Private equity firms are looking to extend investment time horizons, build strong ESG values in companies and use ESG metrics in decision-making processes.
Widely seen as slow to adopt ESG values, experts argue private equity (PE) firms are now incorporating ESG factors throughout the full lifecycle of the investment process, some even revisiting the basics of their business models.
There is growing evidence that larger firms are embracing ESG in some capacity. In October 2020, global accountancy firm BDO published research that revealed almost two-thirds (63%) of surveyed UK PE firms take ESG principles into account in their investments.
Standard-setting bodies in the sector are playing their part to ensure ESG adoption is happening at an accelerated pace. The Institutional Limited Partners Association (ILPA) – the trade association for institutional investors in PE – is calling for ongoing submissions for an ESG Roadmap, intended as “a clearing house of best practices and resources that reflects the ongoing development and evolution of successful ESG in LP organisations”.
However, research conducted by management consulting company Environmental Resources Management (ERM) shows ESG integration remains nascent, despite growing in importance. “Respondents highlighted that it often lacks systematic consideration as an investment opportunity or value creation lever,” Keryn James, ERM CEO, explained in the 2020 report.
“The private equity industry has come on board to the ESG agenda as actively as any other segment of the investing universe,” argued Dr Andy Sloan, Deputy Chief Executive of Guernsey Finance and Chair of Guernsey Green Finance. “I think people now appreciate that LPs are no longer purely concerned about returns.”
Why has private equity been slow on the uptake?
While private equity is a diverse sector, several aspects of its modus operandi are at odds with the long-term value-add approach of the sustainable investing industry. Ranging from billion-dollar buy-outs to much smaller transactions, a common factor is the focus on generating value and selling on within a relatively short-term time horizon – typically between three to five years – which can mean less attention is paid to the grassroots of the business or consideration of its long-term impact. The PE mindset therefore does not lend itself so naturally to the ESG-focused targets and strategies implemented by investors with a longer-term perspective.
The ERM report highlighted visible interest in ESG within the PE space since 2016, with a “threefold increase in the perception of ESG as a positive contribution to the exit multiple in sale processes”. However, interest has been slow to translate into widespread active engagement with ESG issues.
While 93% of PE firms surveyed by ERM said focusing on ESG themes will “generate good investment opportunities”, just 25% have a thematic ESG fund or strategy and “actively seek out ESG-focused investments”.
Furthermore, a 2019 survey on climate risk conducted by Big Four accountancy firm PwC revealed 83% of PE firms were concerned about climate risk, and yet only 31% said they had taken action to address concerns.
According to ERM, PE firms are considering ESG only from a risk management perspective, not fully considering the significant value potentially realised upon exit.
PE firms already investing with ESG in mind
But for firms already embracing ESG, the question is whether to focus on ESG risks and opportunities within every company in which they invest, or whether they invest a percentage of funds into companies specifically because of their ESG potential.
In June 2020, Sweden-based private equity firm EQT announced an ESG-linked fund level bridge facility, valued up to €5 billion, designed to ensure portfolio companies will receive better financing terms if and when their ESG performance improves. The firm has adopted a thematic approach to investing in businesses with positive social impact and is working on the structural development of its portfolio companies by establishing clear ESG standards with its EQT Blueprint.
Bain Capital Double Impact recently raised US$800 million in fresh capital for its second impact investing fund, which will focus on backing businesses the firm believes will benefit investors and society at large. Like EQT, Bain Capital Double Impact groups its portfolio companies (largely mission-oriented for-profit lower middle-market companies across North America) into ESG themes. These are sustainability (water, energy, agricultural), health and wellness (wellness products and services) and education and workforce development (socio-economic mobility).
Richard Burrett, Chief Sustainability Officer at sustainable private equity manager Earth Capital, told ESG Investor that an increasing number of PE firms are developing their own systems to measure ESG metrics within portfolio companies. The firm’s proprietary Earth Dividend system is an ESG scorecard used for each company as part of the due diligence process and thereafter calculated and reported annually.
Co-founded by Gordon Power and Stephen Lansdown (also co-founder of money supermarket Hargreaves Lansdown) in 2008, the track record of the Earth Capital team extends to more than 250 investments with an internal rate of return (IRR) of 28.5%, with sustainable investments earning a 1.6 times higher return, amply demonstrating the potential returns for PE firms should they incorporate ESG investing into their business plan.
“[Earth Capital] invests exclusively in sustainable technologies across energy, food and water. Using the Earth Dividend system, we identify areas these companies can further improve in order to both add value and increase social impact on exit,” said Burrett.
