ESG Considerations in Private Equity Investment Decisions in Latin America

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Introduction

Investment decisions by private equity firms are being driven more and more by environmental, social and governance (ESG) criteria. More than just an ethical practice, ESG compliance has become a prerequisite to raise and invest funds from institutional investors. As Blackrock’s CEO Larry Fink recognised in his annual letter to CEOs, ‘we focus on sustainability not because we’re environmentalists, but because we are capitalists and fiduciaries to our clients.’ Either because ESG-compliant investments are more profitable for ensuring long-term investment value or because it has become part of the institutional investor criteria, ESG is now a fundamental criterion for private equity investments globally and in Latin America. To address the specific ESG challenges, and the lack of ESG standardisation, private equity firms need to develop regional ESG strategies for their investments in Latin America.

Private equity firms and ESG

ESG is now a fundamental investment criterion for private equity firms. As of 2020, 88 per cent of limited partners (LPs) globally use ESG performance indicators when making investment decisions,[2] and 87 per cent of LPs invest in businesses that have reduced their near-term return on capital so they can reallocate that money to ESG initiatives.[3] According to Preqin’s report on ESG investing, almost 25 per cent of the limited partners surveyed by the research firm said they had declined an investment opportunity because they had reservations about ESG standards. A further 39 per cent of LPs said that ‘they are prepared to do the same if necessary’.[4] Recognising the core strengths of ESG-linked investments, 88 per cent of institutional investors now subject ESG considerations to the same scrutiny as operational and financial considerations and many have reduced their near-term return on capital in favour of reallocating that money to ESG initiatives.[5]

Prioritising ESG also pays off for private equity firms. For instance, BlackRock has institutionalised ESG risk analysis into its investment decisions and launched ‘impact funds’, which only invest in companies that contribute to measurable environmental, social or UN ‘sustainable development goal’ outcomes. By implementing these measures, the firm was successful in launching the first ESG-based ETF in Mexico, raising US$450 million in just two months, making the fund BlackRock’s fastest growing ETF across their portfolio at the time.[6] The fund now has more than US$1.1 billion in assets under management (AUM).[7] Other firms have likewise set up similar platforms dedicated to environmentally sustainable investments.

Benchmarking performance of ESG metrics has become essential in many corporate strategies with a view to not only mitigate and manage risk but also to optimise opportunity. This strategy aligns precisely with private equity fund managers’ goals of seeking long-term investment horizons and of supporting stewardship-style management.

Corporate managers throughout Latin America have lately been integrating ESG into their overall risk analyses, recognising that doing so has a direct impact on their valuations and financial creditworthiness. This is confirmed by a recent S&P Global survey that showed that a growing number of investors looking to invest in Latin American businesses have accelerated their efforts in integrating ESG into their strategic plans. As a result, more and more private equity firms are looking to invest in Latin American companies with a strong ESG track record, with the percentage of ESG-seeking investors jumping from 25 per cent in 2021 to 43 per cent in 2022.[8]

ESG investing in Latin America

In 2005, the United Nations established the Principles for Responsible Investment (PRI), as a menu of possible actions for incorporating ESG into investment practices globally. What started as a small collection of signatories has grown to over 5,000 parties, representing US$121 trillion of AUM.[9] Investment managers, assets owners, and service providers in the Latin America region account for approximately 5 per cent of the total signatories to the UN PRI.[10]

A recent industry report noted that roughly 70 per cent of private equity firms plan to deploy capital in Latin America over the next five years, reflecting a level of interest in Latin America that outpaces interest in many other regions.[11] For the United States, Latin America has always been essential because its geographical position, natural resources and human capital. Worldwide, its vast and unique resources and its need for foreign investment have given Latin America a special position in the global markets. Additional to the tax and financial benefits of green investment, mounting pressures from the international community to collectively meet sustainable development goals have driven Latin America’s evolution towards a more ESG-compliant future.

According to a report from IHS Markit, Latin America is expected to be a major focus for climate change initiatives over the next several years due to ‘the strategic environmental importance of the Amazon, including its biodiversity, natural resources and impact on global carbon emissions’.[12] As a result, in the coming years, the need for regulatory compliance is expected to increase in the region as well as the potential reputational hazards and likelihood of delay or abandonment of projects owing to non-compliance with core ESG metrics.

Because Latin American national pension funds now represent a very important source of capital for private funds, they are an important voice for pushing ESG principles for investment in the region. For example, in Mexico, the National Commission of the Retirement Savings System (Comisión Nacional del Sistema de Ahorro para el Retiro (CONSAR)) implemented a new regulation effective as of 1 January 2022, requiring public pension funds to incorporate ESG processes into their investment strategies. As of 1 April 2022, the 10 retirement funds administrators (AFORE) in Mexico have to incorporate ESG matters into their investment strategies to create more attractive returns for employees in Mexico.[13] Pension funds are generally perceived as necessary to stimulate the industries and the long-term financings related to new technologies, housing and climate change.[14]

In Chile and Peru, governments and pension superintendencies are following Mexico’s example, and have recently proposed that pension funds incorporate ESG standards into their investment policies. According to Fitch Ratings, Chile has an ESG relevance score of 5 for political stability and rights.[15] Peru’s Ministry of Environment also launched its Green Finance Road Map to promote ESG integration into the broader financial sector.

