This article is sponsored by PwC.
What is the strongest evidence that PE firms are taking ESG issues seriously?
Aaron Gilcreast: ESG issues are a business imperative that can affect long-term success and value creation. From green initiatives to diversity in leadership and commitment to equity, justice and other societal issues, companies are more accountable to all stakeholders now than ever before. Our recent survey on responsible investment suggests that private equity firms are looking seriously at these issues. For example, 56 percent of respondents have refused to enter general partner agreements or turned down investments on ESG grounds.
Another way of looking at this is to compare the present with the past. In my experience, interest feels demonstrably more real among PE firms than at any point in recent years, judging by the sheer volume of calls we take from our clients. Anecdotal evidence supports my view – we just saw a transaction failure in the plastics industry, principally out of concern about the impact of plastic on the world.
The momentum for portfolio companies to change is also coming from customers that have their own net zero objectives. We recently had a conversation with a smaller portfolio company that emits nominal amounts of greenhouse gas. As such, decarbonization has not been a priority to date for them. But recently, its customers have been calling to discuss their net zero objectives and the importance of the portfolio company having similar goals.
Your survey says that seven in 10 PE firms integrate ESG risks and opportunities into their transformation or value creation plan. A similar number always screen target companies for ESG risks and opportunities before acquisition. Will these practices be absolutely standard in a few years’ time?
“PE firms can earn a return from an ESG turnaround”
Abigail Paris: There will always be outliers, but the vast majority of firms will at least apply key elements of ESG. In particular, a number of key ESG issues are on the forefront of everyone’s minds. I would list inclusion, diversity and climate. I would also list governance issues such as bribery and board independence. Limited partners are highly engaged on these issues. They know such matters could result in value leakage when portfolio companies are being sold.
Have any issues noticeably risen up private equity firms’ agendas over the past year or so of momentous global events?
AG: It is more that various disruptive trends are all converging – whether climate or social justice or pay gaps or tech disruption that forces a reskilling of workforces. There is an obvious lack of trust in institutions, which has been amplified by recent events.
Thinking in practical terms, how can you help PE firms protect and create value?
Eric Janson: MSCI has identified over 30 key ESG issues. We do not ignore any of these. However, we focus our energies on finding the three or four of these factors that matter strategically to each company, in terms of risk exposure and/or opportunity to create value. In its diligence exercise before buying a company, the PE firm should do some initial thinking about value preservation and creation opportunities and how to mitigate the one and take advantage of the other. After the deal closes, we help the PE firm with sustainable value creation, taking a much deeper view of the opportunities for value preservation and creation.
PE firms have worried about ESG risks for a while, but do you think they are thinking more about value creation too, these days?
AP: Compared with 10 years ago, there has been a shift from thinking about red flags for issues that might negatively impact asset values, to a strategy of value creation based on how a company is positioned for the future.
More firms see an advantage to engaging in ESG in this way. It is not necessarily that expensive to do a lot of this. Some of it just requires better co-ordination and understanding; some actions could be quick wins; some are more transformational. I do not want all funds thinking that caring about ESG issues entails a huge cost with little to no benefit.
Are firms prone to underappreciate any particular ESG issues, when considering portfolio companies?
“Most funds find it difficult to collect relevant ESG information”
EJ: All of our private equity clients prioritize digital transformation and data optimization. However, most funds find it difficult to collect relevant ESG information across their portfolio in order to change behavior and make decisions in a consistent way across all portfolio companies. PE firms often send surveys to portfolio companies and collect responses in a spreadsheet, or in emails. They should be trying to find ways to get data on a more consistent and real-time basis, to enable PE firms to take more informed and faster action.
The difficulty of this is underappreciated. For example, every portfolio company will know how much they pay for electricity, but no one has at their fingertips information on which utilities provide that power and what is the mix of that power between coal, other fossil fuels, wind, solar, and so on. In other words, it is hard for them to figure out their carbon footprint.
AG: If you are a portfolio company, perhaps 50 to 80 percent of the data that you need to look after your ESG metrics properly may exist in your system, leaving 20 to 50 percent outside it. Moreover, even some of the data you possess presents obstacles because it is unstructured: it is not in an organized form, such as numbers on a spreadsheet.
EJ: Social metrics present their own challenges. Some clients have set up specialist social impact funds, but it can be difficult to measure social impact. It is hard to put an exact number on the social impact of investing in a milk company in India, for example.
What kind of companies present particular opportunities for ESG value creation?
AG: In public markets investors make a fair point in suggesting that ESG has been bid up so much that it is hard to find value. However, there is still an opportunity for returns in private markets, if you are a house with ESG expertise that you can put to work to find companies that are undervalued because they are not able to do ESG well. PE firms can earn a return from an ESG turnaround: acquiring a company that is dirty in environmental, social or governance terms, cleaning it, and selling it at a premium.
EJ: The auto sector shows promise here. Many traditional auto companies and their suppliers are dirtier in carbon terms. These companies trade at much lower multiples versus alternative energy companies such as electric vehicles makers and their suppliers.
Do all PE firms have the expertise for ESG turnaround investing?
EJ: Every firm needs to look at the mirror to work out what it is good at and not good at. Some lead in their ability to buy dirty and sell clean. However, I do not think all PE firms are in a position to play in that space – especially in the US.