In a relatively short time, environmental, social and governance (ESG) issues have catapulted from the sidelines to center stage of the corporate agenda. Yet many organizations, private equity firms included, grapple with how to execute on the ESG imperative. Private equity (PE) firms often struggle to balance what can easily be perceived as conflicting goals: generating a return for investors while meeting the broader ESG goals of their stakeholders.
As a result of these evolving issues, PE firms are becoming more selective of their targets: 37% of respondents in our Global PE Responsible Investment Survey have turned down an investment opportunity because of ESG concerns.
In our view, companies that are good ESG citizens have the potential to earn a premium, not just in goodwill and enhanced brand, but literally. Today, any portco that can provide investors and other stakeholders the assurance that they are adequately addressing ESG issues has an opportunity to create value. We’ve previously written about what we’re seeing in the private equity space more generally when it comes to ESG. Here we delve into more detail on what PE firms’ boards should do as they focus on the primary concerns within each portfolio company’s industry in order to create value.
ESG priorities differ by company, depending on industry. In some industries, the impacts of ESG issues are direct and well known: regulation has meant that there is a long history of tracking them, with more metrics available. Other issues may be less quantified, either because they’ve emerged more recently and appropriate metrics haven’t yet been standardized or implemented, or because the impacts are indirect or intangible, and are therefore harder to quantify.
Climate change is the predominant environmental concern, imbued with increasing urgency as more nations and companies worldwide commit to net-zero carbon targets. In our global survey of PE firms, half of all respondents say they are taking action on climate risk and nearly half (48%) report taking action on the carbon footprint of their portfolio companies.
For most PE firms and their portfolio companies, “social” is synonymous with diversity and inclusion (D&I). Changes in D&I have grown in importance and prominence in the wake of current events around societal racial equity, but it has been an issue for some time. Yet many PE firms are still developing their own D&I initiatives, as some believe that, to promote change credibly at the portfolio company level, they should practice what they preach. Among the global PE firms PwC surveyed, 46% have established gender and/or racially/ethnically diverse hiring targets.
Social issues go beyond D&I, of course, encompassing companies’ hiring and labor practices and relationships with employees, suppliers, customers and the communities in which they operate. They also encompass job reskilling, especially due to tech disruption, and layoffs as a function of a deal closing, which can be a much greater risk to brand reputation today than in the past. Social issues vary more across industries than environmental issues. Among the more prominent concerns are the use of forced labor by manufacturers and health and workplace safety practices, especially at companies with large workforces. Both continue to draw media and regulators’ attention.
Lastly, the other major social issue for PE firms’ porticoes is data privacy management and cybersecurity. This is not surprising, as more and more companies conduct an ever-growing portion of their business digitally, and they can be vulnerable to ransomware attacks and hacking. As portcos are using new technologies to reach their customers, they are struggling to meet privacy standards (if applicable) or understand what they should do with the volume of customers’ personal data they have stored. In our survey, we found that less than 20% of global PE firms have in place plans for emerging tech and data ethics.
PE firms have been focused on the more typical governance issues, including leadership, executive pay, audits, internal controls, tax transparency and shareholder rights. One issue that often arises in terms of governance is tax transparency. PE firms are looking across their portfolio companies to examine their tax structures, including how much and where they pay taxes. They are seeing that improvements that benefit the communities in which they operate don’t necessarily mean sacrificing their effective tax rate. Leading firms are taking a more holistic view of their tax strategy to consider tariffs, tax incentives, synergies and intangible assets, which can offset effective tax rates favorably while still achieving ESG goals.
Within every industry—and even from company to company—the ESG journey will differ. Every PE fund should develop plans for the near, medium and long term, and address issues for the collection of its portcos, as well as each one individually.
To start, we recommend that funds gather data and conduct a diagnostic on their entire portfolio. For portcos in industries that haven’t yet standardized metrics or benchmarks, it will take additional effort to determine the appropriate steps.
Much of the data needed to provide a reliable performance picture may not be in an easily accessible form. Moreover, getting consistent data across the portfolio may be challenging. Some PE pioneers are finding creative ways: One uses the same payroll processing company for all its portcos. The payroll processor holds relevant data on employees that can inform D&I goals. Some companies have even turned to their cloud service providers to help them gather and analyze the data they need to make their ESG goals happen. In our Cloud Business Survey, we found that 70% of respondents are either implementing or actively looking into how cloud can support their ESG goals.
Once you have the data you need, create an ESG diagnostic that will show how each of your portfolio companies is handling its ESG risks. We recommend that you tailor the diagnostic to those ESG issues that are market priorities in each industry, such as waste management for emitters or safety and injury prevention for manufacturers. Developing an accurate diagnostic will take time, but a diagnostic has the potential to be a cornerstone for how you assess the ESG performance and tracking at your portcos.
When you are thinking about which companies to prioritize first, we recommend that funds:
Build a business case for ESG investment. Demonstrating knowledge of the market’s perspective on ESG and of the changes that can produce the greater return will go a long way toward winning executive buy-in on ESG goals. Let’s look again at manufacturing: Showing that a small change in manufacturing practices can deliver substantial benefits to ESG ratings will help make your case for your ESG ambitions.
Rally the CEOs of your portcos. PE firms face a unique challenge in that funds have a vested interest in the performance and strategy of the underlying portcos, but the portcos themselves need to execute on the strategy. As a result, it’s critical to align the operating models of the portcos and get CEOs on the same page as the PE firm.
Given the number and scope of ESG issues, developing sound and credible policies can be tricky for PE funds and their companies. Our framework offers a good start, helping you make smart, objective decisions based on consistent and credible data, while taking into account the nuances of each industry. By focusing on the major issues in each industry and fostering a unified approach among portco executives, PE funds can do more than demonstrate good citizenship: they can keep their eyes on the value-creation prize.