INSIGHTS | Best of Both Worlds: ESG in Private Equity

Environmental, social, and governance have now become widely practiced by the top investment firms worldwide, influencing billions of dollars in investment decisions and pushing companies to meet investors’ demand for more sustainable and equitable practices. However, the private equity market still sees relatively little action in ESG compared to fixed income and public equity markets, despite its growing presence. According to Harvard Business Review, the private equity industry managed USD6.3tr of assets in 2021, swelling 37.7% compared to the previous year as the fastest growing private asset class. If the world is to mobilize the economy to address pressing environmental and social challenges, private equity has a large role to play.

At present, most ESG initiatives come from public companies under regulatory pressure (such as stock exchange disclosure requirements). In comparison, ESG participation by private companies remains scarce and basic. However, due to long-term engagement and early-stage relationship building, private equity is in fact exceptionally positioned to realize the full potential of ESG to enhance risk management, incentivize positive change, and increase long-term returns.

Incentives for ESG in Private Equity

Corporate governance has long been one of the key considerations in private equity deal sourcing, because a company with optimized corporate governance is more likely to remain resilient in the face of challenges and yield profits over the long run. Yet, as the economy experiences increased challenges from issues such as climate change, resource scarcity, and social inequity, stakeholders across industries now demand environmental and social responsibility to be incorporated into business practice. With ESG playing an important role in assessing the sustainability and profitability of a modern-day business, private equity firms should pay serious attention to the ESG strategy of their portfolio companies if they want to secure long-term returns.

The risks facing today’s economy are complex and unprecedented. The global economy is still reeling from the labor and supply chain disruptions from a pandemic since 2020, and many companies shuddered under energy shortages or saw an exodus of employees due to unfavorable working conditions. Without a set of sensible ESG strategies, a company will inevitably suffer more severe losses from such risks, especially a nascent company without a robust reputation or financial establishment. To screen for high-potential and resilient portfolio companies, ESG can provide private equity firms with additional risk assessment criteria. The emphasis on materiality in ESG analysis brings forth the most financially relevant environmental and social considerations that are traditionally bypassed in the selection of portfolio companies. If private equity is to sustain its high returns, ESG criteria must be factored into its investment decision-making.

ESG for Growth: Integration is Key

Sustainability and ESG are often marketed as a differentiator from competitors, even in the private equity world. But how can ESG move beyond a buzzword and serve to induce lasting profit growth and create real value in the long run? Full integration of ESG values is essential.

First, integrate ESG into the due diligence process. Investment managers must ensure that the target company has a good understanding of ESG issues that are material to its financial performance, with sufficient strategies to assess, monitor, and manage these issues. For example, private equity managers should investigate if a target textile company operates key facilities in water-stressed areas and if it has water-related strategies to mitigate potential risks. If the target company cannot demonstrate a competent understanding of and tactics to address water risks, its production capacity and earning potential would be severely jeopardized by events such as regional droughts and water consumption constraints. To meaningfully avert financially material ESG risks in the due diligence process, private equity managers should move beyond a simple checklist exercise and conduct in-depth conversations with target companies regarding their ESG risks and management strategies.

Second, track and analyze ESG performance in conjunction with financial performance to build a more robust investment approach. Start by gathering data regularly from portfolio companies on their material ESG issues to cultivate transparency on ESG. Firms can start by referencing notable ESG frameworks such as the Principles for Responsible Investment (PRI), Global Reporting Initiative (GRI), and upcoming standards from the International Sustainability Standards Board (ISSB). Over time, investment managers may observe patterns and correlations between ESG and financial performance through benchmarking among portfolio companies. This exercise provides a unique edge by yielding insights to identify high-potential firms in respective industries and calibrate the private equity firm’s investment process accordingly. Explore Seneca ESG’s flagship ZENO platform to see how you can simplify ESG data management across your portfolios.

Third, create value by driving ESG improvement in portfolio companies. Compared to public investors, private equities enjoy a more intimate relationship with the top level of portfolio companies, often engaging with the company from an early stage, or appointing key executive personnel or board members. This presents a unique opportunity to secure top-level buy-in for ESG, include ESG KPIs in funding terms, and provide resources directly to enhance capacity and improve performance. Private equity firms can also create ESG-linked financing terms to offer more competitive rates for portfolio companies that outperform in ESG KPIs consistently.

Finally, continue to share ESG knowledge with internal staff and external partners. Environmental, social, and governance issues are constantly evolving, with regulatory and market implications changing by the day. Those who are well-informed of the interconnectedness between business, environment, and society possess the acumen for spotting truly resilient and worthy investments. Provide ample opportunities for staff to learn the intricacy of ESG issues and how they affect business performance, such as training on what information to look for in the due diligence process. In addition, the private equity funder should keep up with the latest sustainability and ESG regulations of the market, and share resources and expertise on ESG-led value creation with portfolio companies.

Sources:

https://hbr.org/2022/07/private-equity-should-take-the-lead-in-sustainability

https://www.accenture.com/_acnmedia/PDF-174/Accenture-Investing-for-Impact-ESG-in-Private-Equity-POV.pdf

https://www.pwc.com/us/en/industries/financial-services/library/achieving-esg-goals.html

https://www.unpri.org/pri-blog/the-mainstreaming-of-esg-in-private-equity/9451.article

https://www.mckinsey.com/~/media/mckinsey/industries/private%20equity%20and%20principal%20investors/our%20insights/mckinseys%20private%20markets%20annual%20review/2022/mckinseys-private-markets-annual-review-private-markets-rally-to-new-heights-vf.pdf