ESG in private equity

August 2023  |  TALKINGPOINT | PRIVATE EQUITY

Financier Worldwide Magazine

August 2023 Issue

FW discusses ESG in private equity with Tanay Shah, Brian Lightle, Lauren Pesa, Suzanne Smetana and Ketiwe Zipperer at Deloitte.

FW: Could you provide an overview of how environmental, social and governance (ESG) factors are shaping the private equity (PE) industry? How do PE firms typically view ESG issues?

Shah: Environmental, social and governance (ESG) has required private equity (PE) firms to take different approaches, based on their core beliefs and strategy for fundraising, deployment and value creation. There are three fundamental approaches, each of which is shaping the industry. First, firms that view ESG as a risk exercise. These firms are typically looking at red flags and impacts to value. However, they are not focused on developing value through ESG. Second, firms that are focused on investments that connect to the way the world is changing as a result of ESG. Third, the economics of investments are changing. Whether it is needing to consider regulatory requirements or taxes, public policy is a consideration in terms of how it impacts the investment. Some firms consider areas such as decarbonisation in their investment plans, while others do not. However, public policy creates requirements and ultimately creates a price.

Lightle: There is disparity among PE firms on how focused they are around ESG. I think you can put PE into five general buckets when it comes to ESG. First, core to a PE firm’s investment platform. Second, focused more on the risks. Third, using ESG as a catalyst to drive higher returns and value. Fourth, focused mainly on meeting regulatory reporting requirements, such as in Europe. And lastly, not heavily focused on ESG yet, or only caring about doing enough to satisfy their limited partners’ (LPs’) desire to consider ESG factors in the deal process. For those PE firms that are focused on ESG more than others, it still appears more weighted toward qualitative considerations, at least in the US, as key performance indicators (KPIs) and metrics are not as readily available. Given the demands of LPs to consider ESG factors, I think PE will continue to focus more on ESG, although at a slower pace in the US market. Furthermore, as consumers and suppliers start to demand greater focus on ESG considerations and metrics, PE firms will be further incentivised to focus additional efforts around ESG practices that stakeholders view in a positive light.

Pesa: The PE industry evaluates a litany of factors that could impact the timing and amount of cash flows and ultimately valuation. Because of rapid changes in society, whether it be climate change, social unrest or changes in expectations from the workforce, PE firms are looking at ways to include different dimensions of risks in their modelling. While PE firms will continue to use the typical macroeconomic trend scenarios in their analyses, many are starting to consider more nuanced ESG factors in their risk analyses. For example, a PE firm invested in real estate may consider physical risks associated with climate change utilising models forecasting sea level rise. A PE firm may also consider a company’s resilience with respect to its human capital, looking at turnover data to better understand a company’s ability to innovate or capture business opportunities.

Smetana: While the PE industry has been slower to incorporate ESG factors into their investment process than public market investors, there has been a significant increase in adoption in the last year or two. We have also seen increasing consistency of ESG reporting from PE firms, as the industry consolidates around a few frameworks and standards, such as the UN Principles for Responsible Investing (UNPRI). These frameworks are driving demand for adoption of certain ESG practices, which are becoming table stakes for raising capital. While some PE firms are still sceptical about ESG, we have seen that once firms dig in and become more sophisticated in the different applications of ESG, they begin to see it as a lever for value creation.

Zipperer: PE firms are being impacted by a range of ESG topics depending on the industries they focus on, and whether they have funds or have signed up for specific investment guidelines, such as UNPRI. In general though, all PE firms should be prepared to answer questions from investors, as they increasingly see the need for a robust set of disclosures to accurately understand risk.

FW: Focusing on the regulatory angle, could you explain the expanding ESG pressures facing the PE industry? How are firms responding?

Smetana: From a regulatory standpoint, most ESG pressures are on the portfolio companies rather than at the PE firm level. Portfolio companies with operations in Europe are facing new reporting requirements from the Corporate Sustainability Reporting Directive (CSRD), even if they plan to remain private. Portfolio companies in the US are preparing for the proposed Securities and Exchange Commission (SEC) rule if they plan for a public exit. Firms that fundraise in the European Union (EU) are preparing for Sustainable Finance Disclosure Regulation (SFDR) disclosures at the firm and fund levels. In the US, firms are starting to think about the proposed rule on Enhanced Disclosures for Certain Investment Advisors.

