Private Equity RE Funds Feel Pressure to Create ESG Policies

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The unfolding global coronavirus pandemic is grinding economic activity to a halt and throwing the near-term outlook for commercial real estate investment into deep uncertainty, overshadowing all other issues. But when the market does return to some sense of normalcy the shakeout of the pandemic might only heighten the growing pressure private equity real estate fund managers have been facing from institutional investors to strengthen environmental, social and governance (ESG) requirements on their funds.  

According to survey data published in Preqin’s H1 2020 Outlook published in early March, 31 percent of global investors already have an ESG investment policy in place and another 13 percent expect to have one in place within the next 12 months.

“There has been an astounding increase in interest in ESG amongst institutional investors over the last 12 to 24 months,” notes Greg MacKinnon, Ph.D., CFA, director of research at the Pension Real Estate Association (PREA). “It has really been a sea change in attitude.”

Data from the 2019 Institutional Real Estate Allocations Monitor published by Hodes Weill & Associates and the Cornell Baker Program in Real Estate confirms that interest has been increasing. Nearly half of global institutional investors surveyed (46 percent) reported that they have a formal ESG policy. That percentage rose from 39 percent in the prior year’s survey and 33 percent in 2015, when the ESG question was first added to the survey.

Investors based in the Americas have lagged some of their global peers in having ESG policies. However, the survey also showed a year-over-year jump in formal ESG policies from 26 percent to 35 percent in the 2019 survey.

“Over the past 12 months especially there has been a really sharp uptake in interest, both from the point of view from our clients and their consultants,” says Aleksandra Njagulj, global head of ESG at CBRE Global Investors. The scope of questions has doubled, and there also is higher expectation on the level of detail investors require in those responses, she adds. 

Climate change concerns fuel ESG focus

ESG is moving more to the forefront due along with greater emphasis on climate change and sustainability issues in general. In fact, many observers have even likened COVID-19 to a “dress rehearsal” for the eventual response to climate change as the effects grow more severe in the coming years. There also are a variety of “push and pull” forces that are driving more emphasis on ESG policies, notes Njagulj. Some of those push factors are regulatory compliance, risk management and client demand. For example, 175 countries signed the Paris Agreement in 2016 related to the mitigation of greenhouse gas emissions. “This is something we are seeing on a bigger scale now, because various countries are committed to being net carbon neutral and they need to deal with the built environment as part of the overall country target,” she says.

On the pull side, there is more research and case studies that show that green buildings have a value-add component in terms of attracting and retaining tenants, as well as higher rent levels and sale prices they are able to achieve, says Njagulj. Anecdotally, CBRE Global Investors is seeing evidence of a positive correlation between sustainability and financial performance within its own investment portfolios and asset level performance, she adds.

The pushback against ESG in the past has usually come down to the fiduciary responsibility to earn the best risk adjusted returns. However, there has been more research that shows that sustainable properties do no underperform less sustainable properties. They may not outperform, but as long as they are not underperforming, that does check the box of fiduciary responsibility, notes MacKinnon.

Due diligence zeroes in on ESG

Investors and consultants are paying more attention to ESG policies in their due diligence process, including looking at GRESB ratings and addressing a fund and fund manager’s ESG policies in custom questionnaires and meetings. GRESB has emerged as a leading ESG benchmark for real assets, including real estate.

“The questions, depth of questions and knowledge of people around the room has changed,” says Njagulj. “It is not just checking a box. People really know what they are talking about and they really interrogate our approach to ESG rather than just asking ‘are you sustainable, yes or no?’ Those days are gone.”

“The focus on ESG has really ramped up in terms of one of their important considerations when investors are evaluating managers,” agrees Susan Swanezy, a partner at Hodes Weill, a global capital advisory firm focused on the real estate investment and funds management industry. For example, investors are coming into meetings with fund managers with ESG specific due diligence questionnaires (DDQs) that are separate from the investment or operations questionnaire.

“It is very hard to fill out that ESG DDQ for those that don’t have an ESG policy. So, that has forced managers to evolve their internal processes to set up policies,” she says.

Yet investors do have different views on how much ESG policies influence investment decisions. According to the Real Estate Allocations Monitor, more than one third of global institutions (36 percent) said that ESG policies do influence their investing decisions at least somewhat, while 25 percent of institutions based in the Americas said ESG policies influence investing decisions. Preqin’s survey results shows that inadequate ESG policies are not a significant deterrent in most investment decisions, while 26 percent said they sometimes reject funds due to inadequate policies and 9 percent said they frequently do.

Another question is whether ESG policies will further widen the gap between large, established private equity real estate funds and smaller, emerging managers who have fewer resources to devote to creating ESG policies and maintaining GRESB reporting requirements. “That is one of the things investors are still trying to wrap their heads around,” says MacKinnon. What’s the best way to evaluate fund managers of all different sizes, especially when smaller managers might be doing all the right things in terms of sustainability, but don’t necessarily check all of the boxes that a larger manager would be able to? he adds.

Investors do understand that ESG is an evolving aspect of the fund industry. So, investors are willing to look at intentions towards sustainability and what fund managers are actually doing versus solely basing decisions on a GRESB score, notes Swanezy. “Investors are trying to make sure that even if you aren’t there today, are you moving in the right direction. Are you committed to the cause?” she says. “So, investors will give managers the benefit of the doubt if they are in an earlier stage, but they want to make sure they are headed in the right direction on these sustainability concepts.”

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