ESG and Private Equity – Part 2

ESG AND PRIVATE EQUITY

ESG is getting more private. No, we don’t mean that ESG topics are becoming secretive, quite the contrary! By “private” we mean “private markets.” Sustainable funds and sustainable investing (not one and the same, but that’s a different topic!) are becoming more common in the private equity (PE) arena. 

This is notable for a few reasons, but one jumps out. PE firms are relentlessly focused on value creation. Exiting their positions (selling portfolio companies or taking them public) at valuations that deliver attractive returns to their investors is the core of a PE firm business model. They rely on successful (i.e., highly profitable) sales of the companies in their current funds to market (i.e., raise capital for) their future funds, ad infinitum

Given this intense focus on value-creation, the growing interest in sustainability among PE firms indicates that they believe that environmental, social, and governance (ESG) practices within their portfolio companies affect valuations for those companies

PE firms are not “required” to respond to calls for improving sustainable practices in the way that public companies are; they are doing so because they believe ESG has a role in creating value for the companies they hold in their funds. Private equity funds are also indirectly affected by the importance investors now assign to ESG factors, as this influences the valuation a private company will ultimately achieve when a PE firm sells it, through an IPO or another buyer.

Not surprisingly, PE funds in Europe are leading the way. According to Funds Europe, nearly half (47 percent) of private equity managers now address climate change through ESG policies, a 13 percent increase over the previous year. This finding is based on the tenth annual ESG report from LGT Capital Partners, which assessed improvements in ESG for over 300 private equity managers. Eighty-four percent of European private equity managers were assessed as “excellent” or “good” for their approaches to ESG integration, compared to 70 percent in Asia and 50 percent in the U.S.

PE firms see that ESG factors affect the value of companies in every sector of the economy, for reasons OWL and others have explained many times (for example, see 25 Reasons Sustainable Investing Makes Economic Sense). Private equity is particularly well-positioned to invest in “green” projects that emphasize innovation and offer potentially huge pay-offs, but will take time to come to fruition. That kind of investing requires patience and, according to CEOs of many public companies, investors focus on quarterly earnings growth instead of projects with blockbuster possibilities but long lead-times. Those public companies will, instead, be the future buyers of successful companies that private equity firms nurture.

ESG and PE deal terms

For those not familiar with PE deals, the first step is the due diligence process. While we prefer to lead with the positive, here we’ll go negative:  PE firms are increasingly recognizing that poor ESG practices can create financial and reputational risks (and reputational risks often translate directly into value destruction). Therefore, according to JD Supra, PE investors are increasing the use of ESG concepts in the due diligence process.  

As one might expect, the specifics depend on several factors, including the target company’s industry, geographic location, and supply chain, among others. E, S, and G are each important; for some industries, environmental harms may be front-and-center, for others, the potential for human rights violations (child labor, inhumane work conditions), a lack of gender and/or racial diversity, and poor governance practices may be most important.

Beyond the normal terms in a deal, private equity investors are increasingly negotiating ESG-focused representations and warranties relating to policies and procedures. As noted above, these are often industry-dependent, such as a representation that the company is in compliance with international standards against slavery or child labor across its supply chain.

If an ESG risk identified during due diligence cannot be “cured” before the PE firm must commit its capital and fund the transaction, this may cause investors to negotiate a lower valuation – in other words, the expected return must reflect the risk, and lowering the price increases the expected return (all other things held constant). PE investors may also want a company to indemnify the PE fund for any losses it may suffer related to a specific ESG risk.

Despite ESG risk protections using legal documentation or deal terms, a report by consulting firm Baker Tilly International and Acuris Studios found that 60 percent of M&A dealmakers interviewed have walked away from an investment due to a negative assessment of ESG issues in a potential target. Importantly, 60 percent of private equity investors say their ESG investment strategy has had a positive impact on investment returns. And, as many as 87 percent say they consider ESG factors in order to decrease investment risk and potential litigation. 

Beyond ESG Awareness to ESG Focus

It’s one thing to integrate ESG considerations into the PE deal process and require private companies to improve their environmental, social, and governance practices. It’s another thing to pursue private investments in companies in the sustainability space. According to the legal knowledge site JD Supra, “prominent PE firms such as Temasek, Apollo Global Management, TPG and KKR & Co have deployed and/or committed substantial funds to such investments.” 

Morgan Stanley’s recently-launched 1GT fund aims to invest $1 billion in growth capital to back companies that will collectively avoid or remove one gigaton of CO2-equivalent emissions from the Earth’s atmosphere by 2050. 1GT is targeting investments in 20 to 25 private companies based primarily in North America and Europe involved in mobility, power, sustainable food and agriculture, and the circular economy. Morgan Stanley plans to help 1GT’s portfolio companies improve ESG monitoring and reporting, and (we emphasize this next point) pursue earnings growth, multiple expansion and enhanced exit potential. In other words, this is not charity work – Morgan Stanley is using ESG to position 1GT to generate enticing returns for investors.

Some private funds go even further, pursuing “triple bottom line” objectives (financial, social, and environmental) that are highly specific. For example, Deliberate Capital was created with the goal of using investment dollars to have a deliberate impact. It serves as advisor to the Meloy Fund (and a soon-to-be-launched Global Fund for Coral Reefs) that supports small-scale fisheries operating in coastal waters in southeast Asia where unsustainable practices are destroying coral reefs and mangroves that are a critical part of the earth’s natural capital.

Sustainability in private investing just makes sense

We’ve said this many times (and will keep saying it) – ESG is not *just* a “feel-good” concept. Understanding the risks and opportunities related to ESG should be part of any company’s strategy. Those who invest in private companies are realizing this, which creates a virtuous circle: privately-held companies with good ESG practices will be better positioned to attract funding and deliver strong valuations to their investors, which will lead more capital to flow toward other private companies that pursue sustainable practices.

The Corporate Social Responsibility Disclosure requirements that take hold in the EU next year apply to private companies, which should benefit PE investing. We look forward to seeing that trend spread. As always, OWL ESG’s goal is to offer the most comprehensive approach to ESG data and analytics to investors and companies of all types. Contact us to learn more.