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Investors, asset managers and ultimately all of us are becoming more and more focused on Environmental, Social and Governance (ESG) related issues. This translates to a higher focus on the way companies run their business and the impacts they trigger on people and the environment. As a result, ESG investments has seen tremendous traction, amounting to USD 30 trillion today, increasing by 68% since 20141.
What about Private Equity: is ESG a “must-have”, a side marketing instrument, or a contributor to value creation? In other words, is ESG really creating net financial value, or should it be regarded as a net cost to pay to satisfy a certain segment of the investor population?
ESG: a financial value creation driver?
ESG intentionally emphasizes a company’s commitment to creating enduring, sustainable value. As with any transformational strategy, it is not centered around immediate or upcoming profits but on sustainable long-term growth. Hence, embracing an ESG-oriented approach should confer a competitive advantage for those companies that opt to prioritize it over the long haul, due to the value creation and the positive change it ultimately brings forward.
As per the NYU/Rockfeller’s Asset Management paper2, in which over a thousand studies on ESG published between 2015 and 2020 have been aggregated, 58% of the analyzed corporate studies showed a positive relationship between ESG and financial performance (such as return on equity, return on assets, or stock price), 13% showed a neutral impact, 21% mixed results (the same study finding a positive, neutral or negative results) and only 8% showing a negative relationship.
Another study showed that companies that rank higher on ESG metrics have outperformed the market by up to 3% per year over the period 2015 to 2019.
It also demonstrated a positive impact on talent, which is instrumental in fueling growth given the current “Great Resignation” trend: according to the New York Times, employees in purpose-driven companies are 1.4x more engaged and enjoy 1.7x more job satisfaction. These employees are also 3x more likely to stay at their company3.
What about Private Equity?
First of all, despite an image widely spread during the 80s of PE firms as aggressive corporate raiders, the majority of such firms actually strive to enhance the performance of the companies they acquire by implementing stronger corporate governance.
When ESG initially gained popularity, most PE firms considered ESG and sustainability related issues from a risk management perspective. In the first years, greater weight was given to whether negative ESG criteria could lead to reputational risk and/or risks of fines, lawsuits, and therefore value destruction. Recently, a shift has been witnessed, as PE investors are now looking at ESG as a key value driver.
In Europe, nearly half (47%) of Private Equity managers (“General Partners”, usually referred to as “GPs”) now address climate change through ESG policies, a 13% increase over the previous year3! Blackstone for instance, the PE investor with the largest amount of dry powder in 2022 (approximately USD 44 billion), is already planning to reduce emissions in new acquisitions by 15%4. In addition, according to the Principles for Responsible Investment network (PRI)5, the count of Private Equity and Venture Capital GPs who have joined the network has increased fourfold in the last five years, reaching a current total of 1,090. Currently, nine out of the top 10 global GPs are affiliated with PRI.
However, if the industry is committing to net-zero objectives, this is still primarily achieved through sector screening and selection, not through the transformation of existing assets. Furthermore, some funds are at the same time still targeting high-emitting assets in order to boost returns.
Still, 87% say they consider ESG factors in order to decrease investment risk and potential litigation, and 60% of Private Equity investors (“Limited Partners” usually referred to as “LPs”) say that their ESG investment strategy has had a positive impact on investment returns6.
Private Equity firms are currently facing challenging fundraising conditions, with LPs constrained in their ability to make new commitments and closely scrutinizing managers' abilities to perform well in turbulent markets. In this cash-constrained environment, the question arises: will ESG considerations become crucial differentiators or lose significance as LPs and GPs prioritize returns above all else? Early indications suggest that ESG remains overall a critical factor in GP selection and that European LPs are still prioritizing sustainability and incorporating ESG and diversity and inclusion (DE&I) into their due diligence process. A survey conducted by INSEAD's Global Private Equity Initiative7 revealed that 90% of LPs consider ESG in their investment decisions, with 77% using it as a criterion for selecting GPs. Lastly, many LPs are developing more sophisticated approaches to evaluate the GPs' ESG capabilities and are even assisting them in improving their practices.
This LP appetite in ESG and the positive correlation with improved returns are thus overall pushing GPs to become more knowledgeable when it comes to ESG concepts and their concrete implementation. This comes with increased support from advisory firms, covering broad sustainability topics as well as more expert niche areas, such as taking ESG into account in tax policies as part of good governance and transparency disclosures.
The energy transition has also been an important point of attention for PE firms and, according to PitchBook8, PE firms are increasingly focusing their investments on the energy transition and clean industries segments. For instance, some PE firms are embracing the energy transition and contributing to the financing of the carbon-tech ecosystem.
Two concrete examples are the Blackstone’s USD 1.4 billion acquisition in 2021 of Sphera, a software as a service provider that helps companies manage ESG data9 or the USD 1.3 billion Euro Global Social Impact Fund launched by KKR in 2020 pledging to invest in businesses that address social and environmental problems10.
In addition, as firms see increasing demand to diagnose the sources and volume of carbon they emit, companies creating technology and services to collect and organize this data should prosper. As such, carbon-tech companies like Persefoni and Watershed have raised almost USD 170 million over the last two years to fund the expansion of software platforms that help companies to achieve carbon transparency across their value chains and to report their data accordingly11.
Increasing interest from investors and stakeholders will continue to incentivize Private Equity managers to adopt ESG criteria in their investment management strategies and planning. In addition, the evolution of new technologies, regulation and standardization will help drive ESG adoption and support firms in incorporating a sustainable investment approach into their playbooks12.
Even if not all PE managers will embrace ESG, PE firms collectively hold an estimated USD 1.96 trillion in dry powder ready for investment as at end of 2022; this substantial financial clout positions the PE industry as a potent player in the realm of ESG13, capable of generating value for society.
1 "Five ways that ESG creates value », McKinsey quarterly, November 2019
2 “ESG and financial performance: Uncovering the Relationship by Aggregating Evidence from 1,000 Plus Studies Published between 2015 – 2020”, NYU Stern Center for Sustainable Business
3 “ESG and Private Equity”, OWL ESG
4 “Our Next Step in ESG: A New Emissions Reduction Program”, Blackstone
5 Principles for Responsible Investment is a United Nations-supported international network of financial institutions whose goal is to promote the development of a more sustainable global financial system.
6 “ESG and Private Equity”, OWL ESG
7 Private Equity Should Take the Lead in Sustainability, Harvard Business Review, July 2022
8 “PE powers into Europe's renewable energy sector”, PitchBook, July 2022
9 “A Private Equity Lens on the Energy Transition”, Bain & Company, February 2023
10 “Our Next Step in ESG: A New Emissions Reduction Program”, Blackstone, September 2020
11 “A Private Equity Lens on the Energy Transition”, Bain & Company, February 2023
12 “Private Equity embracing environmental, social & governance”, infor.com, March 2021
13 “Global private equity dry powder approaches $2 trillion”, S&P Global Market Intelligence, December 2022