Value creation through an ESG lens in Private Equity markets

Environmental, social and governance (ESG) continue to be high on the agenda in Private Equity (PE) markets. Many general partners (GPs) are now increasingly subject to higher scrutiny and regulatory compliance in an ever-evolving landscape. But although PE firms are uniquely placed to realise ESG opportunities as a key value creation driver, the journey can be challenging and complex.

In our General Partners ESG benchmarking survey across North America, Europe and Asia, we examined how PE firms are adopting ESG across governance, data, climate risk, diversity, equity and inclusion (DEI), and regulations.

1. No single respondent led on all fronts, with only 17 per cent citing ESG strategy as a value driver, behind limited partner (LP) demand and regulation. As GPs displayed varying levels of maturity across ESG, this suggests that ESG strategy is still being approached from the lens of risk mitigation rather than value creation.
   
   
2. GPs are depending on external consultants for most ESG and climate services – from due diligence to reporting, with 63 per cent engaging two or more consultants. This suggests that many firms view ESG as a specialist field and choose to engage external consultants rather than hiring internally.
   
   
3. While more than 75 per cent of respondents collect ESG data from portfolio companies across their asset classes, only 40 per cent collect data for private credit, highlighting the nuances of integrating ESG in credit markets. And while Excel remains a popular tool for data collection, only 46 per cent of respondents disclose ESG metrics to potential buyers at the exit. This suggests concerns about overall data quality during due diligence. With the explosion of carbon accounting software tools available and no clear leader, firms clearly need help in assessing and identifying the right tools and platforms for their business.
   
   
4. Diversity of talent remains a top priority at the GP level, with over 79 per cent of firms having a DEI policy or strategy in place. This does not seem to be translating into change, however, with only 20 per cent and 21  per cent of investment staff being ‘diverse’ or female respectively. At the portfolio company level, while most GPs are setting board diversity targets for their portfolio companies, it is more prevalent for larger GPs.
   
   
5. Despite the regulatory challenges and detailed uplifts required, there is growing interest in aligning with SFDR Article 8 and Article 9 classifications. Only 13 per cent of respondents are looking to align their portfolios with the EU Taxonomy. Surprisingly, 60 per cent of firms are currently working with outside counsel to support various ESG regulations. This suggests an expectation of more Article 8 and 9 products to come, with investor requirements as the biggest driver and ESG integration becoming a gating factor for fundraising.

Before a firm can begin its ESG transformation journey, it must understand where it wants to be and what needs to be done to get there, so setting the tone at the top is important.

GPs can protect and create long-term value by enhancing value levers and integrating ESG through the operating model – measuring performance against targets and building the knowledge and technology to support and improve those KPIs.

Firms also need to drive cultural shifts and promote the ESG narrative through active leadership. This could include organisational changes, such as tying remuneration to ESG and DEI policies to the firm’s mission and strategy and providing training to investment teams and other critical functions, such as IR, Marketing, IT and Legal. Not only will this demonstrate accountability, but it will also bolster the perception of ESG as being comparable to financial reporting, rather than a marketing exercise.

In terms of decarbonisation, we see many firms starting to collect baseline emissions data at the house level, much of it on a best-efforts basis, but they should follow through, report against targets and outline the steps to meet them.

At the portfolio company level, understanding the material ESG topics impacting a target is a key to lowering portfolio risk and presents a real opportunity to support portfolio companies. Firms should tailor the diligence scope to take these into account and build a robust 100-day plan to improve performance and measure this throughout the ownership period.

The lack of data and multiplicity of ESG frameworks remain a challenge, but as the industry matures, tools are being developed and ‘preferred’ frameworks are being adopted to align expectations.

Firms should consider the rationale and feasibility behind certain investment strategies and work to measure and interpret them in line with LPs' expectations and reporting standards. As a fundamental piece of the puzzle, there needs to be a robust governance framework to increase transparency by-

a) identifying what the right metrics are and:

b) tracking, monitoring and reporting on progress.

It’s time to shift the dial from compliance to impact and value.

Our ESG team consists of a global network of specialists combining in-house private equity experience with deep technical knowledge across asset classes and investment strategies. Supported by our ESG IQ platform, the team provides advice, insight and data analytics to investment managers on ESG topics ranging from materiality assessments and due diligence to regulatory compliance. We also support firms in developing their net-zero strategies. We maintain a close relationship with regulators, industry associations and investors to ensure we remain ahead of changes in regulation and trends, and to help our clients get ahead of their competition.

To find out how KPMG can help, please get in contact.