ESG Factors Can Illuminate Due Diligence Processes

There is an increasing amount of evidence to show environmental, social, and governance (ESG) practices of publically traded companies correlate directly with other astute business procedures—supporting positive financial performance.

According to Cerulli’s third quarter 2016 issue of The Cerulli Edge – U.S. Institutional Edition, a growing percentage of asset managers proactively consider ESG factors in conjunction with traditional financial analysis to identify risks and opportunity when investing in companies and evaluating their business practices.

Although many asset management firms have adopted ESG principles, “determining how to implement them remains a work in progress,” warns Michele Giuditta, associate director at Cerulli. “More than half of consultants polled by Cerulli have dedicated resources for ESG manager research, and others are considering adding resources. Cerulli urges asset managers who are not taking ESG criteria into consideration to re-evaluate this decision.”

In addition to their own interest in boosting investment performance, investor demand is another top reason why investment managers are taking ESG issues into consideration, Cerulli finds.

“Investors no longer limit review of their assets to metrics such as revenue, profitability, or valuation,” the report explains. “Strong ESG can correlate with astute business practices and positive financial performance. The financial crisis of 2008 and several cases of management misconduct have prompted institutional investors to conduct deeper operational due diligence before allocating to hedge funds, for example.”

According to Cerulli, some of the ESG considerations that U.S. institutional investors increasingly consider include “political contributions, executive compensation, air and water pollution, deforestation, labor standards, human rights, and many others.” The vast majority (88%) of asset managers integrate at least some of these “ESG risks and opportunities” into their general financial analysis. “However, they vary in how comprehensively they conduct their research,” Cerulli warns.

NEXT: What sound ESG practices look like 

Given that sound ESG practices can add value to portfolio companies and mitigate risks, Cerulli believes that the longer-term benefits will generally outweigh the costs of ESG due diligence.

“Investor demand is already the top reason why alternative investment managers take ESG issues into consideration, with 75% citing this as a motivation,” the report continues. “The objective of an effective operational due diligence process is to identify, and then mitigate to the best extent possible, operational risks that could lead to material losses for investors.”

Some institutional investors are asking increasingly specific and directed questions of the asset managers themselves during due diligence investigations into new providers, for example questioning how well the asset managers’ employees are trained and policed on compliance policies or data security. 

“These factors should not be overlooked,” Cerulli concludes. “A thorough manual is useless if a hedge fund’s employees do not bother reading it. Using more well-known and highly regarded third-party providers can help speed the process and alleviate business concerns, especially for smaller [investment providers].”

Additional findings and more information on obtaining Cerulli reporting is here.