The Evolution of ESG in Private Equity

Over the last decade, ESG (environmental, social, and governance) has evolved from a buzzword into a guiding principle for all sorts of investment activities, particularly in the world of private equity. Today, approximately one-third of all managed assets in the US are deployed with consideration for ESG, and those figures are even higher in some markets abroad. To the skeptics – ESG investments are far from being a generational fad. They have taken root in the core of financial decision making and are likely to continue to do so for the long term.

How and where ESG has Developed

A more deeply interconnected world and rising global wealth have motivated business leaders to define their goals in terms of both financial returns and greater purpose. Many people don’t want to prosper at the expense of others’ well-being, so mission statements and investment analyses now commonly address ESG considerations. These considerations span a wide range of topics, including carbon footprint, natural resource use, management of waste, labor relations, transparent accounting, anti-corruption, and diversity.

LPs often want to know that they are financing sustainable and ethically sound enterprises. Founders, boards, and business owners similarly prioritize ESG practices to ensure that their organizations are positively impacting the world in addition to reaching financial goals. That’s meaningful in the context of M&A, because stewards who focus on sustainability are likely to require partners and acquirers to share that vision to engage in a transaction.

PE funds are jumping aboard as well, with many firms explicitly adding sustainability and governance factors into processes of diligence and investment analysis. The desire to do the right thing is no doubt part of the motivation for this evolution, but there are also numerous pragmatic benefits for those focused on the bottom line.

Financial Benefits of ESG

Sustainability and ethical practices can yield clear and meaningful financial returns. Consumers are increasingly likely to patronize businesses that align with their moral leanings, so PE firms can augment returns by guiding portfolio businesses on the establishment and communication of key stances to their market. This has a real impact on sales.

Common ESG measures also tend to enhance resiliency among businesses. Sustainability planning creates a strategic playbook to address market shocks and economic crises (eg pandemics). For example, companies that strive to use locally-sourced inputs naturally develop more diverse supply chains with redundancies. The stable, relatively slow growth environment of the past decade led many executives to prioritize efficiency to deliver earnings growth, thereby squeezing out redundancies and minimizing the number of suppliers to fetch price savings. The resulting lean supply chains were not resilient, and supplier concentration exacerbated the challenges presented by rolling lockdowns and shipping disruptions of 2020.

ESG leaders also have an advantage in hiring and retaining top talent, especially among a younger generation of workers who find value in contributing to an organization with a noble corporate purpose. Employee satisfaction and engagement are enhanced by a shared goal to improve the world making ESG leaders a destination for prospective employees. A strong team drives fundamental performance and can even enhance equity valuation.

Finally, PE firms that focus on sustainability are more attractive to prospective LPs that share those same values. A wider universe of potential investors and a strong reputation makes fundraising activities more effective and efficient.

Best Practices in PE

PE is in an exceptional spot to thrive with the adoption of ESG, due to long time horizons and their influence in the broader capital markets. To unlock the most value from sustainable and responsible practices, funds should explicitly make ESG reviews a part of the diligence and investment process. This will yield a culture and operational approach that can trickle down to portfolio companies and stand out to investors. Firms that are sustainability leaders should guide portfolio companies on best practices and relevant controls. PE firms should also communicate these policies explicitly to investors, showing that the LPs’ ESG criteria are met and shared by fund management.

Establishing a process and team that embodies principles of sustainability, responsibility, and ethical behavior could yield both financial results and socially-impactful outcomes. That’s gone from a niche consideration to a core component of private equity over the past decade, and the leaders of the next 20 years will likely be among the early and most enthusiastic adopters.