that GPs, especially those managing larger funds, were embracing responsible investment practices – and that LP pressure was the primary driver for that.  That was, perhaps, not surprising:  there are few more compelling reasons to act than to satisfy an investor request.  However, the survey also revealed that “ESG issues are used to screen and evaluate investments … and are then central in value creation during the ownership stage” – suggesting that GPs believe ESG practices can actually improve returns, as well as meet LP demands.

But is there reliable evidence that responsible investment delivers better financial results?

Unfortunately, within the private equity industry, there has not yet been any rigorous academic research into that question, although many academics are keen to explore it.  However, it is certainly true that, in the wider investment universe, the evidence that returns are positively affected by socially responsible investment practices is mounting – although definitional challenges, the paucity of available data, and difficulties in establishing causation (rather than just correlation) pervade all work in this area.

The most recent study to support the view that a focus on ESG issues enhances performance among large companies was issued by the Boston Consulting Group (BCG) last month, following an analysis of 343 companies over a three-year period.  The authors found a statistically significant correlation between a company’s performance on 16 specific ESG topics and its implied valuation multiple.  BCG’s report confirms many previous studies that have shown a link between a company’s financial results and its ESG policies: a 2015 meta-survey found that the large majority of prior studies show a positive relation between corporate financial performance and sustainable investment practices.

Correlation does not prove causation, however, and that has been more difficult to establish.  But there are now several academic studies that can claim to have shown a causal link: for example, a long-term study by Eccles et al. found that early adopters of sustainable practices in the United States significantly outperform their peers, and important work by Alex Edmans on the positive impact of satisfied employees is also frequently cited. 

However, the recent BCG report further highlights a crucial point:  the need to identify which ESG topics are material in the context of the company concerned.  BCG’s extensive study analysed a total of 65 ESG issues – including, for example, combatting corruption, water conservation, and environmentally sound sourcing – and the positive link with valuation was observed in relation to just one quarter of those.  These findings echo academic studies; for example, an article published last year by Khan et al.  demonstrated share price outperformance for firms that focus on material sustainability issues.  There was no discernible effect (positive or negative) for those companies that focused on issues deemed immaterial by the researchers.  What is “material” clearly depends on the sector and the business. 

So (by analogy with the public markets) there is good reason to suppose that private equity professionals are right to argue that a focus on ESG risk issues will enhance a fund’s performance, even if there are not yet any definitive data to prove it.  But the evidence also points to a need for a company-specific approach to responsible investing – not all issues make a difference for every company.  Such a tailored approach is one that private equity sponsors – as active investors, with deep business-specific knowledge – are well equipped to apply.  That suggests that they may have an edge when it comes to reaping the rewards of sustainable investment practices.

The authors would like to thank Ioannis Ioannou (Associate Professor, London Business School) and Alison Hampton, who both provided very helpful comments on an earlier draft of this note.