Why does ESG matter for private companies?

In order not to exclude themselves from funding opportunities, private companies must make ESG reporting a part of their long-term strategy.

In brief

• Private companies need to cater to the demands of public shareholders which are increasingly focused on environmental, social and governance (ESG) factors.
• Regulatory changes, funding requirements, and commercial longevity are the three key factors for ESG reporting and compliance.
• To support key stakeholder relationships such as that with customers, employees, and communities, it is critical for private businesses to put in place a genuine ESG narrative.

One of the advantages of a private company structure is greater autonomy over governance. Theoretically, the burden of bureaucracy is less on private companies compared to their publicly listed peers, which allows them to be nimbler. Also, private companies need to cater to the demands of public shareholders which today are increasingly focused on environmental, social and governance (ESG) factors. But then why should owners of private companies care about ESG in the absence of such external pressures?

Three key factors became more apparent in 2021 which suggested why ESG reporting is imperative for private businesses.

1. Regulatory changes: The assumption that only listed companies will be subject to increasing ESG regulation is outdated. For example, forthcoming EU ESG regulations such as the Corporate Sustainability Reporting Directive (CSRD) and the EU Taxonomy Regulation will impact large private companies¹ by 2023, with their scope expanding to include all small and medium-sized enterprises (SMEs) by 2026.

The indirect impact of the regulations should also be considered as it impacts business relationships with listed customers and suppliers. The requirement for ESG data disclosures, especially climate-related information, will only continue to grow. As an example, all large UK companies² are expected to comply with Taskforce on Climate-relate Financial Disclosures (TCFD) by 2022, which, in turn, may require them to request carbon emissions data from their supply chain partners (i.e., Scope 3 emissions).

2. Funding requirements: ESG is now part of the lexicon of most private fund providers ‑ from private equity to debt and beyond. According to the Pitchbook 2021 Sustainable Investment Survey, 81% of general partners are either already evaluating ESG risk factors or will be turning their focus more to ESG risk factors in the near term. The integrity and diligence of such ESG reviews pre investment may vary. However, private companies should, at a minimum, have an ESG narrative developed in order not to exclude themselves from funding opportunities.

While most PE firms include ESG as a non-financial risk to review investment decisions, some also embrace ESG as a tool to identify opportunities for value creation during the deal life cycle. Ensuring that ESG, in all its forms, is adequately addressed and integrated into a company’s long-term strategy can help maximise exit value, compete for capital against listed peers and align with the increasing listing requirements. In 2021, more than 50% of the global stock exchanges published ESG reporting guidance compared to 15% in 2015.

3. Commercial longevity: In a rapidly evolving world, where the operating landscape can quickly shift by the emergence of pandemics, climate disasters or social disruptions, a focus on ESG can help mitigate future risks. Developing a genuine ESG narrative can support key stakeholder relationships such as that with customers, employees, and communities. There will be some elements of that narrative that will drop down to the immediate bottom line or profit (i.e., short-term expense), while others will relate to the cost of capital or the ease of doing business over the long-term. However, applying an ESG lens can help reorient the focus from short-term to long-term value creation measured not just by profits, but also by environmental and social value.