Commentary: Understanding rising risk of ESG litigation for private markets

As fundraising soared to new heights in 2022, so did ESG's adoption across private capital asset classes. The average ESG fund size increased from $399.3 million in 2017 to $590.3 million in 2021 and $575 million in 2022. In 2023, while attention has since refocused on return generation and value protection in the face of macroeconomic pressure on valuations, it is evident that ESG adoption is broadening.

Alongside this, the number of ESG-related legal claims has been rising, too. While not new, corporate ESG litigation has markedly increased in recent years, and we can only expect this to grow as ESG regulation expands across the globe as disclosure requirements become more enhanced with crackdowns by watchdogs on the rise. According to the World Business Council for Sustainable Development, the number of lawsuits against companies concerning environmental, social and governance issues has grown over the last three decades. Coupled with this, the rise of anti-ESG sentiment in the U.S. is also predicted to increase litigation in the country, testing ESG's legal standing from both its supporters' and opponents' points of view.

However, for private markets in particular, the rise in ESG litigation constitutes, both as an engagement tool on one hand and for financial institutions invested in funds, an increasingly material risk as reputational damage and expensive payouts can significantly affect valuations.

While a large proportion of ESG litigation cases are brought against companies involved in the extraction and sale of fossil fuels, the defendants are increasingly diverse, and financial institutions are among those being sued. Of the corporate ESG claims in 2021, only 41% were brought against fossil fuel companies, while the majority were filed against companies in other industries.

Investors are also conscious of this. In Preqin's November 2022 survey, more than 130 investors were asked what would cause them to begin considering ESG issues in investment decisions, and legal requirements were one of the top responses at 53%.

Recently, for instance, the Universities Superannuation Scheme, the U.K.'s largest private pension scheme with assets worth £82 billion ($102 billion), fought against a lawsuit claiming that it had failed to come up with a plan to divest from fossil fuels. While the case was dismissed, it has garnered significant attention and continues to be hailed as evidence of the increasing momentum by activists, shareholders, and other stakeholders to hold institutions accountable for climate change.

Several ESG-related controversies have recently made waves in private markets, including high-profile allegations of greenwashing and enforcement action by regulatory bodies. However, while growing ESG litigation presents a material risk to institutions, it is also an increasingly important way to ensure accountability, enforce government and corporate commitments, and drive the global ESG agenda, and is being used effectively by private market actors — such as activist shareholders as well as LPs bearing the brunt of poorly managed risks — to do just this.

Unlike more traditional engagement mechanisms, such as voting and consultations, litigation provides a means to hold portfolio companies accountable and compel them to confront issues immediately, helping guide private market actors, seed new fund strategies, engagement methods and reporting.

For example, last year the Swedish pension fund AP7 with 900 billion Swedish kronor ($80.8 billion) successfully brought legal action against Activision Blizzard Inc. and Microsoft Corp. over their planned merger, as the bid and terms breached governance standards and caused shareholders to lose money.

Private market actors have also been using dedicated ESG litigation funds to drive change. In 2018, Aristata Capital was founded, which is the first litigation fund dedicated to driving positive social and environmental change while offering attractive financial returns. The fund provides finance for claimant groups that are unable to afford litigation, and in return, they receive a multiple of its investment or a percentage of the settlement where claims are successful. The fund raised nearly £40 million for the first close of its impact litigation fund.

As more claims are filed and processed, a better understanding will emerge of what ESG means in a legal context, both as a risk and an engagement mechanism. In turn, this will increase transparency among private market fund managers for investors navigating the ESG landscape. In Preqin's November 2022 investor survey, 43% of respondents said they would turn down investment opportunities due to concerns over ESG standards, and 29% said they already had done so.

Increasing the level of reporting standards by providing clear, transparent and credible ESG information is increasingly essential to avoid enforcement action, secure and help maintain investor interest. As of 2023, however, the global average ESG transparency metric, which tracks firms' disclosures in 37 areas, is 9%, suggesting the typical manager is transparent in approximately three of the 37 areas. Drilling into what type of information is being disclosed, there is a clear prevalence of firms providing overarching statements about future targets and long-term plans, rather than granular breakdowns of actions taken. To illustrate this, of the nearly 5,000 fund managers who claim to have "statements, policies or initiatives related to climate change" in place, 44% disclose their own greenhouse gas emissions, and only 28% disclose that they track their portfolio companies' GHG emissions. The rise of portfolio emissions-related claims, combined with the expansion of mandatory ESG-related disclosures and ESG litigation's potential consequences on valuations, contributes to growing pressure from both investors and regulators for managers to incorporate ESG considerations into investment decisions. This will increase transparency, and therefore, we're likely to see continued positive shifts in private markets as ESG remains firmly on the agenda.

Alex Murray is vice president, head of real assets, research insights, at Preqin. This content represents the views of the author. It was submitted and edited under Pensions & Investments guidelines but is not a product of P&I's editorial team.