Shah: Regulations are showing up in multiple ways. These include the CSRD, a European law which is quite comprehensive; its requirement to report pulls in quite a few companies if they operate in the EU, due to its relatively low thresholds for requiring compliance. Additionally Europe just passed a carbon import tax which again adds pressure, by making sure European companies do not use foreign bases to get around requirements. General taxes are also showing up; for example, California’s carbon cap tax and Washington’s carbon emissions cap. Additionally, there are other requirements, such as moving away from the combustion engine in California. In aggregate, this creates a patchwork of laws that can aberrate the economics of a business, and must be handled properly. PE firms are responding by standing up ESG teams that analyse the situation in diligence or during the hold period.

Lightle: In the US, expanding ESG pressures are not as much of a factor as in Europe and other geographies. PE firms are starting to evaluate and collect certain KPIs but not at the level of European PE firms. If and when the SEC issues rules requiring public companies to disclose increased ESG KPIs, PE investors will likely increase their focus around ESG, especially if their road to exit is a likely initial public offering (IPO) or sale to another public entity. That said, regulations will not be the sole driver and may not be the primary driver for a PE firm. Stakeholders such as LPs and customers may drive the focus around ESG, and if certain PE firms are not giving ESG factors enough attention, LPs may choose to invest elsewhere and consumers may choose to spend their money with companies not owned by the PE firm.

Pesa: This is a classic ‘put your money where your mouth is’ scenario – PE firms that say they use ESG factors to make investment decisions are likely to have to provide incremental disclosures to show how they do so. Therefore, PE firms need to be very thoughtful in their public disclosures to avoid accusations of greenwashing or exaggerating how they consider ESG factors. This is not a time for ‘greenhushing’ for PE firms, but for ‘green-sobriety’. If a firm is going to make a public claim, it will need to be prepared to back it up. In particular, the SEC has issued proposed rules for registered investment advisers that may require public disclosure of how ESG factors were considered.

Zipperer: In the US, incentives available through the Inflation Reduction Act are shaping investments in the US. At the other end of the spectrum, the EU is approving carbon tax and similar legislation to avoid carbon leakage as more regulations are introduced. Disclosure requirements are also an issue, largely driven by EU regulations, ESG-related disclosure mandates and an increased need for transparency.

FW: What are the benefits of embedding ESG considerations into PE firm operations, including investment strategies and portfolio management?

Lightle: ESG is going to continue to be an increasing consideration for PE investors. Those that start to embed ESG considerations early in the process should be in a much better position to respond if and when LPs start demanding more disclosures, or their portfolio companies need to provide enhanced ESG disclosures to potential buyers. This early focus will also likely attract certain LP investment where consideration of ESG factors is a significant focus when determining their asset allocations among competing PE firms. From a consumer angle, ESG matters to many people. If a PE firm is not setting the tone at the top for its portfolio companies, and thus those portfolio companies are not all that focused on ESG factors, a subset of consumers will likely move on to other more ‘ESG-friendly’ companies, thus decreasing the value of the portfolio companies over time.

Shah: Embedding ESG considerations into their operations allows PE firms to be mindful of ESG issues during diligence, hold periods and sale, and potentially accentuate value.

Pesa: Embedding ESG considerations into PE operations enables organisations to be more resilient to external forces. Formal ESG programmes that are aligned to standards and frameworks enable PE users to understand the information gathered to define their investment strategies and portfolio management.

Smetana: At the PE firm level, incorporating ESG into due diligence strategy can help reduce investment risk, especially for target companies that may be impacted by the energy transition, and identify value creation opportunities, including both commercial and operational opportunities. Firm-level, post-investment ESG integration may include measurement of ESG KPIs, such as greenhouse gas emissions, ESG target setting and ESG risk reduction measures. These strategies can increase the operational efficiency of portfolio companies, prepare them for further disclosure requirements – regulatory or value chain – and improve liquidity and premium at exit. Additionally, these activities may help in raising capital from LPs that are increasingly focused on ESG.

