How ESG is evolving in manufacturing and industrial

Environmental, social and governance initiatives were all the rage, until they weren’t. Today, ESG investing faces political scrutiny in the US, leading many private equity firms in the manufacturing and industrial sectors to adjust the language they use talk about these programs. Despite these semantic shifts, the values behind the ESG push remain front of mind.

At Palladium Equity Partners, a minority-owned buyout firm focused on US Hispanic markets, the ESG initials have been decommissioned for at least three years, says Carlos Reyes, managing director and head of sustainability for the firm. “Semantics to a certain extent might have clouded the meaning of what we are trying to achieve,” Reyes says. Instead of the “E” in ESG, Palladium refers to “resource efficiency,” he says. Instead of talking about “social” investing criteria, they talk about “people and communities.” Instead of “governance,” they refer to “public accountability.”

“That effectively has been more to try to stay away from some of the debates around semantics,” Reyes says. “We felt that ESG generated an initial backlash with people that misinterpreted the true sense of the word. We were trying to put it into elements that are truly connecting with what we are trying to do with our mission.”

Among private equity peers, some people have decided not to talk at all about it and others are doubling down, Reyes says. At Palladium, renaming ESG goals as stewardship goals helps to convey the concept of value creation in addition to having a positive impact in the communities you’re investing in, he says. “By explaining it that way, we’re able to bridge the debate between the two camps.”

ESG evolves

While PE firms call ESG by other names, their ESG investment approaches continue to evolve.

There is continued stakeholder pressure on PE firms from limited partners to integrate ESG analysis into investment decisions, says Josh Hesterman, a KPMG managing director who advises PE clients on investing in manufacturing and industrial companies. “We’ve only seen that continue to increase.” For example, in the public company world, in 2023 KPMG found that specific ESG terms were mentioned in shareholder proxies for more than 2,000 companies.

Hesterman says the political criticisms of ESG haven’t changed how most of his clients consider ESG factors and their financial impact on investing.

“People are retrenching and saying: OK, we may have to be more specific about how we define out the things that we want in that investment plan and how we think about criteria, without defaulting to ESG as a term, because it has become pretty loaded,” he says.

ESG plays a large role in mergers and acquisitions. In a 2023 survey by KPMG of M&A practitioners, 53 percent of US respondents reported that they had canceled a deal based on a poor finding related to ESG or sustainability factors, and 62 percent said they would pay a premium for a target with a high degree of ESG maturity.

The PE firms that can figure out how to accurately measure ESG impact on investment value will have an inherent advantage in fundraising and generating return on investment, says Eric Janson, global private equity leader for PwC.

Not many large and medium-sized PE firms are making specific net-zero commitments, but most of them are now setting up near-term and long-term goals that can guide their ESG strategies and they’re assessing acquisitions based on sustainability risks and opportunities, Janson says. Two or three years ago, only a few firms were.

“We’ve seen a very big land shift there in terms of the importance this is playing in the investment process,” Janson says.

LPs evolve

Palladium’s investors are evolving in terms of what they want from ESG investments, Reyes says. Earlier on, they wanted “a statement of you trying to do good,” he says, and now they want to know how the investment will make the portfolio company more sustainable. Next will be specific measuring of how much sustainability is created, likely through sustainability audits.

For industrial companies, the concept of emissions reduction has been consistently important, with firms making net-zero commitments for 2030 or 2050, often via purchased carbon offsets, Reyes says. Now investors are demanding that emissions reductions are done via operational changes, which is more environmentally impactful.

“The thing that matters most is not three-letter words or 10-letter words; it’s results”

Chase Jordan
EY Americas

“When you’re talking about industrials, there is an opportunity to truly reduce those emissions, via operational improvements rather than financial instruments,” Reyes says. Industrial companies have more emissions under their direct control than a service company might, for example.

From industrial companies, PE investors are “looking for a path to reduction,” he says, not necessarily reaching a net-zero goal in a short period.

For Chase Jordan, EY Americas’ ESG due diligence leader, the shifting language of sustainability hasn’t altered the overall investment trend in private equity. “I don’t think that the language of ESG versus sustainability actually matters because in PE the universal language is performance,” Jordan says. PE professionals are figuring out how to capture revenue from ESG goals like net-zero carbon emissions or creating a competitive advantage for a business from an investor’s ESG mandate.

“Private equity understands that this is an enduring macro trend,” despite the current political backlash from conservative politicians or the iterations on ESG and sustainability language, he says.

Some companies in the manufacturing sector have been leaders in sustainability since before ESG – when sustainability goals were referred to as EHS (environmental, health and safety) – because removing carbon from the supply chain also removes costs, Jordan says.

“The thing that matters most is not three-letter words or 10-letter words; it’s results. And we are in a period of increased expectation around results.”

The question that company boards and C-suite executives are concerned about is how to achieve net-zero goals, says Sai Yadati, EY Americas advanced manufacturing and mobility sustainability leader.

On a macro level, ESG is opening up new markets for manufacturing and industrial companies, such as in the areas of novel sustainable fuels, Yadati says. For example, chemical companies are considering opportunities to create new feedstocks that require less energy consumption to turn into their end products. Carbon capture technologies are creating new revenue streams for manufacturers. Also, fossil fuel companies are seeking new areas of revenue by transitioning to energy companies.

From a regulatory standpoint, manufacturers and industrial companies are more reticent about becoming early adopters of ESG regulations, such as emissions reporting requirements proposed by the US Securities and Exchange Commission, unless they are forced to by a regulator or by their connection to another company that is an early adopter, says David Bligh, a director for management consultant AlixPartners in Washington, DC.

Meanwhile, PE firms seem to be taking a wait-and-see approach on adopting the ESG standards proposed for public companies until they know who wins the White House in November, which could determine the fate of those standards, Bligh says.

Pulling its own weight

ESG investing for private equity at first was about mitigating risk from environmental, social and governance factors, Reyes says. That view has evolved into ESG investing that generates value, regardless of whether the investment is for an impact fund or not, he says.

The question is whether sustainability can generate alpha returns, Reyes says. “That is going to be the key test of whether sustainability is going to remain as an effective tool of value creation or not. We have seen the market moving toward more factual-based rather than opinion-based. You have to provide evidence.”