In Honduras, the National Banking and Insurance Commission (Comisión Nacional de Bancos y Seguros (CNBS)) issued its first national sustainable finance policy, standardising how foreign investors could manage their ESG risks.

Latin American ESG challenges

Even though Latin American countries are advancing in the implementation of ESG regulation, there are many challenges ahead. While a few major Latin American countries have made global headlines for leading in certain ESG-related areas, the region is playing catch-up with other countries that have prioritised ESG investment principles even more heavily.

First, Latin America has a long history of social and economic inequality. ESG-linked investments are likely to focus on long-standing concerns such as working conditions, workplace diversity, gender equality, and protection and conservation of world heritage lands. While these challenges are not necessarily new, they are undergoing much stricter ESG investment review.

Second, Latin America has had a history of social opposition to environmentally sensitive projects, particularly in the extractive industry. NGOs and social media have enabled local communities to share their concerns on a global scale with a receptive international audience. As a result, social opposition to projects can become an important development barrier. Such social opposition can be legitimate or in some cases staged or financed by interest groups that use it for extortion, political gain or unfair competition, presenting a delicate compliance situation for project sponsors and financing parties.

Third, the region is struggling to educate its own governments about the value of ESG investing. Government support is crucial for the implementation of adequate ESG investment frameworks. As we have seen in countries like Mexico recently, governments can severely affect ESG investment through regulatory action or inaction. Mexico’s current administration is actively favouring the state utilities’ inefficient and highly polluting power generation projects over private, renewable energy projects.

Finally, the lack of ESG standardisation adds a level of uncertainty to investments globally and in Latin America. Today, there are over 600 reporting standards that companies can choose to track their ESG related performance. ESG is currently a concept that can be used with too much flexibility. A standard approach for measuring and benchmarking ESG-related compliance would provide certainty to sponsor and investors.

Conclusion

ESG-based investment criteria can be an important contributing factor for social and environmental transformation throughout Latin America. Countries need to create the necessary conditions for investors driven by ESG principles to invest in Latin America. If Latin American countries increasingly commit to establishing standardised ESG investment frameworks, private equity capital inflows will likely have a positive domino effect across Latin America.


Footnotes

[1] Gabriel Salinas is a counsel and Humzah Q Yazdani is an associate at Shearman and Sterling LLP.

[2] 2020 Edelman Trust Barometer Special Report on Institutional Investors.

[3] ‘Edelman Trust Barometer Special Report: Institutional Investors’, Edelman, https://www.edelman.com/research/2020-edelman-trust-barometer-special-report-institutional-investors.

[4] ‘LPs Are Turning Down Alternatives Managers Over ESG Concerns’, Institutional Investor (23 June 2022) https://www.institutionalinvestor.com/article/b1ylk503n9jr0r/LPs-Are-Turning-Down-Alternatives-Managers-Over-ESG-Concerns

[6] ‘Blackrock’s Sustainable Mexican ETF Shows Rapid Success’, https://mexicobusiness.news/energy/news/blackrocks-sustainable-mexican-etf-shows-rapid-success.

[7] ‘Mexican ESG ETF rakes in $450 million in first two months -BlackRock’ Reuters, 6 October 2020. https://www.reuters.com/article/mexico-etf-esg/mexican-esg-etf-rakes-in-450-mln-in-first-two-months-blackrock-idINL1N2GX0I9.

[8] ‘2022 Private Equity Survey: Spotlight on Latin America’, S&P Global (17 Aug 2022) https://www.spglobal.com/marketintelligence/en/news-insights/blog/2022-private-equity-survey-spotlight-on-latin-america.

[9] Quarterly signatory update, UN PRI Association (April 2022), https://www.unpri.org/signatories/signatory-resources/quarterly-signatory-update.

[10] ‘Principles for Responsible Investment’, United Nations (4 Oct 2022), https://www.unpri.org/signatories Recovery to Rediscovery: Capitalizing on a Changed US Private Equity Landscape.” Auxadi. (June 2021) https://www.auxadi.com/wp-content/uploads/2021/06/Auxadi-PE-Report-US.pdf.

[11] ‘Recovery to Rediscovery: Capitalizing on a Changed US Private Equity Landscape’, Auxadi (June 2021) ,https://www.auxadi.com/wp-content/uploads/2021/06/Auxadi-PE-Report-US.pdf.

[12] ‘Sovereignty vs sustainability: ESG in Latin America’. IHS Markit. (30 April 2021) https://ihsmarkit.com/research-analysis/sovereignty-vs-sustainability-esg-in-latin-america.html.

[15] A scoring system that shows how environmental, social and governance (ESG) factors impact individual credit rating decisions.

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