Why middle-market private equity firms should embrace a proactive approach to ESG

Intense climate change disasters, racial & gender inequality, and data privacy breaches. While all seemingly different, these issues have a common thread: they’re all considered under ESG (Environmental, Social, Governance) management.

Today, one-third of all managed assets in the U.S. are deployed with consideration for ESG, and those figures are even higher in some markets abroad. Stakeholders ranging from customers to suppliers to investors are beginning to use ESG criteria to track everything from carbon emissions and employee wellbeing to supply chain management and corporate board operations.

Because of the current shift toward ESG-focused investing, middle-market private equity (PE) firms are coming under pressure to show they are taking ESG seriously and demonstrate how they plan to integrate ESG issues into the investment decision-making process. Yet, according to EY’s 2021 Global Private Equity Survey, only half of investors surveyed invest in ESG products.

While the majority of large private equity firms are engaging with investors regarding ESG issues, that can’t be said for smaller firms, where 47% are still not engaging with investors on ESG topics at all, the survey showed.

Still, demand for ESG actions is rapidly growing and middle-market private equity firms will need to start adapting to these increasing demands for ESG to remain competitive.

Why ESG matters

Investors want to see clear goals, steady progress, and transparent reporting of results. Limited partners (LPs) want assurance that they are financing sustainable and ethically sound enterprises. ESG practices can help ensure that organizations are operating soundly and reaching financial goals while minimizing their risk and vulnerability to extreme disruption.

While the desire to promote a healthier, more sustainable planet has motivated this evolution, there are clear benefits for those focused on the bottom line. According to MSCI ESG Research, U.S. companies with high ESG rankings in the S&P 500 index have outperformed their counterparts with lower ESG rankings by at least 3% annually for the past 5 years.

ESG investing helps quantify risks that can not be measured using traditional financial metrics and covers a broad spectrum of material impacts. ESG standards like metrics, data, and benchmarking allow management teams to address threats before they happen through risk mitigation strategies, compliance objectives, and disclosures, enhancing investment value.

ESG leaders also have an advantage in hiring and retaining top talent, especially among younger workers who place a high value on contributing to an organization with strong sustainability values. United by a shared vision to help the world, strong, diverse teams are proven to perform better and drive greater innovation.

The trouble with ESG

Across the financial industry, investors and their stakeholders are utilizing ESG criteria to screen investments, manage risk, enhance returns, and tailor portfolios to the increasing demands from institutional investors. In 2019, Bloomberg reported global socially responsible investments grew by 34% to $30.7 trillion in just two years.

While the majority of the PE firms in the EY survey indicated they are taking ESG risks seriously or very seriously in decision-making, the survey stated one-third of firms still said they only consider these risks and opportunities on an ad hoc basis relative to an investment’s performance or don’t view ESG risks as important at all. But considering the benefits of ESG, why are they lagging? There are multiple issues that could causing be a delay in middle-market private equity ESG adoption:

ESG definition & alignment
Socially responsible investing, sustainable investing, and ESG investing: these terms are becoming widely used in today’s investment world. With the expeditious growth and interest in sustainable investing, ESG investing has taken the main stage. However, a lack of standardized terminology has created confusion over how to differentiate ESG investing, sustainable investing, and SRI. While it may seem like a small matter of semantics, understanding the difference between these terms is extremely important and has a material impact on investment decisions.

Greenwashing
According to the Global Sustainable Investment Alliance, investments defined as “sustainable” make up more than 25% of all assets under management globally. However, ESG investing is still young and the factors by which shareholders, investment managers, and individual investors can accurately assess a company’s ESG commitment are still evolving. This lack of regulation leaves the door wide open for what’s known as "greenwashing" and makes it difficult to distinguish the truth about an organization’s ESG products, activities, and policies.

Benchmarking & measuring processes
ESG ratings and benchmarks have experienced a rapid expansion over the last decade. The World Business Council for Sustainable Development reported that, today, there are over 2,000 individual ESG reporting indicators requested by 600 ratings and benchmarks. A lack of standardized benchmarking and metrics continues to support opportunities for greenwashing. Fortunately, while those numbers seem daunting, there are a number of standardized sustainability goals and criteria that have inherent legitimacy and global relevance.

Standardized reporting
The 2019 ESG Global Survey published by BNP Paribas found that 66% of asset owners and asset managers cited data and reporting issues as the biggest barrier to greater adoption of ESG across their portfolios. While ESG reporting and disclosure standards remain far from systematized, many reporting frameworks are showing high levels of alignment.

To address these concerns, PE firms, businesses, regulators, and investors will need to work together to achieve their ESG goals, a move that could benefit small and large businesses and PE firms alike, creating stronger accountability while benefiting the world at large.

Unlocking ESG value

In the EY survey, private equity firms ranked governance as the top ESG risk. However, environmental and social concerns can pose equally harmful risks. Poor environmental decisions can harm a company’s reputation as well as its ability to operate. As racial, political, health, and cultural issues escalate, supply chains, talent management, and human rights issues within corporations are likely to increase.

To address these issues, private equity firms can implement ESG and social responsibility strategies such as:

• Tracking environmental efforts such as energy consumption, greenhouse gas emissions reduction, and waste management systems, creating extreme weather event resilience plans, and strategically planning for impending environmental regulations can all have a material impact on a company’s cost of operations, asset value, and cost of capital.
• Overseeing governance considerations such as board operations, executive compensation, and audit practices are crucial to safeguarding the sustainability of businesses.
• Building awareness of and setting goals for social metrics like community engagement, workforce management, and customer relations can help build positive brand reputation and foster employee satisfaction.

Firms that embrace the principles of sustainability, responsibility, and ethical behavior have the opportunity to capitalize on strong financial results that yield socially impactful outcomes.

The bottom line of ESG

Regulations and pressure from LPs are pushing the private markets toward widespread ESG adoption. Currently, the majority of larger private equity firms have a formal ESG policy in place and middle-market PE firms would do well to follow suit.

Sustainability must be embedded in the core strategy of private equity investments to ensure positive and valuable results across the full scope of the portfolio. Looking at sustainability issues from an ESG lens ensures PE firms are accounting for everything from climate change to accounting practices to employee health & wellbeing that will help investments stand the test of time and change.

As benchmarking and reporting tools are becoming more streamlined, investors and general partners are beginning to agree that the ESG framework identifies risk factors worth incorporating into the investment process. To unlock the most value from sustainable and responsible practices, funds should explicitly make ESG reviews a part of the investment life cycle. This will provide an operational approach that positively impacts portfolio companies and make investments more attractive to prospective investors who share similar values.

ESG materiality assessments

With investors inquiring more and more frequently about what your company is doing in regard to responsible investment, how you treat employees and vendors, your dedication to sustainability initiatives, and other activities that fall under the ESG umbrella, it’s important to have answers to these questions.

An ESG materiality assessment empowers you to easily report on your current state and outline future initiatives while taking into consideration your business goals and risks. Download our guide to creating and extracting the maximum strategic value from an ESG materiality assessment.

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Helee Lev

Helee joined our team in 2012, overseeing strategic account management, new business, and industry alliances. In 2015, she participated in raising $5M of venture capital funding. She leads sales, business development, and Conservice ESG's strategic consulting group.

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