What is ESG Investing in Private Equity?

By: Megann Freston

Director of Product Marketing

April 19, 2024

Over the past few years, one of the biggest trends in the private equity (PE) world has been the growing consensus around environmental, social, and governance (EGS) initiatives. Namely, our landmark 2022 survey indicated that 90% of general partners (GPs) see ESG as beneficial to firm returns, and 85% already had an ESG policy in place. This reflects a shift towards sustainable investing, recognizing that ESG factors are integral to financial performance and responsible investment practices.

It’s clear: ESG investing is not just a trend but a cornerstone of responsible investment strategies in PE.

So, what does this imply on a practical level? What does investing in ESG mean for PE firms, and what impacts can it have on portfolio companies—not to mention on the world at large?

Below, we’ll break down how ESG intersects with PE, exploring the vital role of ESG criteria, ESG risk management, and how ESG integration influences investment decisions. Then, we’ll look at the cross-sections of environmentalism, social justice, and ethical governance. We’ll also touch on the benefits that ESG investing has for PE firms, including improved ESG ratings and adherence to ESG principles, as well as the challenges they may face in pursuing it.

Understanding private equity and ESG

In the broadest sense, ESG investing, or sustainable investing, means targeting ESG goals (i.e., sustainability, equity, and sound management) alongside more conventional metrics like profit or growth. On a more practical level, it attaches quantifiable measures to seemingly qualitative, value-based ends.

For example, companies may measure ESG performance by quantifying environmental impact factors like their carbon emissions or setting measurable goals for energy consumption. PE firms can measure social factors by analyzing equity at all levels of a company, including leadership.

Private equity’s focus on private companies means that investors can’t rely on the uniform approach to ESG-related concepts that come naturally as a by-product of regulations.

This can be both a blessing and a curse.

On the one hand, PE opens up the door for investing in companies with suboptimal ESG metrics; on the other, it enables aggressive targeting of ESG outcomes that regulatory red tape can stifle.

Environmentally focused investing

Environmental investing means targeting assets that take measures to minimize or neutralize their negative impacts on the planet. Investors weigh factors like decarbonization, reduction of water usage, or recycling and composting programs alongside profit and addressable market. Such strategies are part of a broader investment strategy focused on impact investing and socially responsible investing, where ESG factors, including ESG risks and ESG performance, are paramount.

For example, consider the material environmental goals targeted in Allvue’s ESG Policy:

Measuring and minimizing greenhouse gas (GHG) emissions
Ensuring energy efficiency at the level of real estate management
Optimizing waste management and recycling to minimize waste production

PE firms can contribute to these causes, or similar ones, by selecting portfolio companies that already espouse them or making these initiatives a key part of their active management.

Private equity and the environment

According to the Harvard Business Review (HBR), PE is uniquely positioned to be a leader in sustainability, largely because of the way it’s grown in scope. The authors go so far as to say that “society won’t be able to tackle climate change….without the active participation” of PE firms, highlighting the crucial role of ESG investment and ESG funds in sustainable investing.

HBR outlines three main reasons PE can and should shape the future of sustainable, eco-friendly investing. The most important one is that asset owners are concerned about the impacts future climate catastrophes (and large-scale social inequality) could have on the world economy.

These fears lead them to value environmental risks on purely business grounds rather than (or in addition to) moral or value-driven ones, expanding environmental incentives.

The other factors HBR outlines are closely related. GPs are well aware of the outright benefits ESG factors have on general market performance (see below), and the best portfolio companies on offer are also increasingly valuing environmental initiatives and ESG overall. Ultimately, ESG investing is good business that PE firms should be espousing on those grounds alone.

Socially-focused investing

Social investing means prioritizing issues of social justice in the focus and internal governance of target portfolio companies. Investors in this space value things like a company’s demographic makeup and commitment to diversity or the steps it takes to proactively prevent prejudice.

For example, these are the material social focuses that Allvue prioritizes:

Embracing diversity, equity, and inclusion (DEI) at all levels of the workforce
Empowering community engagement and opportunities to give back
Employing customer risk mitigation to minimize clients’ risk exposure
Advocating and targeting ethical supply chain partners

Socially-focused PE firms are well-positioned to acquire (or create) equitable, ethical companies.

Private equity and social justice

McKinsey’s report on the state of diversity in private markets (2023) highlights the many strides PE has made in making more equitable, ethical workplaces a reality across both firms and the portfolio companies they manage. Entering 2023, PE firms approximated gender parity, with women making up 48% of entry-level roles in the industry. Although there is work to be done still in investing and operating roles, progress in this segment portends well for the future.

