How private equity funds can achieve their ESG goals (2022)

In a relatively short time, environmental, social and governance (ESG) issues have catapulted from the sidelines to center stage of the corporate agenda. Yet many organizations, private equity firms included, grapple with how to execute on the ESG imperative.Private equity (PE) firms often struggle to balance what can easily be perceived as conflicting goals: generating a return for investors while meeting the broader ESG goals of their stakeholders.

How private equity funds can achieve their ESG goals (1)

We’ve seen PE firms face the following issues:

  • Potential or current limited partners (LPs) with individual, unique mandates that they require of their PE fund investees.
  • Portfolio companies (portcos) that set net zero requirements that they push down their entire supply chain, or, conversely, customers that set ESG demands that portcos have to follow.
  • A lower pool of funding forportcos on exit if they aren’t meeting the market-established ESG expectations.
  • Being disadvantaged in bidding for a target with material ESG risks and opportunities where a competing firm has more mature ESG capabilities to leverage.

As a result of these evolving issues, PE firms are becoming more selective of their targets: 37% of respondents in our Global PE Responsible Investment Survey have turned down an investment opportunity because of ESG concerns.

In our view, companies that are good ESG citizens have the potential to earn a premium, not just in goodwill and enhanced brand, but literally.Today, any portco that can provide investors and other stakeholders the assurance that they are adequately addressing ESG issueshas an opportunity to create value. We’ve previously written about what we’re seeing in the private equity space more generally when it comes to ESG. Here we delve into more detail on what PE firms’ boards should do as they focus on the primary concerns within each portfolio company’s industry in order to create value.

ESG challenges for PE portfolio companies

ESG priorities differ by company, depending on industry.In some industries, the impacts of ESG issues are direct and well known: regulation has meant that there is a long history of tracking them, with more metrics available. Other issues may be less quantified, either because they’ve emerged more recently and appropriate metrics haven’t yet been standardized or implemented, or because the impacts are indirect or intangible, and are therefore harder to quantify.

(Video) ESG Investment forum: How Private Equity funds achieve ESG goals?

  • Environmental
  • Social
  • Governance

Environmental

Climate change is the predominant environmental concern, imbued with increasing urgency as more nations and companies worldwide commit to net-zero carbon targets. In our global survey of PE firms, half of all respondents say they are taking action on climate risk and nearly half (48%) report taking action on the carbon footprint of their portfolio companies.

Portfolio companies attempt to balance three broad types of environmental risk:

  • Emissions and waste. Climate concerns tend to center on emissions, so heavy industry companies and other emissions producers are likely the first to be questioned about their practices. (They’re also more experienced at monitoring and mitigating impacts as a matter of regulatory compliance.) Other environmental issues for heavy industry companies can include water and land pollution as well as impacts on nature and wildlife. For example, plastic waste produced by fast-moving consumer goods is a fast-growing concern. But every company, whether industrial, manufacturing or service-based, needs to consider its impacts, both direct and indirect, including within its supply chain and its typical day-to-day business (such as air travel).
  • The costs associated with making ESG changes. Reducing emissions, pollution and otherwaste—through modifications to production methods or by developing new production or distribution processes—can be costly. Some PE firms have scrutinized their holdings in industrial companies and other industries with a relatively high environmental impact (such as healthcare). As firms decide whether it makes economic sense to make these investments, it may be the case that the investment costs too much relative to the return.
  • Vulnerabilities tied to climate change. In locations where climate change or other environmental hazards posea threat—for example, flooding in coastal areas or wildfires in drought-stricken areas—physical operations and assets need to be protected.

Social

For most PE firms and their portfolio companies, “social” is synonymous with diversity and inclusion (D&I).Changes in D&I have grown in importance and prominence in the wake of current events around societal racial equity, but it has been an issue for some time. Yet many PE firms are still developing their ownD&I initiatives, as some believe that, to promote change credibly at the portfolio company level, they should practice what they preach. Among the global PE firms PwC surveyed, 46% have established gender and/or racially/ethnically diverse hiring targets.

Social issues go beyond D&I, of course, encompassing companies’ hiring and labor practices and relationships with employees, suppliers, customersand the communities in which they operate. They also encompass job reskilling, especially due to tech disruption, and layoffs as a function of a deal closing, which can be a much greater riskto brand reputation today than in the past.Social issues vary more across industries than environmental issues. Among the more prominent concerns are the use of forced labor by manufacturers and health and workplace safety practices, especially at companies with large workforces. Both continue to draw media and regulators’ attention.

