Private equity firms are harnessing the ESG premium

Private equity firms are focusing on data to help tell a convincing story on ESG.

Three questions to ask

• If PE firms make a commitment to ESG, will it be a competitive advantage?
• Why is explaining the value of ESG to a company so important in ensuring success in ESG value creation?
• Where is the ESG value uplift going to come from and how will it be measured during an exit?

In the February 2023 issue of the Private Equity International Responsible Investing report, Will Rhode, EY Global Private Equity ESG Leader, and Winna Brown, EY Americas Private Equity ESG Leader, answer seven questions about how private equity can harness the ESG premium and ensure success with ESG value creation.

Q. Why is it important for PE firms to make commitments around net zero and other aspects of ESG?

Rhode: Climate-related risks are a focal point for the majority of investors, consumers, lenders, management and employees. This trend is growing. Over the longer term, the adoption of a systematic approach to ESG will prove to be a competitive advantage by virtue of the value that’s created. Firms that are ahead of the curve will benefit in contrast to those that remain less committed.

At present, the pressure on climate comes from the LPs, who may have made their own net-zero commitments. They are looking for private equity funds to show they are aligned to their climate agenda. But beyond climate, ESG is important because PE firms, by virtue of the vast size of their capital holdings and their ability to steward their portfolio companies, represent an incredibly powerful lever for positive change. PE firms have an advantage, and flexibility in how they approach ESG. They have the ability to be rigorous in how they execute on their strategy, because they have the opportunity to think flexibly about what they want to do before they make any explicit commitments. 

Q. What are the key trends around ESG due diligence?

Brown: Just two to three years ago, most PE firms looked at ESG and sustainability-related issues largely from a risk management perspective. There’s been a key paradigm shift, wherein PE investors are now looking at ESG as a key value driver - and that process begins in the diligence phase. ESG is becoming a key focal point for deal teams in addressing the growing mandate from investment committees, certainly in Europe, and we are also starting to see that in the US. Deal teams are looking for an integrated approach, where ESG diligence zeroes in on the financial implications of an ESG dimension on the performance of a company.

As ESG impacts are sector specific, it is essential for firms to have that sector expertise. There is so much change right now, in terms of decarbonization, transition pathways and the technology that is enabling ESG, so teams need to have a perspective on the sector-specific transition pathway.

Finally, there are groups that are developing models that integrate the cost of carbon into EBITDA, or consider the positive correlation between improved ESG scores on deal multiples. Others look at how ESG risks connect to broader strategic issues, such as the cost of energy, and ability to access lower-cost renewable energy sources. That means thinking about ESG, not just in terms of it being an opportunity or cost, but also in the context of deal underwriting. It will be amazing to observe how this evolves over time.

Q. How can PE firms ensure success with ESG value creation?

Brown: The first 100 days are crucial, as with any value creation process. It is important for PE firms to focus on some key ESG themes such as operating model mobilization, decarbonization strategies, supply chain challenges and – especially in the US – DE&I and pay equity. Establishing a process needs to be front of mind. ESG capabilities within the portfolio company should be formalized and the right governance structures need to be in place, to ensure the company will collect, monitor and report on their ESG data.

PE firms also need to consider that portfolio companies have different levels of maturity when it comes to ESG and therefore be prepared to help the portfolio company understand these ESG requirements – which may be quite new to them. What we have found in speaking with both PE firms and management teams, is that it helps to take the time to walk the company through why ESG is a priority and how it can help to create value. If the companies don’t understand why ESG matters, then they are never going to be fully onboard. Working alongside them and bringing them on the journey goes a long way.

Q. In terms of ESG reporting, what are the key considerations for GPs?

Rhode: Reporting is a key aspect of how a PE firm engages with its stakeholders. LPs want to know what PE firms stand for when it comes to ESG. They may want to split their investments to cover different elements of ESG, so it’s important for them to be able to understand what a PE firm is driving at from a value-creation point of view.

LPs also want to see clear frameworks and policies to protect against greenwashing and reputational risk. When it comes to demonstrating performance, there is a move toward reporting sector-specific ESG KPIs. That means, instead of looking at overall ESG scores or ratings, the PE firm helps companies within a specific sector to work toward KPIs that are most materially relevant.

Reliable data is key to help a PE firm ensure it has good provenance on the metrics that are being monitored and measured. As ESG increasingly becomes core to the value creation narrative, ESG indicators will have to be of the same veracity as financial figures if they’re going to deliver on their promised value. GPs therefore need to make sure on the quality of the data that is being gathered for ongoing reporting purposes.

Also, standards are evolving and becoming more detailed over time, so it makes sense to have a scalable approach on reporting against the most important ESG themes. There are multiple standards that require, for example, carbon performance data. You don’t want to have to reinvent the wheel on every report, so operationalizing reporting capacity according to theme needs to be the focus.

Q. What are the main challenges in collecting ESG data?

Brown: Understanding the type of data that needs to collected is critical. Are you focused on absolute data, like absolute emissions data or hazardous waste generated? Or is comparable data, like emissions intensity, for peer comparisons more relevant? Maybe specialized data, with forecasts and adherence to industry standards, is the most important lens. Broadly, what are the metrics and KPIs that you are going to report on and what is the equity story that you are looking to tell? These are the baseline considerations.

A portfolio company also needs to have people that are trained and understand what they are looking for, so they can get the data in a timely and consistent manner and guarantee its quality and integrity. That can be a challenge when there is a lack of experience and bandwidth in the portfolio companies. So, to operationalize good data collection, the PE firm should assess whether the portfolio companies have the scale, people, processes and necessary technology solutions in place.

Q. To what extent is it possible to benefit from an ESG premium on exit?

Brown: EY did a PE divestment study and found that nearly three-quarters of PE firms expect to capture an ESG premium in the businesses they are selling. The big question is where that ESG value uplift is going to come from and how it is going to be measured. You can do great things on ESG, but if you are not measuring it, reporting it, and talking about it, you are not going to get the credit for it. Firms need to be smart about how they crystallize the premium and ultimately increase shareholder value.

Because the hold periods are short, it is especially important for PE firms to get up and running quickly and to be clear on how they present their ESG value-creation strategy. Firms need to be able to capture both the tangible and the intangible benefits of their approach to ESG. If they have focused on climate change, for example, they need to be able to explain how helping emission-intensive assets to adopt a path toward decarbonization is going to return higher multiples. Data is also going to be key – when you are on the receiving end of ESG due diligence at exit, you want to be able to make sure you can demonstrate your achievements.

Q. Given that ESG is becoming more widely practiced, is it still possible for firms to differentiate themselves with their approach to ESG?

Rhode: PE is on a journey when it comes to ESG; and while it’s not yet fully integrated into the investment process for many firms, we think that PE is differentiated as a financial services actor compared with other financial services firms. 

They’re in a position to influence and steward the transition to a sustainable future and they have a broad range of options when it comes to deploying capital. This gives them an advantage versus other types of financial services firms that are more limited in the types of financing they provide and for what purpose. PE is able to direct capital in a focused way towards a specific ESG objective and with more control over the outcomes.

From a product perspective, PE firms can establish a reputation for managing thematic and impact funds that can create lasting change. Especially around impact, they have the ability to grow companies that will meet the needs of the sustainable future, such as those that enable the “brown-to-green” journey.

It’s an exciting time in PE, where firms are embracing the opportunity to create shared value with society. But in order to achieve that vision, transparent frameworks and policies have to be in place. Firms must be able to demonstrate they have the ability to systematically collect reliable data, so that everyone is confident in how the firm is investing, and that the value creation potential of ESG – in all its forms – is fully realized.