How mid-market private equity firms can create value by driving positive ESG change

ESG has been an area that publicly listed companies and large private equity (PE) funds have monopolised, by being under pressure from their limited partner capital providers. Many mid-market PE firms are starting to recognise the value creation potential of driving measurable change through their portfolios.

PE has started to pivot significantly on its commitment to sustainability in recent years. Since 2017 the number of PE firms committing to the UN Principles for Responsible Investment has grown fivefold to over 1000, according to the Harvard Business Review (HBR).

In the situation where a PE buys into the concept, they are able to provide strong direction and control because of the control they have over their portfolio companies, which is much more concentrated than with public companies. This is often supported by board member and direct reporting of performance metrics. If that is not sufficient, firms control the compensation and hiring of CEOs for portfolio companies, allowing them to drive performance improvement over the longer term.

Perhaps the traditional perspective has been reversed and PE firms with an average hold period of over five years, are more able to commit, compared to public companies suffering from the tyranny of quarterly reporting. This means improvements can be made quietly over time, without the pressure to deliver quarterly results. Certainly, these firms are establishing carbon and diversity targets across their portfolio companies and see these commitments are key to themselves retaining talent.

PE has the potential to yield significant influence over society. HBR also report that PE funds are projected to exceed $11 trillion by 2026, with 10,000 PE firms overseeing 40,000 portfolio companies with over 20 million employees. The largest firms, now publicly listed are subject to increased scrutiny. Two examples are Apollo Global Management and Carlyle, that provide useful case studies of organisations that have now made significant ESG investments, appointing Chief Sustainability Officers, establishing board sustainability committees, published annual ESG disclosures and launching transition funds.

The pressure to embrace ESG is impacting on mid-market general partner (GP) firms and this is largely coming from limited partners (LP) providing capital according to Private Equity International who want to see “what you’re doing on this, not only at the portfolio level but also within your firm”. These LPs which include the large asset owners including sovereign wealth and pension funds, are increasingly concerned regarding the systemic effects of climate change. This message is reinforced in Bain’s report where LPs are pressing for measurable and validated progress on ESG, indeed they report from their surveys that “80% of responding LPs expect to ramp up requests to GPs for ESG reporting during the next three years”. Increasing cases of co-investing where LPs make direct investments in portfolio companies, alongside their GP partners is increasing pressure, because LPs are gaining direct access to performance data. This is mirrored by the level of interest in sustainability shown by the British Venture Capital Association and its members, this being reflected in the nature of the due diligence work that Crowe is being increasingly asked to undertake for its clients.

All PE firms are under pressure to meet the expectations of their own people, in terms of attracting and retaining talent. In some ways the business case for investing in sustainability is all about people, their own and their customers’. Social expectations are changing rapidly with respect to equity, diversity and inclusion (ED&I) since COVID-19.

The World Economic Forum urge PE firms not to divest asset but focus on transformation as a way of contributing to addressing sustainability laggards. Opportunities exist in transform these underperforming ESG assets. Perspectives are changing as reported by Private Equity International, the mid-market is increasingly competitive and ESG is now seen as a means of value creation: “mindsets focused on the opportunity to improve a business in a quantifiable way from entry to exit. “

So, given this mounting pressure, what should firms do?

Firms need a sustainability strategy that responds to the needs of their various stakeholders, particularly employees and capital providers, and clearly articulates what they are doing in concrete terms to integrate ESG into their fund strategies. Bain recommend having a mixture of short and long-term targets that are quantifiable and where performance can be monitored and reported over time to show steady progress.

Climate change and ED&I are likely to be the key areas to focus on in terms of driving change in their portfolio companies, although due diligence at the acquisition stage is likely to consider a much broader pallet of issues, including, human rights, financial crime and information security exposures. Focus on climate change across PE firms has been facilitated by iCI, an initiative launched in France in 2015 in support of the Paris Agreement and now closely aligned to the UN Principles for Responsible Investment, with support from over 200 firms with $3.2 billion in assets under management. HBR report for example that Carlyle is focusing on the make up of portfolio company boards with an eye on driving ED&I performance, having set a goal of achieving at least 30% diverse board members in portfolio companies. Given that PE firms often provide board members, that has implications for their own hiring practices. The focus is now very much on improving the underlying performance of portfolio companies themselves, rather than cleaning up portfolios through disposals.

All this implies making a conscious choice to integrate ESG into the mainstream of firm’s operating model and adopting a more sophisticated and rounded approach. This means that the ESG performance of portfolio company needs to move beyond being a compliance checklist item and become part of the financial analysis model supporting the valuation. It naturally then becomes part of the ongoing collaborative work with the company’s board and management to drive performance improvement over time. Larger firms are now gathering ESG key performance data from portfolio companies in a standard way on a quarterly basis. Indeed, HBR report that Apollo Global Management are now looking at post-exit analysis to confirm how ESG issues have affected performance over the holding period and how to build these learning points into future project valuations. Carlyle and Triton are becoming more joined-up between deal and portfolio teams to ensure that the material issues identified are picked up and they assist their portfolio companies to drive improvement, therefore, protecting and underpinning growth.

Not only is it important that firms seek to turn ESG into a positive opportunity to drive value, but is important to avoid situations where a portfolio company might become a ‘stranded asset’ because of its climate change risk profile. For example, if other asset owners are unwilling to take it on, because of the impact it might have on their Net Zero transition plan commitments. In other words, actively managing ESG becomes part of managing threat and opportunity more widely within the portfolio. To do this requires a proactive strategy and a keen focus on execution against a firm’s sustainability plan, with repercussions on key performance indicators, on the basis that what gets measured and rewarded, tends to happen.