How ESG is impacting Private Equity in 2024: Review

Environmental, Social, and Governance (ESG), is a framework for companies to report on their non-financial performance. This framework goes beyond traditional financial metrics to assess a company’s impact on the environment (sustainability, climate change, resource use, and pollution), social responsibility (interaction with stakeholders, employees, customers, and communities), and governance practices (leadership structure, transparency practices, and accountability measures).?

By reporting on ESG, companies provide a more comprehensive picture of their daily operations, potential risks and opportunities, but also the long-term viability and sustainability of a company to their investors, lenders and other stakeholders.?

Since its introduction, ESG reporting has been a highly debated topic. The debate is split between ESG being a useful and necessary metric to improve investing practices vs ESG being superfluous and no more special than other company success metrics such as corporate culture, innovative capability or management quality [1].??

Although the literature on ESG and its impact on Private Equity (PE) is expanding, the findings and analyses remain mixed. Using existing literature, this article will aim to review and summarise the findings in a digestible format and share the most common topics within this space.?

ESG disclosure in PE firms?

Before discussing the challenges and benefits of ESG engagement, it’s important to note that the detail of reporting and disclosure in PE often differs [2,3]. Although principles such as the ones set out by the UN PRI (2018) exist, for the most part, frameworks and metrics continue to be non-standardised.?

It is therefore challenging to strictly define the level of engagement of PE in ESG disclosing and directly compare the data. However, on average it is estimated that between 68% to 72% of PE disclose ESG in their annual and investment reports [4,5,6].?

Cost and challenges of ESG-engaged PE firms?

Data collection and availability?

Gathering reliable and comprehensive ESG data, particularly from portfolio companies, is a significant hurdle. Data can be scarce, inconsistent, unreliable or simply not exist; this poses a significant challenge to objective ESG reporting within portfolio companies [7].?

Internal expertise and resources?

Recruiting dedicated ESG specialists, investing time in data collection, and providing sufficient training for accurate and objective data management requires significant time and monetary resources. This can be especially challenging for smaller PE firms focused on growth [8].?

Evolving regulatory landscape?

The parameters of ESG reporting, although established, are continuing to change together with the existence of multiple regulatory bodies [9]. To deal with the evolving landscape, continual investment into resources, specialists and evolving methods of data collection and availability is therefore needed.?

Greenwashing?

Concerns surrounding “greenwashing” remain a major controversy. This refers to companies presenting themselves as more ESG-compliant than they truly are, potentially through superficial initiatives that don’t address core environmental and social issues [10]. This can be particularly challenging for companies in traditionally “problematic” industries who are genuinely attempting to improve their ESG performance.?

“A challenge has been simplifying the ESG language and narrative?so everyone can understand the meaning and value ESG have for a company and its owners. A major learning for us has been to tie concrete actions to justify why we collect and look at certain ESG Data.

For example, we put a “Sustainability Champion” on the company Board to drive the sustainability agenda to have accountability from the top, we tie performance on certain ESG metrics to financing terms and we help companies to decarbonize by setting science-based targets and increasing the use of renewable energy” – Global ESG Managing Director, A Top 3 PE Fund?

Value creation and benefits of ESG-engaged PE firms?

Enhanced Investor Relations and Fundraising?

A growing number of investors consider ESG factors when making investment decisions. PE firms with strong ESG practices are better positioned to attract these investors and raise capital [11].?

Improved Portfolio Management and Risk Mitigation?

Integrating ESG into portfolio management allows PE firms to identify and mitigate potential risks related to environmental, social, and governance issues, ultimately contributing to more resilient portfolios [12].?

Brand Building and Competitive Advantage?

Demonstrating strong ESG commitment can enhance a PE firm’s brand reputation and attract talent, fostering a competitive edge in the market [13]. By leaning on ESG practices as a unique selling point of the company, it is also more likely to experience a lower talent attrition rate, which in turn reduces hiring costs, drives growth, and promotes a great company culture.?

Future-proofing?

ESG considerations are becoming increasingly vital for long-term business sustainability and growth. By integrating ESG principles, PE firms can better prepare their portfolios for future challenges and opportunities arising from the evolving social and environmental landscape [14].?

Performance of ESG companies?

A growing body of research suggests that companies with strong ESG practices tend to outperform their counterparts on various financial metrics, including stock price performance and risk-adjusted returns [15].?

Impact investing?

PE firms are increasingly exploring impact investing. Through engagement in ESG practices, the judgement of generating a positive social and environmental impact alongside financial returns [16] is more efficient and easier to evidence.

“It’s important to showcase how sustainability could create shareholder value by tagging a company’s revenues from products and services to pre-defined sustainability themes, e.g. Climate & Nature and Health & Wellbeing.

For example, the shift in Climate from fossil fuels to electrification currently taking place in the transportation sector, whereby the electrification part would be tagged as a sustainable revenue stream whereas the fossil fuel part would not be tagged as sustainable.

By going beyond the regulatory requirements, which are commonly considered as a “license to operate” and focusing on and growing sustainable revenues a company could create more long-term shareholder value. “ – Global ESG Managing Director, A Top 3 PE Fund?

Conclusion

Although challenges persist, ESG is shaping the future of PE. As investor demands for sustainability considerations grow and regulations evolve, PE firms that embrace strong ESG practices will likely be positioned for long-term success. In addition, as technological advancements evolve, those will play a crucial role in facilitating accurate and reliable data collection, analysis, and management, resulting in improved integration of ESG in PE [17]. In the evolving ESG landscape, PE firms will become an important contributor to a more sustainable and responsible future.?

Written by: Anita Balcer-Whittle, Head of Research and Insights at STOIX

March 2024

REFERENCES

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12. Amel, A., El Ghoul, S., & Amiri, A. (2018). Does environmental, social, and governance (ESG) disclosure reduce idiosyncratic risk? Evidence from the oil and gas industry.?Business & Society, 57(1), 1-32.?
13. Moeller, S., Kniess, C., & Pforr, C. (2019). It’s not just about the money: How corporate social responsibility and employer branding attract highly skilled employees.” Journal of Business Ethics, 157(3), 757-775.?
14. Hahn, T., Pinkse, J., Preuss, L., & Figge, F. (2015). Tensions in corporate sustainability: Towards an integrative framework.?Journal of Business Ethics, 128(1),?297-316.?
15. Flammer, C., & Luo, X. (2021). Is good corporate governance good business? A meta-analysis.?Journal of Management, 47(8), 2251-2283.?
16. Global Impact Investing Network. (2023). The global impact investing report 2023.?https://thegiin.org/research/publication/2023-giinsight-series/ ?
17. PwC. (2023). AI for good: How artificial intelligence is driving positive change.?https://www.pwc.com/gx/en/issues/data-and-analytics/artificial-intelligence.html ?