Q&A: Prioritising ESG in private equity

September 2022  |  SPECIAL REPORT: PRIVATE EQUITY

Financier Worldwide Magazine

September 2022 Issue

FW discusses prioritising ESG in private equity with Karen Baum at BDO.

FW: To what extent, and in what ways, are private equity (PE) firms responding to increasing stakeholder pressure to act on environmental, social and governance (ESG) issues?

Baum: Private equity (PE) firms continue to find institutional and family office investors buying into environmental, social and governance (ESG) in a major way. This trend has been on their radar, as indicated in our Private Capital Pulse Survey. Last year, 94 percent of PE fund managers said it was important to their limited partners (LPs) that the fund’s investment strategies included ESG criteria. This spring, when asked where they plan to direct the most capital over the next six months, 50 percent of fund managers said that they would set up impact funds or invest in targets with ESG-focused themes. PE’s evolving view of ESG has been shifting from risk mitigation toward strategic integration of ESG into portfolio operations to drive innovation and value. In addition, general partners (GPs) are hiring chief sustainability officers to oversee investments and work with their portfolio companies to develop ESG strategies and programmes. It is a sign of evolution – you cannot just carry out ‘check the box’ investing in ESG, you have to actively nurture it to truly capture the benefits ESG strategies offer.

FW: In what ways are ESG issues being linked to PE performance? How critical a role does ESG play in driving the value of a PE fund?

Baum: Although GPs are finding greater access to capital in the fundraising process, there are divergent views on the correlation between the adoption of ESG and portfolio performance. Adoption of ESG is nuanced across sectors – for instance, ESG risks and opportunities for consumer products companies tend to focus on sustainability in the supply chain, whereas technology companies see data privacy and cyber security as primary areas of focus. That said, we are seeing portfolio companies making investments in ESG to enhance their brand that are paying off, particularly in the retail, real estate and energy sectors. ESG is not a ‘silver bullet’ designed specifically to improve investor returns, but rather to improve outcomes for a broader set of stakeholders. While superior ESG metrics may increase acquisition cost, affecting return on investment (ROI), an ESG strategy can also help boost returns through improvements in operational efficiency – including lower levels of waste, more efficient use of resources, reduced turnover in workforce, and so on – driving value to the bottom line. Strong ESG performance may also lead to higher multiples upon exit.

FW: Generally speaking, how well do firms understand material ESG risks and impacts across their portfolio? What steps should they take to gain this knowledge and keep it up to date?

Baum: According to our 2022 PE survey, just 41 percent of funds perform an in-depth ESG assessment of potential targets. Most funds focus on identifying red flags rather than performing a comprehensive ESG assessment. Post-acquisition, however, we are seeing funds do a deeper dive. Many are beginning to collect ESG data points across their portfolio, but there is still a lot of inconsistency in the breadth and depth of data collected. The key is to start measuring ESG performance on day one, if not earlier. To assess ESG risks portfolio-wide, PE firms need to develop standard quantitative and qualitative metrics that can be aggregated, including the consideration of sector-specific benchmarks. GPs also need to create a structured process for data collection from their portfolio companies. The approach to ESG risk monitoring, measurement and reporting should factor in multiple stakeholders, including regulators, LPs and suppliers.

“Since PE firms are in the business of value creation, ESG is a natural fit. Companies that integrate ESG into their business models will drive competitive advantage, efficiency and sustainable growth.”
— Karen Baum

FW: What challenges do PE firms face when reporting their ESG performance to stakeholders?

Baum: There are two primary challenges with reporting on ESG performance. The first is the availability of ESG data at the portfolio company level. Unless a fund has conducted deep ESG-specific due diligence on its targets during or after the acquisition process, it will take additional effort to determine what ESG risks and opportunities exist within the portfolio. The ability to gather, analyse, monitor and incorporate ESG data into portfolio company strategy is key to driving a portfolio-wide ESG strategy and enabling fund-wide reporting. PE firms are finding data gaps in their portfolios that often require heavy lifting to collect and report data their management teams have not collected in the past. The second major challenge is inconsistency in ESG reporting frameworks and standards. With the ongoing convergence of frameworks and standards in process and Securities and Exchange Commission (SEC) guidance on climate change disclosures on the horizon, PE firms are taking a practical approach by choosing to report against the most widely recognised standards for the relevant sectors they invest in. Funds investing in multiple industries will find reporting more complex and should consider leveraging technology platforms and tools to manage ESG data across the portfolio.

FW: When pursuing transactions, what strategies can PE firms deploy to ensure that ESG risks and opportunities associated with a potential target company are being effectively assessed during due diligence?

Baum: The diligence process continues to evolve. Traditionally, due diligence has focused on the financial integrity of the target and viability of the deal thesis. With ESG, reputational risk is front and centre as there is a much broader horizon of risks that could negatively affect long-term performance and value. The diligence process itself is trending toward more specialisation, including operational, cyber security, legal and now ESG due diligence. It is critical to understanding the industry-specific risks a portfolio company faces as industry benchmarks are used by ESG rating organisations and others to assess a company’s ESG performance relative to its peers. Given time pressures in acquisition due diligence, it is important to focus an ESG risk assessment on material risks relevant to the target’s sector. The analysis should include a review of risks related to reputation, brand, market confidence, and customer and business relationships. Regardless of the industry you invest in, the risk landscape has broadened with the inclusion of ESG risks.

FW: What essential advice would you offer to PE firms seeking to act as responsible stewards and demonstrate their commitment to the ESG agenda?

Baum: At its core, ESG presents a rare opportunity for innovation and value creation. If ESG is embraced strategically, a company can explore new, innovative ways to serve its customers’ needs, differentiating its products and services and gaining first-mover advantage. It can also revamp its processes to use resources more efficiently while improving talent retention by engaging in fair and equitable social practices. ESG is not a PR move, it is a business strategy. You must ‘walk the walk’, not only to avoid stakeholder backlash, but to see the long-term benefits. Since PE firms are in the business of value creation, ESG is a natural fit. Companies that integrate ESG into their business models will drive competitive advantage, efficiency and sustainable growth.

FW: Do you expect the PE industry’s focus on ESG issues to continue rising over the coming years? Is ESG performance likely to correlate with value maximisation?

Baum: We expect ESG to continue to be a major component of the conversation around how PE does business and how institutional investors view their ROI. A strong ESG strategy will become table stakes in how PE funds position themselves to raise funds and manage their portfolio. In terms of ESG performance and value creation, the two will increasingly go hand in hand as more sophisticated methods of data gathering and analysis allow PE funds to better understand and act upon that information. This, combined with consolidation of frameworks and industry standards in reporting, will provide more robust data to investors to make better investment decisions. ESG in private equity is here to stay so long as funds embrace it in a holistic, longer-term strategic manner. How private equity ultimately takes advantage of this opportunity remains to be seen.

 

As a leader in BDO’s global ESG & Sustainability services and a member of BDO’s global private equity and corporate finance teams, Karen Baum inspires and drives sustainable, value enhancing solutions for private equity and corporate clients ensuring best-in-class client service. She is an accomplished strategic corporate finance adviser with more than 30 years of experience working across each stage of the M&A lifecycle. She brings insight and innovation to complex transactions and operational finesse to maximise synergy capture and sustainable value creation. She can be contacted on +1 (214) 243 2928 or by email: kbaum@bdo.com.

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THE RESPONDENT

Karen Baum

BDO

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