Why ESG is a strategic priority for Private Equity Why ESG is a strategic priority for Private Equity

Financial services firms, including Private Equity firms, are responding to increasing pressure from stakeholders globally to act on environmental, social and governance (ESG) issues. The stakes are high and firms are in the spotlight to establish how they are acting as responsible stewards and how they can demonstrate their commitment.

Another challenge has to do with financial performance through ESG. In the UK KPMG 2021 CEO Outlook, 65% of UK CEOs agree that they face increased demand for reporting and transparency on ESG issues, only 37% of them believe that their ESG programmes improve financial performance.

In this two part blog - we take a deeper look at why ESG is a priority for Private Equity (PE) firms and how have firms approached their reporting and measurement strategy. To understand this, we first focus on how ESG issues are linked to PE performance.

Given the increasing pressure from different stakeholders, we are already seeing firms act on the ESG agenda through investment mandates, ESG-focused thematic funds and aligning processes. Firms are also increasingly transparent, publishing ESG performances not only at the asset level, but also at the portfolio level.

ESG plays a critical role in the value protection measures taken by PE firms, and value creation strategies developed. In many ways, they complement each other and ESG inherrently bcomes part of the investment strategy.

Assessing ESG risks in your portfolio can help you better safeguard it. Asset screening, a stringent asset selection process and thorough due diligence prior to an investment are important steps for value protection.

Think of the material ESG risks and impacts for different industries and asset classes that are part of your portfolio. How well do you know them? And are they likely to affect value in the near future? Detailed ESG risk criteria and policies are essential to have an integrated process for responsible investment. As firms mature and ripen their risk appetite, we see greater detail in their ESG investment policies and reporting capabilities.

Data is key to integrating ESG in the investment process. It drives decision making all the way from deal sourcing and due diligence to reverse due diligence at the end of the investment cycle. ESG KPIs and metrics give investors the confidence regarding how their asset will be protected.

Integration of ESG in due diligence can take many forms. These can include developing questionnaires to gauge a portfolio company’s ESG risks and processes or stress testing a portfolio company against climate change. It can also include investigating ESG-related permits, licenses, regulatory compliance, etc. The extensive process with data challenges may even require third-party expertise and sector specific knowledge on associated risks.

Those that do this well will define the material and relevant risks upfront and identify the data needed to assess early. What matters is that the ESG risks and issues investigated are material to the underlying asset.

As PE firms add investee companies to their portfolio and ensure a sound investment case for limited partners (LPs), what’s important is looking at an ESG strategy not just at the management company (ManCo) level, but also how it is translated at the portfolio and portfolio company (Portco) level. 

Reviewing ESG reports by each of the investee companies and conducting engagements on a frequent basis is the starting point. For value creation to be material and sustaining, data is again essential. It is at the heart of ESG performance of the asset and ESG reporting is the ledger for the value created in the investment and its eventual worth.

In the next blog, we will explore at how PE firms are measuring and reporting ESG performance of their portfolio companies.

Do you need support to navigate this increasingly complex and critical landscape? We would be delighted to work alongside you on your ESG journey.