Lastly, the other major social issuefor PE firms’ porticoes is data privacy management and cybersecurity. This is not surprising, as more and more companies conduct an ever-growing portion of their business digitally, and they can be vulnerable to ransomware attacks and hacking. As portcos are using new technologies to reach their customers, they are struggling to meet privacy standards (if applicable) or understand what they should do with the volume of customers’ personal data they have stored. In our survey, we found that less than 20% of global PE firms have in place plans for emerging tech and data ethics.

Governance

PE firms have been focused on the more typical governance issues, including leadership, executive pay, audits, internal controls, tax transparency and shareholder rights. One issue that often arises in terms of governance is tax transparency. PE firms are looking across their portfolio companies to examine their tax structures, including how much and where they pay taxes. They are seeing that improvements that benefit the communities in which they operate don’t necessarily mean sacrificing their effective tax rate. Leading firms are taking a more holistic view of their tax strategy to consider tariffs, tax incentives, synergies and intangible assets, which can offset effective tax rates favorably while still achieving ESG goals.

Taking action: Finding your ESG next step

Within everyindustry—and even from company to company—the ESG journey will differ. Every PE fund should develop plans for the near, medium and long term, and address issues for the collection of its portcos, as well as each one individually.

Get the information you need

To start, we recommend that funds gather data and conduct a diagnostic on their entire portfolio. Forportcos in industries that haven’t yet standardized metrics or benchmarks, it will take additional effort to determine the appropriate steps.

Much of the data needed to provide a reliable performance picture may not be in an easily accessible form. Moreover, getting consistent data across the portfolio may be challenging. Some PE pioneers are finding creative ways: One uses the same payroll processing company for all its portcos. The payroll processor holds relevant data on employees that can inform D&I goals. Some companies have even turned to their cloud service providers to help them gather and analyze the data they need to make their ESG goals happen. In our Cloud Business Survey, we found that 70% of respondents are either implementing or actively looking into how cloud can support their ESG goals.

Once you have the data you need, create an ESG diagnostic that will show how each of your portfolio companies is handling its ESG risks. We recommend that you tailor the diagnostic to those ESG issues that are market priorities in each industry, such as waste management for emitters or safety and injury prevention for manufacturers. Developing an accurate diagnostic will take time, but a diagnostic has the potential to be a cornerstone for how you assess the ESG performance and tracking at your portcos.

(Video) Making Sense of ESG - Private Equity

Where should you start?

When you are thinking about which companies to prioritize first, we recommend that funds:

  • First, examineportcos that are closest to exit. This will allow you to determine what these companies should do to meet market expectations and confirm that they safeguard value.
  • Next, address companies in industries with hot-button ESG concerns. For example, medical waste can be a problem in healthcare, and clothing and footwear manufacturing is in the spotlight for potential child labor and forced labor practices.
  • From there, look at the other industries represented in your portfolio, recognizing that even sectors that may seem exempt may indeed have E, S and G impacts lurking beneath the surface. For example, a tech company may not have direct environmental issues, but some of its global suppliers may be contributing to land or water degradation. A manufacturer that consolidates and abandons a sprawling physical plant could be creating an environmental problem. Similarly, a retailer that pulls out of a shopping center may leave a large volume of packaging that needs disposal or recycling. Or the shopping center may become blighted and create safety issues for the community.
  • Finally, look at newly acquired companies. With the longest timeline to exit,these portfolio companies—even those in sectors with more pressing ESG issues—can be made to shine relative to peers with the right focus and investment.

To build out an ESG plan for an individual portco, we recommend these five steps:

1. Assess where you are now

  • Examine what you’re doing well. Start by looking for areas where your existing ESG investments are linked to revenue growth. For example, we’ve seen eco-friendly production processes that win over consumers,innovations leading to new approaches to privacy protection and reductions in plastics dependence that can be applied across multiple sectors. You may also find that some of your ESG initiatives have led to your company having an edge in attracting diverse talent.
  • Be vigilant in sussing out the negative.Look for areas where your lack of ESG action may be a problem. Your analysis should include potential risks that can be more indirect, such as suppliers’ labor practices, or less obvious,like an abandoned campus or an AI platform that is coded in such a way that inadvertently results in bias. Don’t forget that blind spots may exist, especially in newer businesses where little work has been done to understand or measure the ESG impact.

