ESG for Private Equity: A Primer
Environmental, social, and governance, or “ESG,” describes three categories of non-financial factors that are indicative of corporations’ ability to manage risks and opportunities arising from their relationships with key stakeholders and the environment. While the term “ESG” was introduced in 2004, the concept that a portfolio company’s exit value is influenced by ESG factors such as public reputation, labor relations, dynamic customer preferences, resource optimization, and resiliency to environmental change is longstanding. ESG provides investors with a suite of environmental, social, and governance criteria to determine how well-positioned their investments are to mitigate ESG risks and optimize business performance through ESG opportunities.
ESG is often conflated with impact investing, socially responsible investing, and corporate social responsibility. This is a misconception, as ESG functions primarily as a tool to evaluate companies’ ESG risk and opportunity management, not as a certification of a company’s sustainability, positive impact, or social responsibility. Therefore, while ethically motivated investors may prefer ESG because it identifies adverse corporate impact, ESG provides objective operational analysis; how investors respond to ESG insights is their prerogative.
Drivers of ESG Adoption in Private Equity
The most significant driver of ESG adoption within private equity is limited partners’ (LPs) growing preference for ESG-conscious investing. According to a 2022 study by Bain and ILPA, over two thirds of LPs have integrated ESG into their investment strategy. Further, 80% of LPs plan to increase ESG reporting requirements for General Partners (GPs) in the next three years. Not only do LPs prefer to allocate to funds that consider ESG, but a lack of ESG consideration can be prohibitive to an investment; a June 2022 survey by Prequin found that 25% of LPs surveyed have already turned down an investment opportunity due to ESG concerns.
In addition to LP preferences, there are three key forces pushing ESG forward in PE:
1. Change in social values
Increasing societal interest in ESG factors is trickling up to LPs through their beneficiaries. More than a third of consumers globally make purchase decisions influenced by ESG factors, and over one third of U.S. consumers are willing to pay a premium for more sustainable products and services. As consumers themselves, LP beneficiaries mirror broader consumer trends, and as a result, LPs are adjusting their investment strategies to satisfy preferences for ESG.
2. Increased recognition of ESG impact on business performance
As the impact of poor ESG management (e.g., customer loss due to data privacy concerns, decreased employee efficiency due to high attrition) become more frequent, public, and costly, institutional investors have begun to recognize that ESG criteria are important to portfolio companies’ bottom line. Subsequently, institutional investors responsible for generating sustained returns over time have prioritized ESG to avoid losses from investing on the wrong side of societal, technological, and environmental transitions. In fact, ~90% of the largest public pension funds and sovereign wealth funds, representing over $700B in PE assets, have already incorporated ESG into their investment strategies.
3. Ties to financial returns
While there is little public data on the influence of ESG on private fund performance, data from the public markets supports the hypothesis that companies that incorporate ESG may outperform peers that do not. Most recently, a 2021 NYU Stern meta-study of over 1,000 financial studies found a positive relationship between ESG and financial performance in ~60% of studies, with less than 10% of studies demonstrating a negative relationship. The Stern study also found that equities employing ESG strategies outperformed their conventional counterparts during the economic downturns of 2008 and 2020, indicating that ESG provides downside protection during periods of recession.
How Private Equity Firms Can Incorporate ESG
Regardless of the driver(s), a growing majority of LPs are considering ESG in their allocation decisions, and GPs must incorporate ESG into their investment strategies to maximize access to capital and remain competitive when fundraising. In fact, of the over five thousand PE firms worldwide—double the number of firms from a decade ago—nearly half (42%) of private capital under management is managed by firms with ESG commitments. As a multitude of prospective buyers compete for allocations, an investment strategy that integrates ESG positions firms to compete for capital more effectively.
The first step in positioning a PE firm to address ESG risks and opportunities is to develop an ESG strategy; notably, developing an ESG strategy is the most common GP requirement for ESG-conscious LPs. While GPs may consider developing a boilerplate ESG strategy to satisfy LP demands, creating a tailored ESG approach is more valuable. A bespoke ESG strategy allows GPs to ingrain ESG within their investment thesis, leverage ESG to drive value throughout the investment lifecycle, and integrate ESG into internal processes. Once a firm’s leadership implements an ESG strategy, GPs should distribute the strategy among its investment professionals to ensure awareness of ESG and industry-specific considerations. ESG consultants such as Malk Partners can provide trainings to develop firms’ internal ESG knowledge.
Integrating ESG into the Investment Process
For GPs interested in maximizing the benefits of ESG, the most effective ESG programs operationalize their strategy by integrating ESG within due diligence, portfolio company management, and investor reporting. ESG is impactful when applied to due diligence, particularly pre-sign, as it is inclusive of a broad range of operational risks (e.g., legal, environmental, IT); it also identifies material “red flags” that could lead to challenges during the hold period. Further, ESG diligence identifies risk mitigating and value creating recommendations that can lead to additional revenue streams, increased customer loyalty, and heightened employee retention rates. Post close, GPs can protect and drive investment value by addressing ESG findings identified during diligence and monitoring ESG performance over time. Additionally, ESG metrics, such as GHG emissions and diversity, can be incorporated into investor reports and help fulfill LP requests for ESG data.
As ESG becomes increasingly important to consumers and investors, ESG integration is likely to become a key determinant of success for GPs in raising funds from ESG-conscious LPs and delivering high returns. By integrating ESG into their investment process, GPs can raise funds, protect their investments, and increase exit value. The question is no longer whether ESG factors are impactful, but how they impact a firm’s portfolio.
Malk Partners does not make any express or implied representation or warranty on any future realization, outcome or risk associated with the content contained in this material. All recommendations contained herein are made as of the date of circulation and based on current ESG standards. Malk is an ESG advisory firm, and nothing in this material should be construed as, nor a substitute for, legal, technical, scientific, risk management, accounting, financial, or any other type of business advice, as the case may be.