Engaging investors: PE leverages ESG to maximise value

January 2020  |  FEATURE  |  PRIVATE EQUITY

Financier Worldwide Magazine

January 2020 Issue

Environmental, social and governance (ESG) issues are increasingly at the forefront of decision making for institutional investors. In the private equity (PE) arena, this is especially so, with PE firms under pressure to make their portfolio companies’ ESG oversight more effective.

According to BSR’s 2019 paper ‘ESG in Private Equity: How To Write a Responsible Investment Policy’, the past 10 years has seen PE sector responsible investment approaches move from “exception to expectation”. Essentially, formalised integration of ESG considerations are becoming the norm.

“It is essential for PE firms to support each portfolio company in identifying specific ‘material’ ESG focus areas – that is, topics that are relevant to both business and sustainability,” says David Korngold, a director at BSR. “A PE firm’s commitment to managing ESG factors in its portfolio should be enshrined in a simple, constructive and responsible investing policy. Typically, the first ESG question a limited partner (LP) will ask is about the firm’s ESG policy.”

In its ‘ESG considerations for private equity firms’ report, PwC breaks ESG issues down into five key categories. First, environment: waste management, hazardous materials, pollution, water use, energy use, global warming, emissions to air, resource use, biodiversity and land contamination. Second, workplace: talent attraction and retention, employee development, employee welfare, equality and diversity, and occupational health and safety. Third, community: community impact, local economic development, human rights and community investment. Fourth, marketplace: responsible marketing, responsible products and sustainability within the supply chain. Fifth, governance: governance of sustainability issues, board-level responsibility, anti-bribery and corruption, business ethics and conduct, and grievance procedures.

“The scope of ESG is far reaching,” adds Stephanie Wall, ESG manager at Palatine Private Equity, “from global challenges such as climate change, to local opportunities such as employee engagement and social value. Breaking down the components of ESG allows portfolio companies to demystify the topic and find a way to communicate their strategies in a meaningful way. We are seeing more engagement from companies and ESG becoming mainstream. The reasons for this include the commercial opportunities in doing so as well as the necessity to innovate and develop to ensure businesses can continue to operate. Also, it is now expected – by society, consumers, investors, supply chains and employees.”

Strategies and challenges

To ensure that ESG issues are being properly managed and challenges met, portfolio companies can deploy a range of strategies, with robust reporting processes a key component.

“PE firms should set clear, sensible expectations on ESG management at portfolio companies from day one – the month before exit is too late to get your ESG house in order,” suggests Mr Korngold. “They should begin by agreeing on a core set of material ESG issues to manage and key performance indicators (KPIs) to track progress. PE firms should also require their portfolio companies to include progress updates as part of their regular business check-ins, and the company’s board should conduct a status review at least once a year. It is also important that firms go beyond simply setting a high bar – they should help portfolio companies clear that bar.”

To help portfolio companies monitor and track the progress of their ESG activities, there are numerous reporting mechanisms available. The Principles for Responsible Investment (PRI) and Environmental Resources Management (ERM) report – ‘ESG Monitoring, Reporting and Dialogue in Private Equity’ – proposes a two-tier format for reporting information: core disclosures and additional disclosures. The former is designed to elicit the key information that an LP can use to monitor its investments and assess the responsible investment (RI) performance of its fund managers. The latter is to support a more detailed understanding of the RI performance of the fund manager and its portfolio companies.

Correlation

The ESG expectations of all companies are increasing and portfolio companies are not immune to this trend. And while the underlying business benefits of ESG management are clear and self-sustaining, significant challenges remain, such as more intensive regulatory and stakeholder scrutiny. Ultimately, the question is to what extent does ESG oversight correlate with value maximisation upon exit?

“Effective ESG management should create demonstrable business benefits that can be highlighted at exit,” says Mr Korngold. “Additionally, public markets and secondary buyers have their own ESG expectations, and it is increasingly essential to show a company’s bona fides to the next set of investors.”

In the view of Ms Wall, we are facing increasing environmental and social challenges that are bringing not only risk but opportunity. “This is driving the momentum of the ESG movement, which will only propel the portfolio companies’ ESG agenda further,” she says. “The regulatory position is likely to strengthen; however, we need to ensure that we do not move from being proactive to reactive and focusing solely on compliance.”

Almost certainly no fad, ESG oversight within a PE portfolio company context appears here to stay. “Attention to ESG is driven by fundamental factors in society and the environment that have profound ramifications for global markets and businesses,” concludes Mr Korngold. “Climate change, shifting wealth patterns and the fourth industrial revolution – factors like these are not going away anytime soon and neither is ESG investing.”

© Financier Worldwide

BY

Fraser Tennant