Zipperer: Starting with the diligence period, embedding ESG considerations provides a depth of data that would not otherwise be available. A robust assessment can provide insight into business-related risk from climate change and rapidly evolving regulations.

FW: How should PE firms go about determining ESG priorities and opportunities, and incorporating these into their strategic decisions?

Pesa: PE firms should align their ESG priorities and opportunities based on their investment criteria. Those ESG priorities and opportunities do not need to be separate from financial performance – in fact, they can be embedded in it. Many governments are instituting or contemplating regulations with financial consequences that penalise high carbon emitters; thus, PE firms should ensure they have line of sight into what those regulations may entail and the financial consequences behind them, should their investments be impacted.

Smetana: We would recommend engaging with stakeholders, including LPs, investment professionals and portfolio company management, to understand their priorities and how those align with business goals. This can help PE firms determine where they may get the most value from leaning in. Additionally, they may want to review the ESG practices of aspirational peers to identify further ways to develop their ESG programme long term, and strategically increase their ESG maturity.

Shah: PE firms need to start by determining their strategy, their stakeholders and customers, and the environment they operate in. Ultimately, they need to then figure out what parts of ESG are important – it cannot be everything to everyone all the time. Once they have this, they should publish their policy, advise their partners and investment committee on what matters, and then develop various programmes on analysing and reporting on these.

Lightle: A PE firm needs to decide from the top down how it wants to be perceived in the marketplace and how serious it wants to be about considering ESG when buying and selling companies. Some PE firms appear to be saying all of the right things and making a soft effort to consider ESG in their strategic decisions, but in the not too distant future, LPs and other stakeholders will start to see through the facade. For those that are serious about ESG, it will become apparent to stakeholders.

FW: During a transaction process, how would you characterise the importance of ESG due diligence? What steps should PE firms take to analyse a target’s ESG maturity, to gain insights into areas of risk and upside potential?

Zipperer: ESG due diligence can take multiple forms. ‘Red flags’ diligence centres on risk, while operational and commercial ESG diligence may identify opportunities for value creation related to optimising ESG performance. These could be recommendations like leveraging a company’s strong historical ESG performance to go after new markets or preferable funding, or guiding management to improve performance in order to stay ahead of regulatory pressure.

Shah: ESG due diligence is important if stakeholders care about it, or if a PE firm wants to make sure it does not miss risks across the ESG spectrum. Start by determining materiality areas and conducting a red flags analysis, then analyse the impact of these material ESG areas. Take climate, for example. First, start with a greenhouse gas (GHG) baseline and decarbonisation impact by analysing GHG profiles and benchmarks, as well as the financial impact of carbon abatement. Second, understand climate risk and the financial impact by assessing sector-specific climate risk exposure for the target for physical and transition risks and their financial impact, and then assessing exit risk and the financial impact. This has to be scenario based. Lastly, determine whether risks can be reflected in cash flows, or if some of them may be a discount rate and multiple impact. Cash flow is easiest.

Lightle: Importance depends on how the PE firm perceives ESG. If ESG is paramount to their investment decisions, then ESG diligence takes on a fairly high level of importance. These PE firms will be focused on minimising downside risk, but at the same time identifying areas that can lead to financial upside. Some PE firms rely on internal resources to assess ESG considerations and present their findings and considerations to investment review committees while other firms tend to want to go a level deeper than many internal resources have time to focus on. These PE firms will hire external ESG due diligence providers to more deeply analyse a target’s ESG profile.

