ESG incentives: From compliance to value creation

ESG incentives: From compliance to value creation

Published: 9 Aug 2022 · Last updated: 15 Oct 2023

Why should Private Equity Firms care about ESG?

As more and more global governing bodies, both nationally and internationally, incorporate sustainability into legislation, Environmental, Social, and Governance (ESG) criteria is becoming increasingly important for private equity (PE) firms and privately-owned companies. The pressure to disclose ESG metrics is expected to increase as the percentage share of companies owned by private equity firms grows and the investor-driven demand for ESG becomes more exacting.

Alongside the legislative rulings that work to make ESG management a necessity, there are many other reasons why private equity firms should care about ESG. Understanding these reasons helps managers and general partners to approach their ESG management from a more informed perspective, enabling them to achieve better results.

In this week's article, we've put together a comprehensive list of some of the main reasons that private equity companies should care about ESG.

From compliance through to value creation, we look at what’s driving private equity firms in their efforts towards ESG optimisation. Follow our blog series as we explore some of these topics in more depth.

Achieving ESG compliance

In recent years, legislative bodies and policymakers have formed new rules and regulations to lead fund managers and portfolio companies towards more sustainable and socially responsible investments. (Take a look at the articles on our learning and insights page to read more about emerging regulations).

These challenges have led industry leaders to create innovative ways of measuring and evidencing ESG in order to appeal to modern investors' interests.

But why should private equity firms care?

Private equity firms want to attract investors

The US SIF (the Forum for Sustainable and Responsible Investment) published a report in 2020. Researchers found that, from 2019 to 2020, investors considered ESG factors across $17 trillion of professionally managed assets. This represented a 42% increase since 2018, and this figure continues to grow.

Significant growth in the number of finance and asset managers that consider ESG factors to be a relevant insight into the long-term resilience of a firm has led companies to look for and invest in more opportunities to advance ESG issues.

In Preqin's 2021 Investor Outlook, 79% of the respondents surveyed stated that fund managers establish ESG policies in order to satisfy investor demands. Meeting industry standards or best practices was seen as a secondary driver. 66% cited this as a reason for ESG policy adoption among fund managers. Companies that don't cater to this need risk diminishing the value of their portfolio.

2022 saw the emergence of more stringent regulations, such as the Sustainable Finance Disclosure Regulation (SFDR). Companies that provide comprehensive ESG insights and evidence progress made over time are now setting themselves apart from other companies operating within their sector. Having clearer ESG processes enables these companies to perform more effectively. Their portfolios are significantly less risky, and they become more desirable to investors and limited partners.

Driving value creation

One of the main reasons private equity firms should place more emphasis on their ESG strategies is that ESG develops long-term financial interest and drives value creation. This facilitates better exits.

General partners view ESG as a way of creating and protecting value. Two thirds of general partners interviewed in a 2021 survey said that value creation was one of their top three drivers of ESG activity.

Value Creation for Sales and Progress

In our 'Managing ESG along the investment cycle' article, we looked at the main ways in which ESG processes can aid private equity firms. We assessed this impact from due diligence to the holding period, and right through to exit.

Better exit strategies = Better sales processes. However, this is not the only reason that responsible firms invest in ESG.

Reporting on ESG is an effective way of demonstrating to shareholders and stakeholders that the company is conscious of its role in society. This shifts a firm's approach away from short-term financial results and evidences its commitment to long-term value creation. Companies with a strong focus on ESG have been proven to perform better, reduce their exposure to risk, and minimise the likelihood of potential reputational issues.

Corporate values and Maintaining Accountability

Second on the list was corporate values.

Climate change isn't an abstract future concept. It's happening now. From heat waves to rising sea levels, we're seeing the changes every day, and we're tracking them. Investors have the power and resources to make a difference, and so many invest in ESG measurement techniques to track their portfolio companies' progress.

Following a company's ESG metrics keeps general partners and fund managers accountable. It also helps them to identify areas for improvement, both in terms of sustainability and cost.

If you don't start tracking and adapting your business accordingly, your business won't be sustainable and might not survive in the long term.

Investor Pressure: Private equity firms must cater to the demands of Limited Partners

Limited partners' economic interests are aligned with the long-term value of the fund, and most partners prefer to invest in funds that have strong ESG criteria. Partners are driven by the desire to improve the financial return of their portfolio companies on exit. A survey carried out by Preqin revealed that a quarter of limiter partners have actually turned down an investment opportunity due to concerns over ESG standards.

While the regulation information listed above shapes limited partners' investing tendencies, many are also interested in optimising ESG support for non-financial reasons. Some implement ESG protocols simply because it's the right thing to do. This ties in with corporate values.

Ethical motivations and the desire to lessen a firm's environmental impact often serve as a stronger motivation than profit and value creation.

ESG can therefore be crucial in attracting and retaining capital from limited partners, especially those looking to develop a more sustainable portfolio.

Conclusion

With more regulations planned for 2023, including further SFDR legislation, EU Taxonomy, TCFD, and CSRD, we expect ESG measurements to gradually inch towards the top spot on private equity firms' lists of priorities.

The trend towards sustainable investing is becoming more established than ever, and private equity firms need to adapt to keep up.

KEY ESG can help. Our SaaS platform allows fund managers to optimise their ESG measurement processes. Book a free demo today to see how our software could level up your ESG processes.

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