Once a fringe concern for private equity firms ESG is rapidly taking centre stage

Robert Hirth, Protivit

By Robin Pagnamenta – These are boom times for private equity. In the first half of 2021, over USD500 billion worth of deals were announced globally, setting this year firmly on track to be the biggest in the industry’s history. 

With a wall of investors’ cash parked in firms’ coffers waiting to be deployed and amid rock bottom interest rates, which makes raising the debt required for leveraged buyouts easier to tap than ever, the sector is in rude health. 

But as well as delivering healthy profits for investors, the industry is also becoming increasingly sensitive about something else: environmental and social governance (ESG) factors which are gradually being embedded in the way private equity firms evaluate future deals, manage their existing portfolio companies and consider an ultimate exit. 

ESG has been shaking up the public markets for years, with board executives of listed companies spending more of their time and energy ensuring they deliver on things other than simple financial performance: cutting emissions, trimming waste, monitoring their supply chains for labour abuses, improving diversity and contributing more to the communities in which they operate. 

Ahead of the COP26 climate conference in Scotland this October, about half of Britain’s FTSE100 companies, including bluechip names like AstraZeneca, BT, Vodafone, J Sainsbury and Unilever, have signed up to plans to cut their emissions to net zero. 

These days, private equity firms also are increasingly preoccupied with these matters, and it is not just a desire to make the world a better place driving them to do so, with a variety of powerful reasons propelling the industry rapidly down this path. 

Investors demand change 

First and foremost is the imperative of investor demand. 

The big pension funds and institutional investors which pump billions of dollars into the private equity industry every year are hungry for good returns, naturally. But they are also becoming far more selective about what their money is used for and are unwilling to endorse funding for private equity firms that cannot offer certain specific guarantees. 

In turn, this is pressuring PE firms to sign up to new policies such as the United Nations Principles on Responsible Investment (UNPRI) or to proactively publish their own ESG reports to assist them in marketing their funds and tapping sources of cash they are keen to attract. 

Just as importantly, the PE model requires an ultimate sale to a likely listed strategic buyer, another private equity firm or an IPO. 

In every possible scenario, the portfolio company’s ESG credentials are likely to be an important consideration which will help achieve a higher valuation. 

The growing importance of ESG in the sector is well illustrated by research published in July by Investec, which showed that 62 per cent of general partners (GPs) at private equity firms declined to invest in a company due to ESG or ethical considerations in 2021. 

That is a significant increase from 58 per cent of GPs interviewed last year and 55 per cent in 2019. 

Challenges persist 

The growing interest in ESG is not without its challenges, however. 

For starters, the lack of standardised ESG reporting poses a headache for investors and private equity firms alike. 

A global industry is therefore emerging to document and measure ESG performance more accurately and to report it in a consistent, reliable and understandable fashion. 

“We have got it baked into the way we market funds and the way we satisfy our customers,” says Robert Hirth (pictured) of Protiviti, the management consultancy firm. “We have got it baked into the due diligence process as we evaluate each of our companies. And we have started to bake it into the portfolio company actually being ESG sensitive.” 

Given all this, there is little doubt that ESG is a topic that is not going away, and which private equity firms need to think long and carefully about as they go about sourcing deals, supervising companies they own and preparing them for eventual sale or IPO.  

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