2. Define your end goals

  • Understand who your portco’s stakeholders are, and define your goals based on what ESG success looks like for your portco. To form this view, understand what your industry’s investors care most about. For example, the manufacturing industry has always focused on workplace safety and health of its workers. The ESG ratings for that industry reflect this focus and may weigh it more heavily than other industries. By understanding this, you can focus on the specific ESG capabilities you need to help track your progress. Is it monitoring equipment? A new protocol to help log ESG issues? The answer will be different for every company and industry.
  • Define your level of ambition. Pragmatic companies, for example, view sustainability as a factor influencing their financialperformance—they delegate responsibility for sustainability to company management and aim for quick wins to meet stakeholder requirements. Idealists, at the other end of the spectrum, see sustainability as a main driver of the company’s purpose,and believe that responsibility for it starts with the CEO.

How private equity funds can achieve their ESG goals (2)

3. Identify options to deliver your ESG strategy

  • Define a set of potential ways your portco can deliver on the end goal. Take manufacturing: A company can improve workplace safety in any number of ways,such as investing in better equipment, changing work practices or augmenting training.
  • Prioritize based on data. Use your diagnostic tools and ESG analysis to help you focus on strategies that can yield the most for your ESG dollar invested—and in turn, give you a greater advance in ESG rating for every dollar spent.

4. Make it happen

  • Build a business case for ESG investment. Demonstrating knowledge of the market’s perspective on ESG and of the changes that can produce the greater return will go a long way toward winning executive buy-in on ESG goals. Let’s look again at manufacturing: Showing that a small change in manufacturing practices can deliver substantial benefits to ESG ratings will help make your case for your ESG ambitions.

  • Rally the CEOs of your portcos. PE firms face a unique challenge in that funds have a vested interest in the performance and strategy of the underlying portcos, but the portcos themselves need to execute on the strategy. As a result, it’s critical to align the operating models of the portcos and get CEOs on the same page as the PE firm.

5. Tell your story

  • Tell your portco’s story. Share your ESG performance in your established financial reporting processes. At present, portcos are determining which ESG framework and disclosures to follow. As a result, there can be confusion in how to tell your story. Those who use existing controls and reporting structures to report ESG performance through investor-grade standards will likely stand out where standing out can move the needle: financial services CFOs, investors and other key stakeholders. As you develop your reporting, keep in mind that you should take credit for what you’re doing well, and make it clear what you’re still working on and where you are headed.

Conclusion

Given the number and scope of ESG issues, developing sound and credible policies can be tricky for PE funds and their companies. Our framework offers a good start, helping you make smart, objective decisions based on consistent and credible data, while taking into account the nuances of each industry. By focusing on the major issues in each industry and fostering a unified approach among portco executives, PE funds can do more than demonstrate good citizenship: they can keep their eyes on the value-creation prize.

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FAQs

Why is ESG important to private equity? ›

Environmental, social and governance (ESG) factors are poised to shape the financial investor industry for years to come. There is growing evidence that when investors embed ESG considerations into their strategies, they achieve superior valuations and a host of positive outcomes.

How do you develop ESG goals? ›

How To Develop and Implement an ESG Strategy
  1. Step One: Conduct a Materiality Assessment. ...
  2. Step Two: Establish Your Baseline. ...
  3. Step Three: Determine Objectives and Goals. ...
  4. Step Four: Gap Analysis. ...
  5. Step Five: Develop Your ESG Roadmap and Framework. ...
  6. Step Six: Put the Plan into Action and Measure Key Performance Indicators (KPIs)

What are 3 principal ESG strategies? ›

ESG Strategies

We have identified five primary strategies of ESG investing — exclusionary screening, positive screening, ESG integration, impact investing and active ownership.

What are the main challenges with respect to ESG investing? ›

Investors' Top 5 ESG Challenges
  • Transitioning Your Portfolio. Building a sustainable portfolio tailored to specific requirements can be time consuming, and the financial and sustainable impact may be unclear. ...
  • Making Sense of the Data. ...
  • Choosing the Right Product. ...
  • The Emerging Climate Trend. ...
  • Company Engagement.
1 Apr 2022

Does ESG impact private companies? ›

Since discussion about environmental, social, and governance (ESG) strategy tends to focus on publicly traded companies, you might wonder if ESG is relevant for private companies. The short answer is – absolutely.

