While adoption is widespread, how groups are configured and what their mandate is varies greatly. Many firms still approach ESG primarily as a reporting exercise, focusing on nonfinancial metrics. However, the real opportunity lies in fully embedding ESG principles across the entire business to drive enhanced returns.
When we interviewed general partners (GPs) in a recent EY PE Pulse survey about how they are leaning on ESG as a value creation, less than one in three said they were looking at ESG holistically to drive deal metrics and a measurable return on investment (ROI). Too many well-intentioned firms are getting bogged down in the legalese of the latest regulations as opposed to engaging and challenging their portfolio companies to adapt.
With PE firmly in the era of operational improvements, ESG will continue to play an essential role in investee companies’ value creation strategies. To capitalize on such, funds should ask themselves whether they are approaching ESG in a way that unlocks its full potential.
To maximize financial returns, ESG must evolve into a fully integrated practice that permeates all operations from LP fundraising to exit planning.
The benefits of an integrated ESG practice
- Improved deal-making processes
When ESG teams are seen as separate entities, their value as potential deal accelerators can be overlooked.
Ensuring that ESG teams are fully integrated and aligned with deal teams from the outset allows for the early identification of investment opportunities that meet the ESG principles of the fund and have the potential to generate the highest returns relative to their risk profile. This integrated approach can smooth the process of sourcing and evaluating opportunities, shorten the timeline for dealmakers to execute opportunities ahead of competitors, and lead to more informed investment decisions and higher-quality deal flow, all of which can culminate in more competitive lending terms once targets have been identified and due diligence completed.
- Optimized value creation strategies
Investors recognize that companies with strong ESG practices can drive top-line growth by expanding their customer base; increase margins by reducing waste and cutting unnecessary product lines; and secure cheaper finance terms. The key question for sponsors is how to optimize these strategies to deliver the greatest ROI.
An integrated ESG strategy ensures that deal teams, operating partners and portfolio management maintain an “ESG on” mindset from day one, pursuing only those initiatives that will positively impact sales, profits and financing to strategically improve investee valuations and, ultimately, investor returns.
By setting clear ESG priorities up front, particularly in the 100-day plan, the flight path to value creation can be smoother and more direct. Maintaining a mission-critical focus enables all stakeholders to prioritize executing a few critical initiatives exceptionally well, thereby maximizing the impact of ESG on traditional value creation levers from the outset — a key factor that will separate market-beating exits from merely successful ones. ESG for portfolio companies can occur in supply chain transformation, grants and incentives from a tax review, or net new products and services.
- ESG as a route to superior exits
Acquirers increasingly value companies with robust ESG credentials, viewing them as lower-risk and higher-potential investments. By integrating ESG throughout the deal lifecycle and building a compelling ESG equity story, PE firms can position their portfolio companies as leaders in sustainability and social responsibility, a key differentiator that can attract a broader range of buyers and increase the competitiveness of auction processes.
Three actions to unlock the financial potential of ESG
To devise an integrated ESG strategy that incorporates all operations and maximizes financial returns, there are three actions that can help you prepare a return-maximizing ESG strategy.
1. Fund strategy and structure
Client needs are changing. Fund structures are becoming complex to accommodate specific investors, with separately managed accounts providing a unique opportunity for funds to develop a fundraising strategy that aligns with investor goals and ESG preferences. An increasingly important dynamic given the regionalization of ESG investor preferences – so to ensure buy-in across all stakeholders. This activates investor relations and legal teams as co-authors on an ESG strategy, not just required tactical support. The outcome of these close conversations can be a better private placement memoranda, ESG policies, and improved LP-GP reporting and transparency.
Actions to consider: Assess regulatory and commercial markets of comparable products, mapping LP ESG requirements across regions and archetypes; integrate legal advisors with investment operations specialists to test market appetite; develop private placement memorandum outlining ESG strategy, with optionality for separately managed accounts (SMAs).