Similarly to Bain Capital Double Impact, Earth Capital is solely focused on companies that have delivered a positive impact when ESG factors are considered, rather than rooting out carbon-offenders. Through its Earth Dividend tool, the firm identifies and implements sustainable changes over the course of ownership to enhance business value. While many PE firms are keeping ESG-related investments separate from their traditional practices, firms such as Earth Capital are integrating the two.
Are investors driving PE’s growing ESG interest?
Put simply, ESG has become impossible to ignore; it is now bleeding from the listed sector into private capital. Speaking in a recent webinar, Andy Pitts-Tucker, Managing Director of Apex ESG Ratings and Advisory, confirmed that investor pressure has been the “main driving force” behind incorporating ESG values into PE.
“[The need to translate] the combined ESG needs and requests of investors, regulatory bodies and government directives has been moving down the financial supply chain. Nowadays, clients are all telling me that they are having a conversation with yet another LP who has their own ESG reporting needs,” Pitts-Tucker said.
Investors are looking for a response to ESG-based concerns and science-led recommendations from all facets of the investment industry; PE firms need to address concerns about the impact of the physical and transitional risks of climate change on the value of financial assets if they want to stay open for business.
However, investors are not the only force encouraging positive change. Regulatory developments, such as the Modern Slavery Act (which decrees slavery and human trafficking should not take place in businesses or supply chains), are playing their part in ensuring PE houses, alongside other business owners and investors, take greater accountability by providing transparent disclosures to wider stakeholder groups.
In some respects, PE firms are better placed than longer-term investors to respond to new expectations. Burrett pointed out that PE firms can enact rapid, extreme change within their portfolio companies, contrasting with minority shareholders merely able to have a say. PE firms can enable accelerated shifts to ESG-focused policies and processes within companies, i.e. implementing stricter hiring guidelines to improve diverse representation in the workforce, before exiting.
“As a private equity investor, arguably you have a greater degree of influence over the companies you invest in and that could be vital in the ESG space,” he said.
Extending the PE time horizon
According to a State Street report, more than 40% of surveyed asset owners and managers said the best time horizon to deliver ESG outperformance by way of returns was “greater than five years”, longer than many PE firms are willing to stay in a company.
Last year, asset management firm BlackRock issued a public note calling for PE firms to consider a longer-term approach to investing, noting that ESG factors can have a material impact on both value creation and company performance, alongside contributing to the betterment of society.
PE firms looking to integrate ESG factors into their business models may need to look at their time horizons and consider longer-term investing in companies that have clear potential to quickly and efficiently implement ESG targets within their business plans.
Companies with strong ESG metrics are more likely to generate healthy returns even within a five to seven-year timeline, State Street noted, as well as ensuring portfolio companies continue to have a long-term beneficial social impact.
This also provides PE firms and their investors with that all–important increased value upon exit, Burrett said.
What do PE firms need to work on?
ERM outlined four key recommendations PE firms should follow if they want to realise the full potential of ESG factors, which includes an overhaul of the industry’s existing mindset to view ESG as a “significant value creation opportunity”.
“A disciplined focus on ESG themes can result in generating higher returns and improve [a PE firm’s] prospects of accessing increasing pools of committed capital from asset owners to tackle the biggest ESG challenges,” the report said.
ERM emphasised that PE firms need to invest in a wide range of ESG-focused data sources and analytics to help identify future investment opportunities which meet evolving investor criteria. Having ESG data to hand could help PE firms appeal to ESG-focused clients and “win competitive deals”, the report added.
PE firms may increasingly need to make portfolio companies “ESG strong” during ownership, in order to then benefit from a higher exit multiple. This means integrating material ESG factors fully into company plans, including board engagement, and potentially linking management incentives with desired goals, the report said.
“PE firms will need to ensure that ESG disclosures at exit from investee companies provide a credible and complete picture of the company’s strong ESG programme to demonstrate resiliency and to attract valuation premiums from ESG sensitive buyers.”
Time for private equity to go public
Industry experts who spoke to ESG Investor agreed on one point of consensus as the sector looks to embrace ESG factors more thoroughly: private equity needs to add its voice more clearly to the net zero carbon emissions pledge. Making a public commitment to sustainable and impact investing will go a long way to confirming trust with investors, as well as reassuring the wider industry that PE wants to catch up.
“PE needs to consciously decide to push investments into green and social infrastructures and support more active positive changes,” Burrett said.