How ESG Value Creation in Private Equity Works?

by David P Colney Sr. Financial Advisor at PageGroup, New York

The environmental, social, and governance (ESG) impact can be seen in different sectors. Today, companies are dedicating a significant amount of time to developing models to assess the correlation between ESG scores and company growth. They also study the ESG risks, strategic issues like energy cost, and accessing low-cost and renewable energy sources. Hence, whether ESG is an opportunity or a cost, it is important to study its evolution.

A few years ago, most private equity firms saw ESG as a risk management approach. However, there is a big change now. In the current times, private equity investors consider ESG as a key value driver. ESG has become a focus area for deal teams in countries like the USA and Europe. Its growing mandate in investment committees requires individuals to go for an integrated approach. They must implement ESG with due diligence and improve the company's performance.

The Role of ESG in Shaping the Private Equity Industry

Though the private equity industry has been incorporating ESG factors very slowly, an evident rise in ESG adoption in the last couple of years cannot be denied. The market has witnessed better consistency in ESG from private equity firms. The frameworks like UN Principles for Responsible Investing or UNPRI push the ESG adoption demand higher.

ESG has added many new approaches to private equity firms. Firstly, some firms see ESG as a risk. They are unable to think about creating value through ESG. Secondly, some firms are using ESG to generate higher returns and value. Thirdly, some companies are primarily focused on meeting regulatory requirements. Some companies have not been focusing much on ESG but are still doing sufficiently to meet the 'limited partners' requirement.

ESG is expected to be the prime consideration for private equity investors. Those who want to build a career in private equity must start imbibing ESG considerations in their process at the earliest. It will be easier for them to respond to the partner's, buyers, or portfolio company's disclosure demand. The private equity firms that incorporate ESG into their business strategy can lower investment risk, tap commercial and operational value creation opportunities, enhance the operational efficiency of portfolio companies, and improve premiums. All of this can help in the easy raising of capital from the ESG-reliant partners.

Private Equity Success with ESG Value Creation

According to INSEAD's Global Private Equity Initiative survey, 90% of LPs factor ESG into their investment decisions. Since ESG is important to limited partners, most private equity firms are now looking forward to improving their portfolio companies' performance through corporate governance. These asset owners are concerned about climate change and inequality.

The private equity industry creates ESG value for a sustainable economy. Doing so will enable them to meet the stakeholders' demands and generate better financial returns in the long term. Private Equity is not hesitating in making huge ESG initiatives investments. The concerned also attend workshops, where they get to know the different perspectives on ESG value creation.

It has become critical for the private equity industry to prioritize ESG themes. They must establish a specific process, formalize ESG capabilities, and have a justified governance structure. All this will enable the business to gather, assess, and present ESG data. Private Equity is no longer restricted to the Wall Street niche. It is becoming a key driver of the global economy.

Wrapping up

ESG has become a differentiator for private equity funds. The application of ESG in private equity promises considerably high financial returns due to increased sales, lower costs, employee engagement, better valuation, etc. However, private equity firms new to ESG norms face challenges getting ESG key performance indicators and metrics.

Private Equity will continue to focus on ESG, though gradually. With the rise in ESG demand from consumers and suppliers, a greater focus on ESG may come. Private Equity firms might have to make additional efforts to inculcate ESG practices. Focusing on the ESG paradigm is important to create impact and value. Embracing the same would mean superior returns and a more sustainable world!