OPINION
2021 Jul/27
Considerations for Facilitating Korean PEFs’ ESG Investing
Jul. 27, 2021
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- Summary
- ESG investing is garnering huge attention in Korea’s PEF market. PE’s full engagement in long-term investment and the management of portfolio companies could be an important catalyst for ESG management to spread and take hold. Overseas PE has perceived ESG investing as a tool for value enhancement and risk management, helping it to spread rapidly. In overseas PE firms, ESG integration is achieved in the overall investment cycle from capital raising, investment and value creation to exit, each of which is done by capitalizing on ESG experts and incorporating ESG culture internally. Under current ESG discussions, the most critical area requiring a solution is absence of standardized ESG data. Korean PEFs should double their effort to facilitate ESG investing under Korea’s somewhat disadvantageous ESG environment where small stake investment is prevalent and most of their investee companies are private small and medium-sized enterprises or middle market firms.
Background
As Korea’s financial and non-financial industries have recently paid heightened attention to ESG management and responsible investing, Korea’s private equity funds (PEFs)—especially leading players in Korea’s expanded PEF market—have been turning their eye to ESG investing. As is widely known, ESG investing refers to an investment practice trying to manage risk and generate sustainable, long-term profits by making investment decisions based on environmental (E), social (S), and governance (G) factors that could impose a significant impact on a portfolio firm’s performance and reputation.
Since the United Nations’ Principle for Responsible Investment (UN PRI) was first established in 2006 and subsequently signed by leading asset owners, asset management companies and other service providers, capital market investors such as mutual funds, exchange-traded funds, hedge funds, and private equity (PE) have been playing a leading role in disseminating the practice of ESG management.1) However, it takes a long period of time and a significant amount of human and physical resources before ESG management produces visible outcomes. From that perspective, PE making profits out of their longer-term investment horizon and deeper engagement in their investment targets could function as an important catalyst for ESG management to take hold. PE has a large market taking up about 41% of the global alternative investment market by measure of AUM at the end of 2020.2) This article tries to explore what considerations matter in promoting ESG investing among Korean PEFs who are relatively disadvantaged than PE in overseas markets where ESG investing is already gaining momentum.
Current status of ESG investing by overseas PE
Thus far, about 4,000 investment-related organizations have signed the UN PRI. The list of those signatories consists of asset management companies (74%), asset owners (15%), and other service providers (11%). According to a Bain & Company report, PE firms account for about 14% (430 firms) out of 3,000 asset management companies as of end-2020, but only 16 firms are reporting ESG’s impact on investment returns. Of those firms, only 8 firms are found to monitor their portfolio firms’ ESG factors in a systematic manner. As such, the report shows that ESG investing has yet to fully take hold even in overseas markets.3)
Dissemination of ESG investing in overseas PE markets, like other capital market investing, is largely driven by several factors, for example, the declaration of ESG investing by asset owners such as pension funds, tougher government regulation over ESG factors, and changes in perception of ESG among stakeholders such as consumers and employees. Traditionally, PE has placed its focus on improving firm value by providing incentives to directors and employees. However, more and more PE firms are bolstering their level of ESG engagement as investors these days have recognized that ESG engagement for meeting stakeholder needs could actually improve firm value as well as reduce investment risk.
Like other investment methods, PE has evolved from negative screening that focuses on checklists for discovering risk factors in advance into positive screening for identifying opportunity factors. More recently, it shifts towards ESG integration. For PE, ESG integration means a compatible investment system where ESG-related risk and opportunity factors are identified, considered, monitored, and reported during the whole process of investment decision making and post-investment monitoring activities. Although varying depending on the nature of investee firms, ESG integration is incorporated into the whole investment process from capital raising, investment and value enhancement to exit. ESG integration in each phase of that investment cycle is currently heading in the direction that maximizes its link to firm value in a bid for value enhancement. Currently, ESG integration capability becomes a major point of differentiation among PE firms.
Global PE firms partner with not only the management of their portfolio companies, but also internal ESG experts and external professionals, aiming to consider ESG factors in their due diligence before making an investment decision as well as in their value creation process known as a 100-day plan after investment. A change like this means an evolvement of global PE firms’ ESG investing into firm-value enhancement where ESG elements are integrated into their existing team of operations specialists. In addition, another shift taking place is heading in the direction where PE firms themselves adopt ESG management principles by linking ESG investment performance to rewards, and thus cultivates ESG culture in their organization.
