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How private equity can optimize ESG to maximize value creation

Photographic portrait of Chase Jordan
Chase Jordan

EY Global Private Equity ESG Leader

Contributors

5 minute read 12 Nov 2024

Sustainable value creation in PE depends on evolving ESG into a fully integrated practice in order to unlock superior financial returns.

In brief
  • ESG is a critical tool for leading private equity firms to enhance deal-making processes, optimize value creation strategies, and improve exit opportunities.
  • EY analysis shows that funds with advanced ESG practices realize an internal rate of return (IRR) up to eight percentage points greater than competitors.
  • To maximize returns, ESG should be fully integrated into all operations, shifting from a compliance tool to a cross-functional value creation enabler.

Societal impact drives stronger financial outcomes, creating value that compounds across the investment cycle. In the long run, private equity (PE) will be better placed to deliver its strongest results when societal and shareholder value are treated as one.

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Today, a growing majority of funds have incorporated environmental, social and governance (ESG) principles into their deal-making and value creation playbooks, recognizing ESG as a relevant driver of financial performance.
 

A recent EY-Parthenon study shows that funds that are excellently positioned on ESG can realize an internal rate of return (IRR) up to eight percentage points higher than their competitors.


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 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. Strategic fund-structuring

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.


In tandem, investor relations teams have an opportunity to create value by working in lockstep with ESG teams to develop transparent fundraising documentation outlining investment strategies, ESG objectives and risk factors, to ensure accountability, investor confidence and alignment between the GP and limited partners.

Actions to consider: Develop comprehensive private placement memoranda outlining ESG strategies; develop dynamic fund structures bespoke to individual investors; establish dedicated ESG committees; and implement robust ESG reporting frameworks.

2. Incorporate ESG into assurance work

Incorporating ESG into all assurance processes, not just tax, legal and accounting practices, helps firms gather data to comply with regulatory requirements while capitalizing on ESG-related incentives – a strategy leading companies are adapting to reduce costs and maximize EBITDA by aligning financial and sustainability goals.

Actions to consider: Conduct comprehensive ESG tax audits and develop strategies to manage carbon liabilities.

3. Full investment cycle integration

Incorporating ESG into deal origination and due diligence ensures firms can understand the market landscape, assess risks, and identify opportunities for post-acquisition value creation from the start of a transaction’s lifecycle.

As managers’ focus shifts from deploying capital to harvesting returns, funds have the opportunity to prioritize developing a robust ESG strategy. While all PE investors have an ESG equity story, funds that are able to maximize the upside potential are those that continuously refine and enhance it throughout the holding period - a mission-critical step to ensure all your value creation efforts are fully rewarded, particularly when engaging with ESG-focused buyers.

Actions to consider: Embed ESG into origination and diligence; create a comprehensive 100-day plan for integrating ESG strategy; develop a robust ESG equity narrative; and engage early with ESG-focused buyers.


Summary 

Successfully navigating between both shareholder and societal value is paramount if PE funds are to optimize financial performance.

Classic deal-making lenses of tax, legal, financial, and commercial diligence will benefit from incorporating a sustainability angle, as well as the incorporation of ESG factors such as carbon emissions into assurance exercises. Leading firms will integrate a holistic ESG strategy across the entire fund operation and investment lifecycle, from fundraising and ESG due diligence to value creation and exit readiness, to protect the future of their business and maximize returns.

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    About this article

    Photographic portrait of Chase Jordan
    Chase Jordan
    EY Global Private Equity ESG Leader
    Sustainability pragmatist who helps align profits with purpose. Advisor to Private Equity and their portfolios. Amateur chef and professional foodie.

    Contributors

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    Private equity

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