Pesa: It is unthinkable to imagine financial due diligence without well-defined financial accounting standards. With sustainability performance on the minds of investors and those that seek to attract them, the corollary is apropos: well-defined sustainability standards and frameworks are accelerating the path to a more efficient PE industry. PE firms have much to gain in learning the new ‘grammar’ of ESG and incorporating it into their diligence programmes. PE firms can drive progress on the incorporation of ESG factors by indicating which standards and frameworks targets should use to measure their ESG performance. The best way to begin is to engage in a dialogue with those they seek to obtain ESG information from. Once a PE firm identifies which risks and opportunities are deemed most relevant, it can then identify leading standards and frameworks that give the best ‘grammar’ to address those risks and opportunities. If both parties in diligence can have a mutual understanding of what standards and frameworks will be leveraged in the information provided, the diligence process will be smoother and the assumptions underlying valuation, better known.

Smetana: The importance of ESG due diligence will vary depending on target growth maturity, industry, stakeholders and potential exit strategy. Generally, companies with higher ESG risk – for example within the fossil fuel value chain – or with a larger ESG opportunity, such as current or potential commercial opportunities related to ESG or the energy transition, may benefit from increased ESG scrutiny pre-investment.

FW: How important is it for PE firms to demonstrate their commitment to ESG in the current market? What methods are available to measure and report ESG performance to stakeholders?

Lightle: Many stakeholders are focused on ESG, so it is important that PE firms demonstrate a certain level of commitment to analysing and considering ESG to avoid LPs and customers from moving away from certain PE firms and their portfolio companies. Most PE firms seem to be gathering certain limited KPI measurements across their portfolio in an effort to report out to stakeholders but often times, this level of reporting is far less than what European regulators are requiring or what the US might eventually require. PE firms need to closely monitor the desires of their stakeholders and adjust their reporting, marketing and actions accordingly, or else stakeholders will take their cash elsewhere.

Pesa: It is important for PE firms to begin to show progress toward how they intend to leverage ESG data to evaluate performance, risks and opportunities. If they do not, they risk being seen as a party that only considers singular dimensions of performance. In the world of investing, it is rare to hear ‘that is too much information’. As ESG initiatives purport to provide more information to make investment decisions, it is counterintuitive to think about PE ‘unsubscribing’ from this incredible opportunity to gain more information.

Smetana: The importance for PE firms to demonstrate their commitment to ESG may vary based on their LP, stakeholder base and target industry. However, we would note that the expectations for PE firms are evolving quickly, and they should evaluate their ESG strategy and ambition if they have not recently. They may find themselves falling behind in ESG maturity if they are not planning to advance their ESG programme. Regarding methods to measure and report ESG performance to stakeholders, we find that many PE firms still prefer private reporting to stakeholders rather than full public disclosure. Thus public disclosures may be more high-level than private. Again, we have seen consolidation in reporting aligned with certain frameworks such as the UNPRI, the Institutional Limited Partners Association’s ESG Assessment Framework, the ESG Data Convergence Initiative (EDCI) and the Initiative Climate International (iCI).

Zipperer: While expectations are evolving, PE firms should at a minimum have a robust understanding of what topics may be considered material for their private equity-backed portfolio companies. This provides a framework for determining what data should be collected, and where corrective action may be required.

Shah: There are lots of different guidelines and standards which provide KPIs. PE firms need to start by determining what is material.

FW: Looking ahead, how do you expect ESG issues to evolve within the PE industry? Do you believe ESG is likely to become a key aspect of value creation?

Shah: I think there is already a value creation play, particularly around companies that participate in ESG value chains – for example companies that create chemicals and substances needed in electric vehicle batteries, or software and technologies for the energy transition. Moving beyond those ‘superhighways of change’, regulations will push companies over. It reminds me of an Upton Sinclair quote: “It is difficult to get a man to understand something when his salary depends on his not understanding it.” Regulations help create markets sometimes. In this case, I think it will, as regulations and taxes either continue to aberrate economics or together policymakers in a few large markets succeed in creating fully functioning carbon markets. Once there is a value attached to ESG, whether through taxes or the market, it will lead to value creation opportunities broadly.

Lightle: I think PE firms will continue to increase their focus on performing more robust diligence around ESG and measuring more quantifiable KPIs across their portfolio. In the near term, most PE firms appear primarily focused on satisfying the demands of LPs and to a lesser extent, other stakeholders, but over time an increasing number of consumers will likely choose to do business with companies that value ESG. As such, there is an opportunity to create value in the right industries with the right customer base, whether that is because of increased prices consumers are willing to pay or increased market share or cost savings achieved by investing in greener technologies that can yield tax incentives in the near term, and true cost savings over the long term.

