Why now is the time for private equity to invest in ESG

Like most sectors, private equity has faced many pressures and uncertainties during the COVID-19 pandemic. Private equity global buyout and exit transactions both decreased from January through April by 60% and 72% respectively.

The struggling economy undoubtably hurts the ability of private equity firms to identify portfolio companies with the greatest growth potential during and after this pandemic. Fortunately, successes by ESG (Environmental, Social, and Governance) actors during this crisis highlight decisions and investments the private equity sector can make to perform well financially now and into the future. While COVID-19 caused the S&P 500 Index to drop by 23.7% in the first quarter, funds earning the highest ESG ratings by Morningstar reported a smaller loss of 17.7%. In addition, Morningstar estimated a net flow of $10.5 billion into 314 open-ended and exchange-traded sustainable funds in the first quarter.

Goby believes ESG priorities and practices align with the strategies that private equity and the whole investment sector should implement in response to crises such as this pandemic. PricewaterhouseCooper (PwC) covered six key crisis-related issues that private equity may face of crisis management and response, workforce, operations and supply chain, finance and liquidity, tax and trade, and strategy and brand. We’ve found that private equity firms with strong ESG strategies will adequately address all six issues as explained below:

Finance & liquidity

As proven by Q1 2020 Morningstar data, ESG engagement attracts investments from Limited Partners (LPs) in times of crises. It also attracts LP investments during normal times. The US SIF Foundation 2018 biennial Report on US Sustainable, Responsible and Impact Investing Trends has tracked a compound annual growth rate of ESG assets in the United States of 13.6% between 1995 and early 2018. Public pension funds and other publicly pooled portfolios held more than $4.6 trillion of the total $12 trillion US sustainable, responsible, and impact assets in 2018. Education-related organizations and foundations accounted for an additional $602 billion in ESG assets. In an RBC survey of more than 500 LP investors, 90% said they believe ESG performs the same or better than conventional funds.

Crisis management & response

The private equity sector expressed large concern for ESG risks in a PwC survey of private equity firms. In the survey, 85% of respondents stated they were concerned about cybersecurity risks for their portfolio companies, followed by 79% for human rights, 79% for climate risk, and 75% for carbon footprint. ESG started as an avenue for companies to identify and reduce these risks. Private equity firms and portfolio companies that implement ESG best practices and strategies focused on stakeholder engagement, scenario planning, telecommuting, and energy supply diversification can proactively address these concerns.

Workforce

Portfolio companies need proper guidance, monitoring, and planning from your firm if they wish to maintain worker productivity during uncertain and stressful times. Many portfolio companies lack the capital for critical HR staff and programs, which put them at risk of decreased worker productivity during COVID-19. More than 40 million Americans filed for unemployment since the coronavirus pandemic began in March 2020. A Harvard Business Review study found that remaining employees after layoffs experienced a 41% decrease in job satisfaction, 36% decrease in organizational commitment, and 20% decrease in job performance. ESG and HR programs promoting mental health support, paid sick leave, and emergency salary guarantees focus on retaining employees and keeping them happy to increase worker productivity during times of crisis.

Operations & supply chain

Your private equity firm has a financial incentive to avoid costs and increase revenue during both hard and normal times by identifying as many potential liabilities or inefficiencies in the supply chains of portfolio companies. ESG reporting and benchmarking systems like GRESB, SASB, CDP, and GRI continually expand and improve their metrics to capture as many business and operational practices across the supply chain as possible.

Tax & trade

Federal, state, and local governmental regulations and taxes will not go away after COVID-19 ends. In fact, they will likely increase to help communities recover from this pandemic and prepare us for the next societal challenge of climate change. Portfolio companies may look to their general partners to identify these potential taxes and regulations down the line.

ESG leaders are already on top of these issues. The Principles for Responsible Investment (PRI), for example, partnered with Vivid Economic and Energy Transition Advisors to create the Inevitable Policy Response initiative. The initiative determines that the current socio-economic environment will require governments to pass policies to address climate change and other issues by 2025. The initiative then names the eight most likely policy levers that governments will implement, all of which are addressed by ESG:

1. Coal phase-out
2. Internal combustion engine sales bans
3. Carbon pricing
4. Carbon capture and storage projects
5. Zero-carbon power
6. Energy efficiency
7. Land use-based greenhouse gas removal
8. Agriculture

Strategy & brand

The coronavirus has likely shifted consumer demand for the products and services of your portfolio companies. An Accenture survey of more than 3,000 consumers in 15 countries recorded these demand changes during the first month of the pandemic. Some of these changes included 50% of consumers stating they shopped more health-consciously and 45% stating they made more sustainable purchasing decisions. All of the consumers that made more health-conscious and sustainable purchasing decisions said they plan to continue to do so in the future.

Future global consumer data and trends indicate that these survey respondents will not be alone. Over the next 30 years, more than $30 trillion in wealth will shift from baby boomers to more sustainability conscious millennials. Morgan Stanley’s Institute for Sustainable Investing conducted a study that found millennials are twice as likely than the overall population to purchase products from sustainable businesses. ESG leaders are most poised to create value as wealth shifts to a younger and more aware demographic and as the COVID-19 pandemic increased consumer demand for sustainable products and services continues into the future.

What now? How to strike ESG investment while the iron is hot

ESG offers one of the best paths forward for private equity in response to COVID-19 due to the expanded demand for sustainable products and services, increased frequency of social, regulatory, and environmental risks, and measurable improvements in financial outcomes by current ESG actors. Despite ESG’s high potential, obstacles such as long-term benefit realization, inconsistent quantification methods, and the inherent small size of portfolio companies has discouraged private equity from ESG investment in the past. If these obstacles are deterring your firm from investing in ESG, you may find that your firm’s tendency to commit to portfolio companies for multiple years and to closely monitor these investments greatly align with ESG principles. Meanwhile, Goby’s team will help overcome the other obstacles by extracting value from your ESG data and delivering winning strategies to your firm.

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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