Towards greater alignment in ESG ratings

Limited Partners in private markets lack essential sustainability information compared to public market investors, leading to information gaps and asymmetry. This has led to a surge in complex evaluation frameworks and questionnaires which trickle down to fund managers and portfolio companies, fostering an inefficient ‘tick-box’ culture. To tackle this, Limited Partners should abandon bespoke questionnaires and instead focus on alignment, collaboration, and engagement.

Mette Dalgliesh Olsen and Peder Michael Pruzan-Jørgensen, Raison Consulting ApS, June 30th 2023


Towards greater reliability and transparency in public market ESG ratings

Publicly listed companies and investors have long voiced their concerns regarding the lack of standardization and transparency in ESG ratings. In a past study, researchers found that the average correlation among the five largest ESG rating companies was just 61%. In comparison, large credit ratings exhibited a correlation of 99%.

In this context, EU’s latest sustainable finance update launched on June 13th 2023 includes a welcome proposal to improve the reliability and transparency of ESG rating agencies. This is good news for companies and investors alike, creating a better basis for comparison while driving efficiencies in the extensive data collection requests from rating agencies to public companies.

The proliferation of investor driven ESG ratings in private markets

In private markets, the situation is different. Due to the lack of publicly available sustainability data for privately held companies, Limited Partners often perform the role carried out by ESG rating agencies in public markets: They create their own bespoke indicators, develop their own bespoke methodologies, and send, collect and store an abundance of bespoke data points from fund managers and their portfolio companies. In many cases, these approaches mirror the same type of elaborate questionnaires that are used by ESG rating agencies to collect information from larger and more mature companies in public markets.

The impact of “questionnaire frenzy”

The proliferation of bespoke sustainability questionnaires and comprehensive data requests from LPs has arguably had its merits over the past years: simply asking questions can send a powerful signal to fund managers and their portfolio companies and create greater levels of awareness and incentives to change. Just like in public markets, the lack of standardization does, however, also have its downsides.

Firstly, it is deeply inefficient, driving up administration costs for all actors in the system. Take the example below, which is based on real-life experiences working with start-ups and VC funds in private markets backed by large institutional LPs. For companies in Article 9 funds, the phenomenon is even more pronounced as LPs and fund managers continue to have varying interpretations of what good looks like (we will unfold this phenomenon in future posts looking at the challenges and opportunities in “dark green” investments!)

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Illustration of the trickle-down effect from bespoke sustainability ratings in private markets

Secondly, extensive questionnaires can also foster cynicism if seen as a “tick-mark” exercise rather than a catalyst for real change. For many fund managers and portfolio companies, the concern with answering bespoke questionnaires isn’t necessarily the time and resources it takes to complete them, slicing and dicing the same information in various ways. Rather, the frustration sets in when the information goes into a black-box with no real sense of how the information is used to drive investment decisions.

Align, Collaborate, Engage

The forthcoming promise from EU policy makers to harmonise ESG ratings and methodologies in public markets will to a large extent be enabled by the increased availability and standardisation of sustainability data through the Corporate Sustainability Reporting Directive (CSRD).

In private markets, information asymmetries are however likely to prevail given the larger proportion of small and medium-sized companies, who will not be subject to the same requirements. In other words: LPs in private markets will still need to request sustainability data from their fund managers and underlying portfolio companies for many years to come.

So how can LPs in European private markets avoid getting caught in “questionnaire frenzy” while meeting the increased demands for sustainability data and transparency from their key stakeholders and complying with applicable sustainable finance disclosure regulations?

1. Align: It has been said before but cannot be repeated enough: while LP needs for sustainability data will vary according to level of ambition, fund classifications, sector focus etc., it is critical for LPs in private markets to begin to align their evaluation frameworks with the emerging sustainability disclosure standards, notably the forthcoming disclosure requirements under CSRD and the Principle Adverse Impact (PAI) indicators. This will not only be more efficient, but also help privately held companies better prepare for future disclosure obligations. The ESG Data Convergence Initiative (EDCI) is a good example of such efforts, however in terms of data points collected, it still only touches the surface.

2. Collaborate: Having looked at hundreds of bespoke investor questionnaires and assessment frameworks from LPs and fund managers alike, we feel confident in saying that one is as good or as imperfect as the next. To drive efficiency and effectiveness of ESG data exchanges in private markets, LPs should join forces with like-minded peers and fund managers to find workable, digitised solutions where portfolio companies, fund managers and Limited Partners can collect, share and compare standardised non-financial information. This type of ‘data arbitrage’ could take place at fund level and/or at PC level and could be incorporated into shareholder agreements.

3. Engage: Finally, LPs should consider carefully not just what data they want to collect but howthey will use the information to drive and incentivise performance of their fund managers and portfolio companies. This requires LPs to shift from passive collectors of data to (more) active and engaged owners, setting clear expectations to fund managers while establishing proper feedback loops and mechanisms to address critical gaps and help build the much needed capacity for standardised sustainability disclosures in privately held companies.

Share your thoughts!

What are your thoughts? Are LP questionnaires a necessary evil in private markets, and if so, what tips do you have for using this instrument thoughtfully and meaningfully to drive efficiencies and avoid tick-box approaches?


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