By: Bruce Martin, CPEA
Institutional and portfolio investors, limited partners (LPs), and private equity firms’ investors are moving beyond an awareness of the environmental, social, and governance (ESG) programs of the portfolios and private equity firms with which they invest. While investors have been voicing concerns about sustainability and ESG issues for several decades, conditions have changed dramatically over the past several years as awareness of topics including climate, energy efficiency, labor practices, and other ESG concerns has exploded. Although many portfolio investments and private equity firms have been moving toward awareness of ESG factors, the progress has generally been slow. Investors, however, have been undeterred by this lack of progress and are expected to continue pushing for more ESG-focused investing.
Given this interest, a growing number of private equity firms are seeing that building ESG standards into their investment strategies is becoming an essential strategy for continued success. More importantly, as social and environmental issues increasingly affect business conditions, there is growing evidence that ESG programs can actually improve returns and limit risk.
The Scope of ESG Issues
ESG is a term used by investors to describe how they evaluate non-financial performance indicators. Though ESG is a broad concept with no standard definition, most can agree that it covers a wide range of issues ranging from climate, waste management, and traditional environmental risks to the social and governance topics that impact all industries including labor practices, responsible sourcing of materials, and fair employment issues.
The Growing Importance of ESG
The importance to investors on how a company manages ESG issues continues to grow. Since 2012, the number of signatories to the UN-supported Principles for Responsible Investment has grown from 1,050 to almost 2,400 funds, a group that controls a staggering $86 trillion in capital. Those funds have committed to principles that include a pledge to incorporate ESG principles into how they choose and manage investments.
According to a 2019 survey of investors by Private Equity Real Estate, 78% of LPs consider ESG factors when selecting a private equity fund to invest in, but only 19% of general partners’ (GPs’) investments strongly reflect their ESG policies.
The trends indicate that the message from investors is clear: incorporating ESG standards into investment strategies and operating principles is an essential element for future success.
Developing an ESG Approach as an Essential Strategy
Developing and sustaining an approach to ESG for a private equity firm includes several considerations:
- Goals for how the firm intends to balance financial returns and ESG impact
- Plans for how those goals will define its investment approach
- Approach for how it will measure results and how it will communicate with stakeholders
ESG strategies should define specific operating changes within the firm and a timeline for implementation. The ESG approach should be applied throughout the investment value chain, from deal sourcing and due diligence to monitoring and realizing ESG goals during ownership.
Examples of a well-designed ESG approach include getting early warnings on ESG ratings for target companies, assessing companies’ track records on delivering on key ESG initiatives, or helping portfolio companies succeed by supporting them in developing sustainable procurement practices.
Measuring and tacking ESG performance can be difficult with so many variables. While many firms have developed their own methods of measuring ESG performance, there are several tools that private equity firms can use to assess and measure ESG performance.
- The Global Impact Investing Rating System (GIIRS) uses a tool called B Impact Assessment to provide an accounting of the portfolio’s impact on workers, customers, communities, and the environment.
- The Environmental Defense Fund’s (EDF) ESG Management Tool is a resource for private equity firms to make measuring and managing ESG performance a standard practice for value creation across their funds The ESG management tool provides a framework for private equity firms to assess and improve ESG management across their portfolio companies. For example, users of the tool can evaluate performance in areas such as access to ESG resources and integration of ESG management into the investment process and portfolio company operations.
While every firm should define its own unique ESG strategy based on its investment approach, culture, and stakeholder preferences, it is clear that no private equity firm can afford not to think about ESG.
During ownership, costs can be reduced using ESG principles by pinpointing areas where resource spending (e.g., energy, water) can be decreased and improved. For example, EHS Support is supporting clients in a variety of industries that are taking on projects that demonstrate a commitment to ESG progress, including:
- Focusing on reducing greenhouse gases through energy efficiency
- Implementing solar power options on their properties and facilities to reduce or eliminate their dependence on electricity from the grid
- Creating plans for water use reduction and increasing the quality of wastewater prior to discharge
- Focusing on efforts to manage and reduce contact and impact with stormwater
- Increasing community outreach and education on ESG initiatives
In addition, preventive measures can be put in place so buyers can avoid ongoing ESG risks such as environmental liabilities, employee health and safety issues, social and labor issues, and supply chain compliance, to name a few. Furthermore, portfolio companies can reach a larger customer base as U.S. consumers become more interested in sustainable products and practices.
Finally, having a strong ESG program in place allows private equity firms to communicate the proactive ESG risk-mitigating processes they have implemented over their holding period, enabling them to negotiate a premium upon divestiture. This is especially beneficial when selling to a public company that may already have ESG reporting requirements in place.