THE PRIVATE EQUITY ADVANTAGE

Sentiment about sustainability has soured in some circles; elsewhere, it has simply been overshadowed by geopolitical tension. But for private equity, this sentiment shift creates two distinct opportunities—one strategic, the other tactical, as argued in a Wall Street Journal podcast?last month.

A private equity investor deploying hundreds of millions of dollars (or equivalent) in equity in a leveraged buyout will largely base today’s bid for a target on its expected value at exit, say, five years from now. Therefore, a private equity firm investing in 2025 must evaluate the target's financial performance and?prospects in 2030 when the future value of the target is crystallized.

This raises two questions: How will material sustainability drivers affect the business's financial performance between now and 2030? How will its non-financial performance influence its prospects and?marketability in the world of 2030? Answering these questions forces a reality check that cuts through market sentiment, and, as critically, through individual ideological biases.

Under a reasonable scenario, sustainability challenges, such as supply constraints (including commodities, labor, fresh water or electricity), and other factors (physical climate risk, biodiversity, or air pollution) will be more pronounced and visible in 2030 than they are today. Under these circumstances, firms with a superior sustainability profile (considering what they do and how?they do it) may not only generate higher earnings in 2030 but will also command a higher valuation multiple thanks to their enhanced quality growth and return on capital profile.

Thus, ahead of deploying capital today, the private equity firm must determine whether the targeted business is intrinsically well-positioned to tackle tomorrow’s sustainability challenges. Separately, it must identify sustainability-related actions with an expected positive net present value?that can be implemented under its ownership. The goal is purely financial: to further enhance the asset’s sustainability profile and maximize its equity value by 2030.

By emphasizing risk management, ‘future-proofing’ fails to adequately capture the value creation potential unlocked by a sustainable corporate strategy. ‘Future-maximizing’ would be more appropriate.

Because it is less exposed to public scrutiny and enjoys a tight alignment between shareholders and management (an alignment that is being challenged in the US financial markets), private equity benefits from a significant advantage over public investors. They can take a rational approach to long-term value creation through the implementation of strategic, sustainability-driven initiatives—whether it is energy efficiency in real estate, carbon emissions in logistics, water use in apparel, employee training in luxury goods, recycling in plastics, talent in professional services, or waste management for hospitals.

Aside from this strategic advantage, private equity also benefits from a tactical one. Any divergence between sentiment and reality creates a valuable arbitrage opportunity for private equity investors. Not only can private equity implement future maximizing sustainability strategies, but they can also play the sustainability sentiment cycle by timing their acquisitions and subsequent disposals. Today’s sentiment favors selling overvalued sustainability underperformers and acquiring undervalued outperformers. Four years ago, it was the reverse. Four years from now, the cycle may shift again.

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