Obstacles to PE’s ESG investing: ESG data standardization
In the end, asset owners assess PE investing based on quantified investment returns. Hence, PE management can hardly be sustainable unless ESG integration leads to financial outcomes. Simultaneously, asset owners have demand for monitoring whether their delegated asset managers carry out ESG investing in a faithful manner, and how ESG investing affects firm value. In response to that demand, PE firms need to monitor their investee companies’ ESG activity, and report the outcomes to their investors. Although ESG monitoring on investee companies posits a set of measurable, standardized indicators for ESG performance, it is a daunting task to systematically collect standardized ESG data and reflect those in investment strategies in reality.
The issue of ESG data for PE roughly comes down to four points?봞bsence of a uniform standard, overlaps in ESG reporting caused by investor level reporting, need for standardize various forms of ESG data, and understanding the linkage between ESG indicators and firm value indicators. In a bid to measure risk factors and assess the possibility of value creation, it is necessary to accumulate empirical parameters on how to relate ESG information and data to the financial and performance indicators that are used for a standard valuation process. The absence of such ESG-related standardized data and measurement indicators could be pointed as a problem in the overall ESG-related area, but PE is an area where the problem stands out the most. Although imperfect, it is possible, albeit incompletely, to roughly measure the impact of ESG elements to the value of public companies. However, such an estimation is inevitably uncertain for private companies that represent a significant portion of PE’s portfolio companies. But certainly, this will improve with time. Once each of global PE firms accumulates ESG-related investment know-hows and experience to a certain extent, the market is expected to gradually have standardized industry-wide data in place.
Korea’s PEF market: Characteristics and the impact on ESG investing
In Korea’s PEF market, public pension funds and policy financing institutions are expected to increase their level of ESG engagement and thus play a leading role in facilitating ESG investing. Given PEFs’ nature of collecting capital from a small number of investors, those major investors’ ESG pledge could be an important game changer. According to that trend, the gap between leading firms with a relative advantage in human and physical resources and late-comer firms without them could widen further. Also, Korea’s pace of growth in ESG investing could be affected by Korea-specific factors including the differences in investee firm size and investment methods compared to overseas markets.
First, most of the firms invested by Korean PEFs are SMEs or middle market firms. Of those firms, leading players that can be invested by PEFs belong to supply chains of the manufacturing sector in Korea and abroad. Those firms are facing a growing need for ESG adoption as part of their effort to survive or manage reputational risk. However, those firms—mostly unlisted SMEs and middle market firms—are not subject to ESG disclosure mandate, and thus lack both ESG-related data and designated workforce for ESG execution. Although listed companies in Korea are striving to build an ESG disclosure framework before ESG disclosure mandate comes into effect in 2030, nothing has been done thus far to review an ESG disclosure scheme for unlisted firms. To sum up, PEFs are mandated to engage with their portfolio firms—mostly SMEs and middle market firms—on ESG issues, but those portfolio firms lack ESG workforce or other resources. Hence, it may take a long period of time for ESG investing to actually take hold in a substantial sense.
Second, despite the recent increase in buyouts in Korea’s PEF market, a significant portion of the market is represented by small stake investment that often comes with an innate limit hindering proactive ESG engagement with investee firms. This is an issue commonly raised in Asian PE markets where small stake investment takes up a higher proportion, unlike western PE markets whose primary transactions are buyouts. It may be hard to pursue ESG integration with a significant minority stake investment. Moreover, if small stake investment meets with negative screening that is often adopted in early-stage ESG investment, it may be difficult to find sufficient investment targets to invest the raised capital.
Meanwhile, in order for sustainable ESG investing to spread further, PEF managers should adopt their own ESG management, share their ESG investment philosophy with their staff, and link ESG investment outcomes to their employee remuneration scheme. All of those will serve as organizational capital that induces Korean PEFs still at a nascent stage of their ESG engagement with portfolio companies to achieve effective and sustainable ESG integration in the long run.
Korea’s PEF market is relatively disadvantaged in terms of the ESG investment environment, compared to overseas PE markets in the EU and the US where PE is mature and ESG investing was introduced earlier. Hence, PEF managers in Korea need to double their effort to overcome the disadvantageous environment shaped by some Korea-specific features, in addition to their dealing with other commonly found ESG issues such as ESG performance assessment, ESG disclosure, and investor reporting.
