Private equity has become a powerful force for change in ESG, sustainability, and climate. It helps principal investors, and private equity funds create outsized value by integrating sustainability considerations throughout the investment cycle.
ESG is a source of differentiation for private equity funds and a way to create value. It has the potential to deliver lasting benefits. Funds at the forefront of applying ESG in private equity see significant financial returns from their investments, including more robust sales, lower costs, higher employee engagement, and superior valuations.
Fundamentals of Sustainable Investing
ESG is an acronym for Environmental, Social, and Governance (ESG) in PE. This means that potential investments are evaluated not only on their financial returns but also on the risk mitigation of their environmental impact, as well as social responsibility and governance practices.
ESG factors are historically a secondary consideration, if they even existed at all, in the investment decisions of PE firms. This trend has changed dramatically over the past few years, partly due to the new regulatory environment that favors sustainability and the associated business value. According to Principles for Responsible Investment report, more than 80% of private equity investment decision-makers now place ESG factors at the center of their decisions. This development reflects an increased understanding of ESG factors’ impact on long-term performance.
Understanding ESG in Private Equity
ESG is a set of criteria that evaluates a company’s performance, such as social responsibility, environmental impact, and corporate governance. Various factors have driven the integration of ESG principles in the operation of private equity funds.
1. Like other industries, private equity is subject to regulatory pressures to improve sustainability. ESG was introduced to the private equity sector in the early 2000s due to the climate change obligations imposed by governments that funded DFIs. The E in ESG has been the focal point of attention for a long time. Many fund managers also see ESG as an environmental program. Governments have gradually increased regulations around ecological issues. Investors are increasingly subject to laws that apply ESG principles.
2. Investors who are looking to have a positive impact on society through their investments are driving the trend toward responsible investing. It is often attributed to
the shift in values of post-baby-boomer generations. Most of these investments go into ESG-dedicated funds or portfolios, with a portion of the assets dedicated to ESG investing.
Some private equity industry has incorporated ESG principles in their operations, believing that they can mitigate risk and create value over the long term.
Why ESG Factors Matter in the Private Equity World
1. Guardians against Risk
The ESG factors act as vigilant guardians of risks. According to research, companies with poor ESG performances are more likely to experience financial distress than others.
2. Creating Value
Integrating ESG factors is similar to creating value. Companies that excel in ESG have better stock performance over the long term.
3. Investor Magnet
With 93% of impact investors giving ESG a thumbs up, prioritizing this factor becomes a powerful force. Evidence shows that companies with sustainable finance are more likely to attract investors.
4. Opportunity Architects
Companies adept at navigating ESG environments often emerge as opportunity architects. According to studies, companies with higher ESG scores tend to be more resilient in economic downturns.
Benefits of ESG Investing in Private Equity
PwC’s study on ESG benefits for PE firms confirms what we have found about the industry’s embrace of ESG. Over 50% of firms considered ESG during their entire due diligence process and most opportunity sourcing processes.
Why? Four primary pillars are highlighted in the survey responses:
· Risk mitigation
· Brand Reputation
· Competitive differentiation
· Attraction and retention of clients
About one-third (33%) of PE firms cite these as the primary reason ESG is a value driver in most recent transactions. In addition to actively seeking ESG when selecting investments, most firms reported not following a deal because they had doubts or concerns regarding ESG commitments within a potential asset. These benefits are not taken lightly.
Conclusion
Private capital has a long-term investment horizon and focuses on active ownership. It can also affect meaningful strategic and operational changes within portfolio companies. A growing number of ESG considerations in the investment decision-making process while encouraging GPs to improve ESG-related policies, data, and disclosure practices. We see a significant opportunity in the future for private capital to be a key player in driving positive social and environmental outcomes, supporting the transition to a lower-carbon economy, and contributing to an equitable and inclusive society.
