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ESG remains relatively underappreciated as a value creation lever for the private equity industry

AGEFI Luxembourg

By Shanu SHERWANI, Partner at Antwort. Published in the AGEFI Luxembourg Février 2022

For many institutional investors, having a solid ESG profile is a requirement. Most have committed to one or more international initiatives, such as the Principles for Responsible Investment or the Net-Zero Asset Owner Alliance, and thus must invest in or finance companies that adhere to those commitments.  The ripple effect extends to middle-market private equity and private credit firms and their present and prospective portfolio companies.

It is no surprise that the most recent discussion around private equity and the issues of environment, social, and corporate governance (ESG) has focused on reporting requirements and metrics as firms scramble to fulfil their investors’ increasing expectations on ESG compliance.  However, as ESG factors can affect valuations and deal pricing, private markets are paying even more attention.  Debt and equity investors may preferentially or exclusively treat ESG-strong companies, improve fund performance, more efficiently match ESG-inclined buyers with sellers, and lower capital costs.

For example, according to new research, sustainability has risen to the top of private equity companies’ decision-making agendas, although most dealmakers do not believe it adds significant financial value.

According to research conducted by Big Four firm KPMG, worries over environmental, social, and governance (ESG) problems drove nearly three-quarters of UK private equity companies to withdraw from a deal, rising to 90% for larger firms. However, only 4% of private equity firms questioned viewed ESG as a critical lever for creating financial value in a corporation.

Many companies are considering ESG aspects early in the transaction process, and if that assessment raises significant concerns, investors are more than willing to walk away. As a result, more than 90 per cent of the largest companies in the KPMG poll said they would not invest because of ESG performance worries. About 73 per cent of private equity companies have withdrawn from the market in the United Kingdom due to environmental, social, and governance (ESG) considerations.

According to the report, ESG is still «somewhat underestimated» as a value creation lever in the industry. I expect that to change as the benefits of ESG factors are better understood and become more integrated within valuations. Private equity firms must look beyond a traditional ‘buy and build’ approach as the industry’s socalled ‘value levers’ change, and I could not agree more.

The «buy & build» strategies, in which firms acquire a target company to make subsequent «add-on» acquisitions, remain an essential value creation lever for private equity firms. However, technology transformation is set to overtake «buy & build» as the third most crucial value creation lever in the next three years. According to KPMG’s analysis, data availability enables organisations to consider a broader range of value levers when negotiating deals.

Regardless of how the industry evolves, ESG has become a catalyst for transactions.  Simultaneously, as their materiality increases, ESG considerations are garnering increased attention in due diligence and contract terms.

Additionally, there is a heightened regulatory focus on ESG, as evidenced by the global adoption of reporting requirements (including in the United Kingdom, Japan, Hong Kong, and China) and European efforts to impose new corporate governance and risk management requirements on companies relating to ESG. While analytics and compliance are unquestionably critical, the private equity sector is overlooking a far more significant potential within our grasp: we can pioneer the development and dissemination of ESG best practices across global portfolios.

For starters, private equity suffers from a perception issue. It is well-known for its capacity to improve operational performance, particularly growth and productivity, which results in favourable returns for its endowment, foundation, and pension fund investors. Many believe that the flip side of such investing success is a mistaken notion that the asset class is primarily short-term oriented, ignoring evidence that many private equity managers invest in long-term value linked with ESG principles. Private equity ownership, in my opinion, is ideally positioned to accelerate the adoption of best practices while remaining true to the values of shareholders, management, and other stakeholders.

Private equity’s ultimate goal is growth, and M&A has an impact as well

Private equity firms seek to produce value upon exit, not upon investment. To earn a profit, they must construct a better firm than they purchased. For example, a lowcost structure alone (through optimising processes) is insufficient. Naturally, lower costs will enhance margins and provide some value. However, I believe that growth is significantly more valuable than profit, and thus, high-performing private equity owners attempt to raise the trajectory of development during their ownership time sustainably.

For instance, businesses must consider ESG concerns not just because they – or the companies they wish to purchase – may violate legislation but also because such violations may have a negative impact on their reputation or future performance.  Negative ESG issues — whether connected to environmental implications, board diversity, supply chain management, or other variables – can jeopardise deal certainty in M&A by affecting target valuations in previously unanticipated ways. They may also impair a transaction’s ability to obtain finance since lenders and investors focus on these difficulties.

Furthermore, millennials, the largest population group in the United States, will inherit more than $30 trillion from previous generations over the next few decades.  This largely progressive generation will contribute to developing an investing landscape that rewards companies that incorporate ESG into their business strategies.  This shift will impact portfolio company management, limited partners, general partners, and other stakeholders because the population of decision-makers will change as well.

Alignment between management and private equity stockholders. 

Transformations are usually complex and costly, affecting short-term income, and shareholders and management must remain aligned.  However, transitions rarely go according to plan; they are frequently altered by market and competitive forces.  Quality management will respond to these influences by changing their programs and activities nimbly, so reaching longer-term goals with less volatility in the immediate term. Since private equity shareholders are fewer and closer to management, they are better equipped to understand and support such mid-course modifications, notably on ESG implementations.

When it comes to disclosing ESG data and improving portfolio companies’ ESG performance, private companies can even act faster than their public counterparts.  Private companies are typically smaller, leaner, and less bureaucratic than large public companies. Many of these sustainability initiatives necessitate quick action on the company’s part.  To be honest, that’s more difficult to accomplish in a public company.

Private equity managers can integrate environmental, social, and governance considerations into their overall operational excellence strategy. 

Many private equity value-creation strategies include operational excellence, closely tied to ESG considerations. Limited and general partners alike can profit from investing in ESG as it stresses a company’s commitment to creating longterm value. It isn’t focused on next year’s revenues like any transformational plan.  However, an ESG journey is a story of growth through time.

Employing a responsible ESG approach can do more than just avoid reputational risks, resulting in the perception of an organised and managed firm worth more.  Companies can use ESG in the same way they use growth, productivity, and cost reduction. This might result in an ESGembedded value multiple, similar to how high-growth companies secure a growth multiple.

As transitional owners with a five-year hold tenure, some private equity companies believe they cannot impact ESG issues long-term. Private equity firms can, in my opinion, be positive change agents and engines for quick ESG implementation. In the next two decades, private capital may affect one-third of the global economy. That kind of scope and impact might significantly affect corporate strategy and execution.