1) In this article, private equity is a specific type of investing or a specific asset class, and is referred to as two terms—PE for overseas private equity and PEF for Korean private equity.
2) Preqin, 2020, Future of Alternatives 2025
3) Bain & Company, 2021, Global Private Equity Report 2021
As Korea’s financial and non-financial industries have recently paid heightened attention to ESG management and responsible investing, Korea’s private equity funds (PEFs)—especially leading players in Korea’s expanded PEF market—have been turning their eye to ESG investing. As is widely known, ESG investing refers to an investment practice trying to manage risk and generate sustainable, long-term profits by making investment decisions based on environmental (E), social (S), and governance (G) factors that could impose a significant impact on a portfolio firm’s performance and reputation.
Since the United Nations’ Principle for Responsible Investment (UN PRI) was first established in 2006 and subsequently signed by leading asset owners, asset management companies and other service providers, capital market investors such as mutual funds, exchange-traded funds, hedge funds, and private equity (PE) have been playing a leading role in disseminating the practice of ESG management.1) However, it takes a long period of time and a significant amount of human and physical resources before ESG management produces visible outcomes. From that perspective, PE making profits out of their longer-term investment horizon and deeper engagement in their investment targets could function as an important catalyst for ESG management to take hold. PE has a large market taking up about 41% of the global alternative investment market by measure of AUM at the end of 2020.2) This article tries to explore what considerations matter in promoting ESG investing among Korean PEFs who are relatively disadvantaged than PE in overseas markets where ESG investing is already gaining momentum.
Current status of ESG investing by overseas PE
Thus far, about 4,000 investment-related organizations have signed the UN PRI. The list of those signatories consists of asset management companies (74%), asset owners (15%), and other service providers (11%). According to a Bain & Company report, PE firms account for about 14% (430 firms) out of 3,000 asset management companies as of end-2020, but only 16 firms are reporting ESG’s impact on investment returns. Of those firms, only 8 firms are found to monitor their portfolio firms’ ESG factors in a systematic manner. As such, the report shows that ESG investing has yet to fully take hold even in overseas markets.3)
Dissemination of ESG investing in overseas PE markets, like other capital market investing, is largely driven by several factors, for example, the declaration of ESG investing by asset owners such as pension funds, tougher government regulation over ESG factors, and changes in perception of ESG among stakeholders such as consumers and employees. Traditionally, PE has placed its focus on improving firm value by providing incentives to directors and employees. However, more and more PE firms are bolstering their level of ESG engagement as investors these days have recognized that ESG engagement for meeting stakeholder needs could actually improve firm value as well as reduce investment risk.
Like other investment methods, PE has evolved from negative screening that focuses on checklists for discovering risk factors in advance into positive screening for identifying opportunity factors. More recently, it shifts towards ESG integration. For PE, ESG integration means a compatible investment system where ESG-related risk and opportunity factors are identified, considered, monitored, and reported during the whole process of investment decision making and post-investment monitoring activities. Although varying depending on the nature of investee firms, ESG integration is incorporated into the whole investment process from capital raising, investment and value enhancement to exit. ESG integration in each phase of that investment cycle is currently heading in the direction that maximizes its link to firm value in a bid for value enhancement. Currently, ESG integration capability becomes a major point of differentiation among PE firms.
Global PE firms partner with not only the management of their portfolio companies, but also internal ESG experts and external professionals, aiming to consider ESG factors in their due diligence before making an investment decision as well as in their value creation process known as a 100-day plan after investment. A change like this means an evolvement of global PE firms’ ESG investing into firm-value enhancement where ESG elements are integrated into their existing team of operations specialists. In addition, another shift taking place is heading in the direction where PE firms themselves adopt ESG management principles by linking ESG investment performance to rewards, and thus cultivates ESG culture in their organization.