Pesa: Risks and opportunities underlying ESG will change based on broader changes in society and the environment, but the fundamental principle that ESG integration enables PE firms to make better, more timely investment decisions will not change. ESG is here to stay, and its pace of adoption will only increase in the years ahead. ESG is not likely to become a key aspect of value creation – it is already a key aspect of value creation. The rapid acceleration in the issuance of new and the convergence of existing ESG standards and frameworks has occurred against a backdrop of profound societal change, increased environmental regulation and risk, and reimaginations of how people live and work. This makes the need for consistent, comparable metrics on which to communicate risk and opportunity critical. For PE firms seeking to raise capital, being able to furnish information on ESG factors in alignment with standards and frameworks will allow them to communicate that the information provided in diligence meets the boundaries, assumptions and judgments expected from an investor. While judgments in accounting for ESG performance will persist, a mature standards and frameworks landscape will lead to greater transparency among negotiating parties. Those able to furnish this ESG information will have a competitive advantage, and thus greater access to capital.

Smetana: Peering around the corner, we expect to see more ESG reporting – both public and private – more demand from LPs for ESG incorporation from their general partners (GPs), and more expectation for private companies to have tracked and mitigated ESG factors at exit, whether public or private. For higher maturity PE firms, we expect to see more setting net zero, science-based emissions GHG targets – for which demand again is being driven by LPs. If portfolio companies hope to play a role in the supply chain of larger organisations, preparing material ESG data may be a valuable exercise, especially for climate-related information. GPs can provide meaningful value-add, especially as the regulatory environment evolves on supply chain data requirements.

Zipperer: Because of the rapidly emerging incentives and disclosure requirements, PE firms can expect that ESG is a topic here to stay. How much it creates value may vary by industry – for example, investing in sustainable solutions in industries such as cement – could create exponential returns. By contrast, investments in software may not have their valuation impacted as greatly by ESG factors.

Tanay Shah leads Deloitte's M&A strategy and ESG practices, where he focuses on helping clients determine growth pathways through portfolio strategy, M&A strategy, diligence and transformation. He focuses on private equity, and consumer, including the transportation, hospitality and auto sectors. He can be contacted on +1 (312) 909 9427 or by email: tanshah@deloitte.com.

Brian Lightle is an advisory M&A partner with 27 years of professional experience with Deloitte (over 21 years dedicated to M&A transaction services). He works with many leading global private equity firms and large multinational corporations primarily focusing on the technology industry, including software development and deployment, mobile applications, semi-conductor design, fabrication, assembly and testing, SaaS, B2B commerce, hardware and networking. He can be contacted on +1 (415) 599 9206 or by email: blightle@deloitte.com.

Lauren Pesa is an accounting and reporting advisory partner and is Deloitte’s US real estate sustainability, climate & equity leader. She can be contacted on +1 (312) 486 4647 or by email: lpesa@deloitte.com.

Suzanne Smetana is a managing director with Deloitte & Touche LLP’s sustainability and ESG services practice, working with clients to achieve their sustainability and ESG objectives. She is based in Boston and focused primarily on the financial services sector where she has over 28 years’ experience. She can be contacted on +1 (617) 645 3505 or by email: ssmetana@deloitte.com.

Ketiwe Zipperer advises clients on M&A strategy and execution with a focus on building a sustainable future, leading ESG diligence and integration projects across industries. Her decade of M&A consulting experience is complemented by experience driving operating model and ERP modernisation as a senior director of transformation for a Fortune 500 company, as well as years working in public-private partnerships. She can be contacted on +1 (470) 408 7800 or by email: kzipperer@deloitte.com.

© Financier Worldwide

THE PANELLISTS

Tanay Shah

Brian Lightle

Lauren Pesa

Suzanne Smetana

Ketiwe Zipperer

Deloitte