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Incorporating ESG into Due Diligence

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Incorporating ESG into Due Diligence

Published: 14 Sep 2022 · Last updated: 15 Oct 2023

Implementing effective ESG strategies in due diligence

Around 95% of private equity fund managers evaluate ESG criteria during the due diligence phase. 54% of these perform a high-level assessment, and 41% say they perform an in-depth assessment during their initial evaluation of a target.

As ESG metrics become an increasingly necessary consideration for investors, the importance of ESG insights during the due diligence phase cannot be understated.

Due diligence reports reveal whether or not a firm is compliant with ESG standards. They offer tailored support to enable investors to make more informed decisions with regards to the environmental, social, or governance impact of an investment. The questions asked and the level of detail demanded tends to vary depending on the market. However, as ESG performance disclosure requirements have become more comprehensive, investors have been looking to take more and more data into account.

Why include ESG during the due diligence phase?

There are several reasons why investors and general partners might choose to involve ESG during the due diligence phase.

  • They may want to avoid investing their capital into businesses that carry considerable and hard-to-mitigate ESG risks. This could stem from either conscientious desires or logical decision-making. Many investors look to conduct themselves ethically and lead by example. They invest more sustainably simply because it's the right thing to do. They are driven by the desire to invest conscientiously and the need to avoid potential guilt. This means that they seek out investments that align with their own environmental, social, and governance morals.
  • They are able to factor ESG considerations into their pricing. Some investors look to pay less towards investments with poor levels of ESG implementation. The financial savings made during the sale of companies with poor ESG performance tend to go towards the purchase of the resources required to rectify any current ESG issues. Other investors will pay a premium for firms whose ESG protocols require less work.
  • They understand where best to expend time and effort, building an appropriate action plan post-investment to improve ESG performance and increase firm value. It is often hard to quantify the exact value creation generated from ESG performance improvement. However, certain initiatives have a measurable impact on revenue and EBITDA (Earnings Before Interest, Taxes, Depreciation, and Amortization).
  • They are signatories of the United Nations Principles for Responsible Investment (UN PRI) and are thus expected to integrate ESG considerations into their investment decision-making.
  • They want to secure ESG-incentivized loans. During the due diligence phase, lenders can offer ESG-incentivized loans when deal financing is being arranged. Investors can receive interest rate reductions linked to ESG performance and can benefit from reaching ESG performance improvement targets. This generates more value for the private equity firm.

Best practices for screening ESG during due diligence

Savvy investors screen ESG during the due diligence phase, but how do they do it? What are they looking for? And how do they reach a verdict?

They begin by screening the investment for ESG risks and opportunities, before identifying any potential ESG-related red flags. These red flags could stop them from investing altogether, or they could lead to the investor seeking a reduction in price.

Investors will also consider how improving ESG might impact upon the value creation of their investment case. They will consider how much potential value could be added if they were to optimise ESG procedures.

It is always advisable to discuss ESG considerations with potential lenders. In many cases, lenders are able to offer better rates that are contingent on whether or not certain ESG targets are attained.

ESG data sharing requirements should also be discussed during this phase, and potential KPIs should be considered when drafting up acquisition agreements.

How to build best-in-class processes to assess ESG performance during due diligence

Our ESG experts have put together a fool proof step-by-step guide on how to assess a firm's ESG performance during due diligence. It is worth noting that each investment is different. Due diligence assessments are rarely thought of as 'one size fits all'. The following steps provide structure to ESG assessments, but additional steps will be required to accommodate the requirements and tendencies of the specific firm.

1. Create a formal ESG policy and questionnaire

Setting a formal ESG policy coherent across all levels of your firm will help guide your ESG efforts and will inform your questionnaire. If you are a signatory of an ESG initiative, this is a good place to start. If you are not, either get started with a questionnaire template (ILPA, LSTA, or Invest Europe) or customize your own. Your questionnaire should be sent out to all relevant parties.

Learn more about KEY ESG's solution to questionnaire building. Previously considered one of the most arduous tasks, this step is now one of the easiest thanks to KEY ESG!

2. Focus on ESG materiality

Not all ESG topics are relevant to all companies. The ESG concerns of a large corporation will differ exponentially from those of a small business. Your approach should be adjusted along with the scope of the investment. Always focus on material ESG issues, risks, and opportunities.

3. Track and store your data securely

Gathering data across all of your prospects will often take longer than you think. Keep your line of inquiry consistent. This ensures that your data is comparable across different assets. KEY ESG’s software solution can really help you to get ahead of the game at this stage.

4. Make sensible comparisons

The data gathered at this stage can be used to develop and leverage action plans during the holding period so it is important to compare apples to apples. Establish which metrics you'd like to compare, make sure the data you've collected across your prospects is comparable and build your dashboard. KEY ESG's software allows you to organise your own dashboard and view all of your metrics at a glance.

Boost your ESG Due Diligence with digitized questionnaires

Our team works tirelessly to help private equity firms and venture capitalists streamline ESG processes. From due diligence to the holding period, and right through to exit, we're with you every step of the way.

KEY ESG enables you to automate and digitize your ESG Due Diligence questionnaires, creating an efficient and seamless Due Diligence experience for all parties involved. Collect, compare and store ESG data in one place with our intuitive tool and make it easy for your investment teams to identify ESG risks and opportunities.

As always, wherever you are on your ESG journey, our teams are on hand to answer any questions you might have. For further information, get in touch!

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