Is private equity sustainable? ›

Private equity well placed to lead on sustainability

In fact, with its full ownership model and relative freedom from short-term pressures, the industry is well placed to lead the way in capturing value through sustainability.

What are the ESG strategies? ›

An environmental, social and governance (ESG) strategy is defined as a business model that emphasizes social responsibility. All businesses seek profits, but today's investors and shareholders want to see businesses making efforts to make the world a better place as they generate those profits.

What is ESG investment strategy? ›

ESG investing is a form of sustainable investing that considers environmental, social and governance factors to judge an investment's financial returns and its overall impact. An investment's ESG score measures the sustainability of an investment in those specific categories.

What are the main tools and strategies related to ESG investing? ›

An organization's performance against ESG issues helps stakeholders make key decisions, and there are many tools available to measure or report on ESG performance. Some of the most popular include CDP, the Global Reporting Initiative (GRI), the Task Force on Climate-related Financial Disclosures (TCFD), and EcoVadis.

How companies can improve ESG? ›

Six steps to improve your ESG performance
  • Integrate ESG into your business strategy. ...
  • Identify your material topics. ...
  • Understand your ESG ratings. ...
  • Align to global & regulatory frameworks. ...
  • Strive for 'investment grade' data. ...
  • Consider your communication channel.

What is ESG in simple words? ›

Environmental, social and governance (ESG) is a term used to represent an organization's corporate financial interests that focus mainly on sustainable and ethical impacts. Capital markets use ESG to evaluate organizations and determine future financial performance.

What are the 4 strategies of sustainable investing? ›

We deliver active investment strategies across public and private markets and custom solutions to institutional and individual investors.
...
  • Clarify Your Motivations and Investment Philosophy. ...
  • Identify Your Implementation Approaches. ...
  • Define Your Investment Strategy. ...
  • Design Your Operational Model.

What is the main challenge implementing ESG policy? ›

One of the main points of confusion for organizations approaching ESG is the lack of a single standardized set of frameworks or reporting requirements.

What are ESG risk and opportunities? ›

ESG risks include those related to climate change impacts mitigation and adaptation, environmental management practices and duty of care, working and safety condition, respect for human rights, anti-bribery and corruption practices, and compliance to relevant laws and regulations.

Why is ESG important in finance? ›

ESG analysis can provide valuable insights about factors that can have a significant impact on the financial metrics of a company and therefore better inform our investment decisions.

Why does ESG matter for private companies? ›

Private companies need to cater to the demands of public shareholders which are increasingly focused on environmental, social and governance (ESG) factors. Regulatory changes, funding requirements, and commercial longevity are the three key factors for ESG reporting and compliance.

Why does ESG matter to companies? ›

From our experience and research, ESG links to cash flow in five important ways: (1) facilitating top-line growth, (2) reducing costs, (3) minimizing regulatory and legal interventions, (4) increasing employee productivity, and (5) optimizing investment and capital expenditures (Exhibit 2).

What are examples of private companies? ›

Examples of companies in the private sector

Examples include: Sole proprietorships: Plumbers, technicians, contractors, developers and designers. Partnerships: Legal, accounting, tax and dentistry. Privately owned corporations: Hospitality, leisure, retail and food.

How Does private equity create value? ›

‍ Private equity firms create value in three distinct ways: multiple expansion, leverage and operational improvements.

What is ESG due diligence? ›

ESG due diligence is the process of uncovering a company's ESG policies and risk factors. This information then informs ethical and less risky investments decisions, mergers, and acquisitions. ESG stands for environmental, social, and governance. ESG factors relate to a company's policies and practices in each area.

What is ESG BCG? ›

As the climate crisis deepens and the uncertainty of the global pandemic lingers, employees, consumers, communities, and investors are increasingly holding companies to account for environmental, social, and governance (ESG) stewardship.

What are ESG principles? ›

Adopting ESG principles means that corporate strategy focuses on the three pillars of the environment, social, and governance. This means taking measures to lower pollution, CO2 output, and reduce waste.

What are ESG indicators? ›

ESG - Key Performance Indicators for Sustainable Reporting

Environmental, Social, and Corporate Governance (ESG) refers to the three dimensions for measuring the sustainability impact of an investment in Sika. These criteria help to better determine the future financial performance of companies.