Obstacles to PE’s ESG investing: ESG data standardization
In the end, asset owners assess PE investing based on quantified investment returns. Hence, PE management can hardly be sustainable unless ESG integration leads to financial outcomes. Simultaneously, asset owners have demand for monitoring whether their delegated asset managers carry out ESG investing in a faithful manner, and how ESG investing affects firm value. In response to that demand, PE firms need to monitor their investee companies’ ESG activity, and report the outcomes to their investors. Although ESG monitoring on investee companies posits a set of measurable, standardized indicators for ESG performance, it is a daunting task to systematically collect standardized ESG data and reflect those in investment strategies in reality.
The issue of ESG data for PE roughly comes down to four points?봞bsence of a uniform standard, overlaps in ESG reporting caused by investor level reporting, need for standardize various forms of ESG data, and understanding the linkage between ESG indicators and firm value indicators. In a bid to measure risk factors and assess the possibility of value creation, it is necessary to accumulate empirical parameters on how to relate ESG information and data to the financial and performance indicators that are used for a standard valuation process. The absence of such ESG-related standardized data and measurement indicators could be pointed as a problem in the overall ESG-related area, but PE is an area where the problem stands out the most. Although imperfect, it is possible, albeit incompletely, to roughly measure the impact of ESG elements to the value of public companies. However, such an estimation is inevitably uncertain for private companies that represent a significant portion of PE’s portfolio companies. But certainly, this will improve with time. Once each of global PE firms accumulates ESG-related investment know-hows and experience to a certain extent, the market is expected to gradually have standardized industry-wide data in place.
Korea’s PEF market: Characteristics and the impact on ESG investing
In Korea’s PEF market, public pension funds and policy financing institutions are expected to increase their level of ESG engagement and thus play a leading role in facilitating ESG investing. Given PEFs’ nature of collecting capital from a small number of investors, those major investors’ ESG pledge could be an important game changer. According to that trend, the gap between leading firms with a relative advantage in human and physical resources and late-comer firms without them could widen further. Also, Korea’s pace of growth in ESG investing could be affected by Korea-specific factors including the differences in investee firm size and investment methods compared to overseas markets.
First, most of the firms invested by Korean PEFs are SMEs or middle market firms. Of those firms, leading players that can be invested by PEFs belong to supply chains of the manufacturing sector in Korea and abroad. Those firms are facing a growing need for ESG adoption as part of their effort to survive or manage reputational risk. However, those firms—mostly unlisted SMEs and middle market firms—are not subject to ESG disclosure mandate, and thus lack both ESG-related data and designated workforce for ESG execution. Although listed companies in Korea are striving to build an ESG disclosure framework before ESG disclosure mandate comes into effect in 2030, nothing has been done thus far to review an ESG disclosure scheme for unlisted firms. To sum up, PEFs are mandated to engage with their portfolio firms—mostly SMEs and middle market firms—on ESG issues, but those portfolio firms lack ESG workforce or other resources. Hence, it may take a long period of time for ESG investing to actually take hold in a substantial sense.
Second, despite the recent increase in buyouts in Korea’s PEF market, a significant portion of the market is represented by small stake investment that often comes with an innate limit hindering proactive ESG engagement with investee firms. This is an issue commonly raised in Asian PE markets where small stake investment takes up a higher proportion, unlike western PE markets whose primary transactions are buyouts. It may be hard to pursue ESG integration with a significant minority stake investment. Moreover, if small stake investment meets with negative screening that is often adopted in early-stage ESG investment, it may be difficult to find sufficient investment targets to invest the raised capital.
Meanwhile, in order for sustainable ESG investing to spread further, PEF managers should adopt their own ESG management, share their ESG investment philosophy with their staff, and link ESG investment outcomes to their employee remuneration scheme. All of those will serve as organizational capital that induces Korean PEFs still at a nascent stage of their ESG engagement with portfolio companies to achieve effective and sustainable ESG integration in the long run.
Korea’s PEF market is relatively disadvantaged in terms of the ESG investment environment, compared to overseas PE markets in the EU and the US where PE is mature and ESG investing was introduced earlier. Hence, PEF managers in Korea need to double their effort to overcome the disadvantageous environment shaped by some Korea-specific features, in addition to their dealing with other commonly found ESG issues such as ESG performance assessment, ESG disclosure, and investor reporting.
1) In this article, private equity is a specific type of investing or a specific asset class, and is referred to as two terms—PE for overseas private equity and PEF for Korean private equity.
2) Preqin, 2020, Future of Alternatives 2025
3) Bain & Company, 2021, Global Private Equity Report 2021