In recent years, there has been a significant shift in the world of private equity (PE) deals as ESG (Environmental, Social, and Governance) and Sustainability considerations have emerged as key drivers influencing investment decisions.
Historically, PE deals were primarily focused on driving fast financial returns through clever financial engineering. When the debt markets dried up following the Global Financial Crisis (GFC) the emphasis shifted to driving value through digital transformation. This still remains a key driver but now it has been superseded by a stronger focus on more long-term sustainable objectives, as investors and companies are today using sustainable investments to drive financial performance.
ESG and sustainability, The North Star of value creation
PE Investors and their companies are becoming more aware of their responsibility to tackle some of our global challenges in regards to climate change and start integrating ESG and Sustainability in the core of their strategy and portfolio companies, as they see a strong correlation with value creation, and premium in valuation at exits.
What is ESG versus Sustainability or Responsible Investing?
For the uninitiated, ESG is a framework that allows investors to assess and integrate environmental, social, and governance factors to de-risk their investments in companies and create long-term value during the entire investment period.
ESG themes help review materiality risks of investments against the financial, reputational, and regulatory impact it might have on the business and wider stakeholders. ESG doesn’t integrate profitability considerations as it treats the non-financial and financial aspects separately and doesn’t look at how they drive better performance for companies. Responsible investing goes a step further and looks at how investments can deliver financial returns as well as measurable positive impact for the environment and society.
Hence, Investors and companies are today acknowledging that ESG, sustainability and profitability are not mutually exclusive, but rather interconnected facets of successful businesses and are key to long-term value creation.
So, what factors are driving this shift towards ESG and Responsible investing?
After all, the elegant simplicity of the private equity model, focused on return on investment (RoI) is something that I have always loved, and I particularly enjoy that PE investors today also use their investments to tackle some of the key challenges around climate change, inequality or diversity while proving that both financial returns and impact can be complementary.
As I see it, these are the key drivers of this shift:
- ESG and Sustainability as a Differentiator
In the fiercely competitive landscape of private equity, ESG & Sustainability have emerged as crucial differentiators. Investors are increasingly aware that embedding ESG in their portfolio can enhance a company’s long-term growth potential, resilience, reputation and ability to attract the best talent. Furthermore, companies with robust ESG practices often demonstrate better risk management, operational efficiency, and innovation capabilities, thereby positioning themselves as more attractive investment targets with consequently higher valuations. - Changing Investor Expectations
The World’s largest investors (LPs), including Pensions, Sovereign funds and Endowments are increasingly concerned about the global impact of climate change and inequality and are demanding greater transparency and accountability on ESG matters from the PE funds they back[1]. They are scrutinizing the impact of their investments beyond financial returns and are nowadays far more committed to aligning their portfolios with measurable sustainable outcomes. As a result, they demand private equity firms to incorporate ESG metrics and Sustainability practices into their investment strategies and portfolio companies, if they want to retain capital from them. - Shifting Regulatory Environment
Regulatory bodies around the world (The EU’s SFDR Taxonomy, the roll out of the TCFD-related disclosures in the G7 economies) are recognising the importance of ESG disclosures regimes and implementing frameworks to encourage its adoption. Governments are enforcing stricter environmental regulations, promoting social equality and diversity, and emphasizing corporate governance standards. Private equity firms must navigate these evolving regulatory and compliance landscapes, leveraging ESG and sustainability as a value-creation tool rather than a mere box-ticking exercise. - Driving Value Creation
ESG and sustainability considerations are no longer just about regulatory requirements or risk mitigation but also present opportunities for value creation and driving better financial and societal returns. By integrating sustainability initiatives early, private equity firms can unlock operational efficiencies, enhance brand value, reduce reputational risks and tap into new market segments such as: energy transition, climate tech, education and healthcare and other innovative responsible businesses that can generate attractive financial returns while delivering positive impact for People and the Planet.
What are the best-in-class PE leaders in ESG and sustainability doing differently?
The best PE firms have an active ownership style, with a sustainability team working closely with the investors and portfolio companies to support them embedding sustainability early in their portfolio companies. This is achieved in the following ways:
- The integration of ESG factors early in due diligence from onboarding all the way to exit
- Increased transparency in the reporting of ESG metrics and sustainability performance for their portfolio companies and at the level of the Fund, often sharing best practices with their peers
- The use of KPI metrics to follow their portfolio journey on ESG
- The collection of data on their own decarbonization efforts or net zero pledges and active tracking of their progress and their portfolio against these datasets
- The growth and development of ESG capabilities of their teams and portfolio companies through the recruitment of impact leaders and investors who have a solid understanding of ESG issues and sustainability skills
Conclusion
The increased integration of ESG and sustainability factors into PE deals marks a transformative shift in investment practices. As investors have increasingly recognised the correlation between sustainability and profitability, ESG considerations have become a key driver in deal-making decisions. Businesses that successfully incorporate ESG & sustainability today gain a competitive advantage, attract more capital, better talent, and position themselves for long-term success.
Having been a professional investor for much of my career, focused on impact investing, I am now relishing the challenge of helping our clients find ESG leaders for their investment teams and for their portfolio companies. Ultimately, the rise of ESG and responsible investing in private equity deals represents a massive positive shift for all of us as it delivers better returns for both investors, society as a whole, and the planet each of us inhabits for only a short while.
[1] recent survey of LPs by INSEAD’s Global Private Equity Initiative found that 90% of them factor ESG into their investment decisions and 77% use it as a criterion in selecting general partners