Does ESG investing actually make a difference? ›

The evidence on investment returns is more ambiguous — some studies find the stock prices of companies with high ESG ratings outperform, but others find no measurable effects, and some even document lower monetary returns.

What is sustainable investing and how its connected to ESG? ›

Sustainable investing balances traditional investing with environmental, social, and governance-related (ESG) insights to improve long-term outcomes. In many ways, sustainable investing can be seen as part of the evolution of investing.

What does ESG mean sustainability? ›

ESG means using Environmental, Social and Governance factors to evaluate companies and countries on how far advanced they are with sustainability.

What is Ilpa in private equity? ›

Institutional Limited Partners Association - ILPA.

What is investment ESG? ›

ESG Investing (also known as “socially responsible investing,” “impact investing,” and “sustainable investing”) refers to investing which prioritizes optimal environmental, social, and governance (ESG) factors or outcomes.

Is impact investing private equity? ›

While many perform well, the return on impact investments may be lower than more traditional investments'. Impact investing is largely limited to private equity, but individuals can get involved via broader ESG funds.

What does ESG stand for? ›

ESG stands for Environmental, Social, and Governance.

What are ILPA standards? ›

ILPA produces best practices aimed at improving the private equity industry for the long-term benefit of all industry participants and beneficiaries. ILPA continues to assert that three guiding principles form the essence of an effective private equity partnership: alignment of interest, governance, and transparency.

What is Ilpa statement? ›

The ILPA's Quarterly Reporting Standards (QRS) establishes the minimum level of periodic disclosure expected from GPs. These guidelines, which include a range of sample reports and working templates, will improve an LP's ability to monitor their portfolio and reduce their ad hoc data requests.

What is a diversity in Action signatory? ›

Diversity in Action signatories currently undertake four essential DEI actions and at least two additional actions (from an optional set of nine). The Diversity in Action framework includes a broad range of possible actions that span talent management, investment management and industry engagement.

Why is ESG important for investors? ›

According to Smith, ESG investing assumes that there are certain environmental, social and corporate governance factors that impact a company's overall performance. By considering ESG factors, investors get a more holistic view of the companies they back, which can help mitigate risk and identify opportunities.

How do ESG funds work? ›

ESG funds are portfolios of equities and/or bonds for which environmental, social and governance factors have been integrated into the investment process. This means the equities and bonds contained in the fund have passed stringent tests over how sustainable the company or government is regarding its ESG criteria.

What are the ESG goals? ›

Environmental, Social and Governance (ESG) goals are objectives set within a business in order to direct and actively manage the organization's impact on society and environmental sustainability.

What is the difference between impact investing and ESG? ›

ESG looks at the company's environmental, social, and governance practices alongside more traditional financial measures. Socially responsible investing involves choosing or disqualifying investments based on specific ethical criteria. Impact investing aims to help a business or organization produce a social benefit.

How do private equity funds work? ›

Private equity is defined as capital that is not listed on a public exchange and is composed of funds and investors that directly invest in private companies. Private Equity funds invest in businesses that are more established, usually with some profit history.

What is sustainable investing and how its connected to ESG? ›

Sustainable investing balances traditional investing with environmental, social, and governance-related (ESG) insights to improve long-term outcomes. In many ways, sustainable investing can be seen as part of the evolution of investing.

How ESG engagement creates value for investors and companies? ›

Beyond the clarification of investor expectations, engagement allows companies to manage investor impressions of them. For instance, engagement can be used to convey a more accurate picture of company positions in ESG-related controversies, than that which may be portrayed in the media.

What is ESG example? ›

Carbon emissions. Air and water pollution. Deforestation. Green energy initiatives.

Who is responsible for ESG in a company? ›

ESG is already a part of each board member's fiduciary obligations to stockholders and those obligations may not be delegated to others. Boards have two principal fiduciary duties that implicate ESG: the duty of care and the duty of loyalty.

Videos

1. Can Private Equity Firms Meet Responsible Investing Expectations? | Claudia Zeisberger
(Professor Claudia Zeisberger)
2. How ESG Metrics Work And Why All Investors Should Care
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3. What is ESG? Private Equity, Venture Capital & ESG
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4. Ep. 15 - John Goldstein: Achieving ESG goals with Impact Investing
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5. Episode 1: What Does Sustainable Finance Mean? | Sustainable Finance | SDGPlus
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6. ESG Investing: Challenges & Opportunities for Private Equity Funds & Asset Managers
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