How private equity funds can achieve their ESG goals
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.
We’ve seen PE firms face the following issues:
- Potential or current limited partners (LPs) with individual, unique mandates that they require of their PE fund investees.
- Portfolio companies (portcos) that set net zero requirements that they push down their entire supply chain, or, conversely, customers that set ESG demands that portcos have to follow.
- A lower pool of funding for portcos on exit if they aren’t meeting the market-established ESG expectations.
- Being disadvantaged in bidding for a target with material ESG risks and opportunities where a competing firm has more mature ESG capabilities to leverage.
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 challenges for PE portfolio companies
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.
Environmental
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.
Portfolio companies attempt to balance three broad types of environmental risk:
- Emissions and waste. Climate concerns tend to center on emissions, so heavy industry companies and other emissions producers are likely the first to be questioned about their practices. (They’re also more experienced at monitoring and mitigating impacts as a matter of regulatory compliance.) Other environmental issues for heavy industry companies can include water and land pollution as well as impacts on nature and wildlife. For example, plastic waste produced by fast-moving consumer goods is a fast-growing concern. But every company, whether industrial, manufacturing or service-based, needs to consider its impacts, both direct and indirect, including within its supply chain and its typical day-to-day business (such as air travel).
- The costs associated with making ESG changes. Reducing emissions, pollution and other waste—through modifications to production methods or by developing new production or distribution processes—can be costly. Some PE firms have scrutinized their holdings in industrial companies and other industries with a relatively high environmental impact (such as healthcare). As firms decide whether it makes economic sense to make these investments, it may be the case that the investment costs too much relative to the return.
- Vulnerabilities tied to climate change. In locations where climate change or other environmental hazards pose a threat—for example, flooding in coastal areas or wildfires in drought-stricken areas—physical operations and assets need to be protected.
Social
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.
Governance
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.
Taking action: Finding your ESG next step
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.
Get the information you need
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.
Where should you start?
When you are thinking about which companies to prioritize first, we recommend that funds:
- First, examine portcos that are closest to exit. This will allow you to determine what these companies should do to meet market expectations and confirm that they safeguard value.
- Next, address companies in industries with hot-button ESG concerns. For example, medical waste can be a problem in healthcare, and clothing and footwear manufacturing is in the spotlight for potential child labor and forced labor practices.
- From there, look at the other industries represented in your portfolio, recognizing that even sectors that may seem exempt may indeed have E, S and G impacts lurking beneath the surface. For example, a tech company may not have direct environmental issues, but some of its global suppliers may be contributing to land or water degradation. A manufacturer that consolidates and abandons a sprawling physical plant could be creating an environmental problem. Similarly, a retailer that pulls out of a shopping center may leave a large volume of packaging that needs disposal or recycling. Or the shopping center may become blighted and create safety issues for the community.
- Finally, look at newly acquired companies. With the longest timeline to exit, these portfolio companies—even those in sectors with more pressing ESG issues—can be made to shine relative to peers with the right focus and investment.
To build out an ESG plan for an individual portco, we recommend these five steps:
1. Assess where you are now
- Examine what you’re doing well. Start by looking for areas where your existing ESG investments are linked to revenue growth. For example, we’ve seen eco-friendly production processes that win over consumers, innovations leading to new approaches to privacy protection and reductions in plastics dependence that can be applied across multiple sectors. You may also find that some of your ESG initiatives have led to your company having an edge in attracting diverse talent.
- Be vigilant in sussing out the negative. Look for areas where your lack of ESG action may be a problem. Your analysis should include potential risks that can be more indirect, such as suppliers’ labor practices, or less obvious, like an abandoned campus or an AI platform that is coded in such a way that inadvertently results in bias. Don’t forget that blind spots may exist, especially in newer businesses where little work has been done to understand or measure the ESG impact.
2. Define your end goals
- Understand who your portco’s stakeholders are, and define your goals based on what ESG success looks like for your portco. To form this view, understand what your industry’s investors care most about. For example, the manufacturing industry has always focused on workplace safety and health of its workers. The ESG ratings for that industry reflect this focus and may weigh it more heavily than other industries. By understanding this, you can focus on the specific ESG capabilities you need to help track your progress. Is it monitoring equipment? A new protocol to help log ESG issues? The answer will be different for every company and industry.
- Define your level of ambition. Pragmatic companies, for example, view sustainability as a factor influencing their financial performance—they delegate responsibility for sustainability to company management and aim for quick wins to meet stakeholder requirements. Idealists, at the other end of the spectrum, see sustainability as a main driver of the company’s purpose, and believe that responsibility for it starts with the CEO.
3. Identify options to deliver your ESG strategy
- Define a set of potential ways your portco can deliver on the end goal. Take manufacturing: A company can improve workplace safety in any number of ways, such as investing in better equipment, changing work practices or augmenting training.
- Prioritize based on data. Use your diagnostic tools and ESG analysis to help you focus on strategies that can yield the most for your ESG dollar invested—and in turn, give you a greater advance in ESG rating for every dollar spent.
4. Make it happen
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.
5. Tell your story
- Tell your portco’s story. Share your ESG performance in your established financial reporting processes. At present, portcos are determining which ESG framework and disclosures to follow. As a result, there can be confusion in how to tell your story. Those who use existing controls and reporting structures to report ESG performance through investor-grade standards will likely stand out where standing out can move the needle: financial services CFOs, investors and other key stakeholders. As you develop your reporting, keep in mind that you should take credit for what you’re doing well, and make it clear what you’re still working on and where you are headed.
Conclusion
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.
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