This article is sponsored by Crowe LLP
ESG has been a central focus of private equity firms for several years now. How has this evolved recently toward a more formalized approach?
The overall focus on ESG data and reporting has become much more serious due to increasing stakeholder demands. For a start, you can’t ignore the regulators and the SEC, in particular. The SEC has a very simple but critical premise: ESG information is important to investors and impacts the allocation of capital. So, anything someone says about ESG issues, broadly defined, equals an investor disclosure. That creates a new level of responsibility in communications and opens you up to the risk of enforcement actions.
The SEC has an ESG and Climate Task Force, and even without new regulations in place – they haven’t passed the climate rule yet – they have already pursued many enforcement actions in the last couple of years because they have made that link between ESG information and investor disclosures. They are saying that, just like telling someone ‘we’re going to earn a certain rate of return,’ if you say, ‘we’re a green fund’ or ‘we have certain ESG accomplishments,’ those may be viewed as equal disclosures.
Investors are also more focused on ESG data, as are ratings agencies, customers, activists and even your employees and competitors. All these stakeholders should be considered as you assess reporting goals and obligations.
Is increased scrutiny from the SEC encouraging firms to be more or less specific in their ESG commitments?
Some firms will step up to take a leadership role and most will be pressed to improve their data and processes to better support what they have said or would like to say around ESG. Some may have to take a step back to reassess their commitments to ensure they are attainable. I suspect we will see more enforcement actions as the pressure on disclosures increases. And it’s critical to note that “disclosures” aren’t limited to investor documents or financials but broadly include any claims you make anywhere: on your website, in an advertisement, on a product label, etc.
Unlike financial or income tax reporting, there’s not yet a consistent format for ESG disclosures. There are numerous voluntary frameworks – SASB, GRI, TCFD, CDP – so the volume and content of reporting varies significantly. The reporting is not yet regulated in the same manner as audited financial filings. But the SEC is pushing now for a comparable level of rigor in the way you compile these reports.
“While we tend to focus on risks and costs, we also need to remember that ESG trends can create opportunities”
Given this pressure, it’s best to support your sustainability team with input and review from legal and compliance, internal audit, and others who can help ensure data quality and solid process and IT controls. We will see sustainability reports become more systematic, consistent and verifiable over time.
What are some regulatory developments that have caught your eye recently?
We see a proliferation of existing and pending regulations globally around supply-chain transparency, anti-human trafficking, emissions and other ESG issues. It’s critical to understand the detailed aspects of any business you are buying through a regulatory and ESG lens.
One impactful example would be purchasing a manufacturer that sources products from China. That’s very common, except now we have the Uyghur Forced Labor Prevention Act in place in the US, which bans products from a key region of China. Your due diligence on the target should drill into the supply chain to ensure your products aren’t unexpectedly banned because of an anti-slavery regulation.
Would discovering this kind of information during diligence mean a firm wouldn’t pursue the deal?
That would depend on the regulatory exposure and impact, but you can’t assess it properly if you can’t see it. You could have direct exposure, or you may buy a company that has customers subject to these regulations, and the customers can place significant data and compliance demands on you. If you are buying a business that has a heavy carbon footprint, you need to know about it in advance to understand future obligations for reporting, reductions, offsets, etc. Also consider what progress you want to make during ownership to enhance the value on exit.
What’s your advice for a private equity firm looking to completely overhaul their approach to ESG?
You can start with a materiality assessment and stakeholder engagement effort to ensure you have a current and comprehensive understanding of the demands of your investors, employees, regulators, customers, etc. Don’t guess, make the process robust to capture valuable feedback, insights and benchmarking, and educate your team to ensure collective buy in to your efforts. You can do research, conduct interviews and circulate surveys as needed to gain the right information from your stakeholders.
A comprehensive process will yield a proper roadmap and timeline for implementation of processes and technology to achieve your goals around performance and disclosures. The materiality assessment should be updated periodically and may delve more deeply into certain areas of key importance. You should document the approach clearly so it can be replicated and improved upon. The scope and specifics of the process will vary depending on what industries you focus on, what size deals, what types of investors you have, and whether you are exposed to public or private companies.
There are clearly a lot of costs and challenges, but what are the opportunities for private equity firms?
While we tend to focus on risks and costs, we also need to remember that ESG trends can create opportunities. Shifting market needs around new software technologies and the focus on renewable energy, carbon offsets and similar initiatives creates a host of new investment opportunities.
Professional service firms are seeing increased opportunities for advisory and staffing support. The focus on ESG measurements can also yield operational efficiencies that improve margins – lower energy costs, improved insurance rates and even preferred borrowing rates on sustainable bonds and credit facilities.
Depending on the specific market and pool of strategic buyers, firms that outperform and disclose on ESG metrics may command higher multiples on exit. Large pension funds and institutional investors increasingly prefer to allocate funds to firms that prioritize investments that advance greenhouse gas emission reductions, diversity and inclusion initiatives, and other sustainability goals. There’s so much happening in the ESG space with the evolution of regulations, frameworks and market demands that sophisticated investors can find lots of opportunities.
Chris McClure is partner and ESG services leader at Crowe LLP