In addition, the racial and ethnic makeup of PE senior leaders as of the end of 2022 grew significantly closer to representing population-wide demographics in the US and Canada.

Beyond internal strides, McKinsey observed increases in investors’ interest in DEI metrics in funding and portfolio selection processes. What all of this points to is a future wherein the forward-thinking, socially-minded PE firms of today are reaping the benefits of diversity.

Governance-focused investing

Governance investing is somewhat more vague in terms of direct implications than environmental or social investment. The best way to think about governance for ESG purposes is a programmatic (i.e., top-down) application of the ethical principles underpinning all other ESG efforts.

In our perspective, some of the most important material governance initiatives are:

Ensuring accountability and responsibility for corporate leadership
Assessing for ethical business practices across operations
Implementing rigorous data privacy and cybersecurity safeguards
Disclosing ESG practices and priorities to all stakeholders

As with the environmental and social initiatives above, PE firms’ ability to ensure sound governance is not limited to portfolio companies’ existing cultures at the time of acquisition.

Private equity and sound governance

One unmistakable takeaway from a Financial Times (FT) investigation into how PE can meet its public responsibilities is that the “E” and “S” run through the “G.” That is, governance unlocks PE firms’ potential to create environmental and social impacts across their portfolio companies.

This is because of the overall structure of PE funding, especially the roles GPs take.

FT notes that, because firms have so much stake in the companies they acquire or invest in, they are able—and eager—to leverage “board representation and ongoing dialogue” to advocate for aggressive pursuit of things like sustainability and inclusion. GPs and the firms they manage have a much greater ability to drive change in companies than public market investors. They’re able to set agendas that value ESG outcomes on par with (or over) traditional financial goals.

Benefits of ESG investing in private equity

A PwC study on the benefits of ESG for PE firms confirms our own findings about the industry’s buy-in on ESG. An overwhelming majority of firms reported looking at ESG in most opportunity sourcing and due diligence processes, and over 50% reported considering ESG in all instances.

But why? The survey responses highlight four primary pillars of upside for PE firms:

Risk mitigation
Brand reputation
Competitive differentiation
Client attraction and retention

These are among the reasons that about one-third of PE firms saw ESG as a primary value driver in the majority of their recent deals. And, in addition to positively seeking out ESG in investment selection, a majority of firms reported not pursuing a deal due to doubts or concerns about ESG commitments in a potential asset. In other words, these benefits aren’t being taken lightly.

Challenges to ESG private equity strategies

Despite the many benefits of ESG investing for PE firms, there are roadblocks and potential pitfalls that can prevent investors from maximizing their ESG ROI. According to our private equity ESG survey, the challenges differed slightly between GPs and limited partners (LPs).

Namely, the majority of GPs (51%) felt collecting ESG data from portfolio companies was the most challenging aspect of ESG, whereas 40% of LPs found the aggregation of said data to be more of an issue (20% also found collection most difficult). Among GPs surveyed, aggregation was not a major concern, but 18% did rank reporting (closely related) as the biggest challenge.

There was broad consensus about the difficulty of navigating global regulatory compliance standards, with 21% of GPs and 18% of LPs ranking it as the most difficult aspect of ESG.

There was also consensus about the best way to solve these challenges, as 57% of LPs and 64% of GPs ranked in-house ESG leaders or teams as their primary resource. Majorities in both groups saw fintech as promising, although 50% of LPs specifically had not yet implemented it.

Making the most of private equity ESG investments

Here at Allvue, we’re fully on board with savvy PE firms’ embrace of ESG. We’re committed to environmental, social, and governance initiatives ourselves, and we’re happy to help both individual investors and organizations make the leap by removing ten boundaries to ESG.

To that effect, our private equity software makes collecting, aggregating, and mobilizing all kinds of data—including but not limited to ESG reporting—easy and accessible for GPs, LPs, and investment professionals working under and with them. Our tools empower data visualization and analysis of ESG metrics and risks, which accelerates investment and management decisions, in turn maximizing your impact on the world (and the performance benefits that come with it).

To learn more about how our platform empowers ESG in PE, contact us today!

Sources:

Financial Times. Can private equity meet public responsibilities? https://www.ft.com/content/3d78e733-3c2c-4c60-b63c-c961d7a89c0f

HBR. Private Equity Should Take the Lead in Sustainability. https://hbr.org/2022/07/private-equity-should-take-the-lead-in-sustainability

McKinsey & Co. The state of diversity in global private markets: 2023. https://www.mckinsey.com/industries/private-equity-and-principal-investors/our-insights/the-state-of-diversity-in-global-private-markets-2023#/