Private equity (PE) firms have an enormous opportunity to create social value and improve the environment and, in doing so, improve their financial returns.
This can be done by integrating environmental, social, and governance issues (ESG integration) into all aspects of the PE process– from initial screening of opportunities to due diligence and negotiating the deal, to oversight of the company while in the firm’s portfolio, and finally to capturing value on exit.
The origins of private equity go back to the middle of the 20th century. It has grown from being a small and rudimentary form of “alternative investment” to a huge asset class in its own right. A private equity firm is known as the “General Partner (GP),” and those that invest in it, such as pension funds, foundations, and high net worth individuals are called “Limited Partners (LPs”). According to the “2016 Preqin Global Private Equity & Venture Capital Report,” in June 2015 the global PE industry – in its narrowest definition – had assets under management (AUM) of $2.4 trillion, and a total of $288 billion was raised by 689 PE funds which closed in 2015. Under the broader category of “private capital” (which includes private debt, real estate, infrastructure, and natural resources), these global numbers are $4.2 trillion and $551 billion, respectively. The purchasing power of this $2.4 trillion is doubled by the fact that debt levels in PE deals over the last four years have averaged around 55%.
The size of the PE industry, therefore, and the characteristics of its business model mean that it can and should take a real leadership role in ESG integration. One important reason for this is the time frames in which PE firms operate. In 2015 the average holding period of a portfolio company by a PE firm was 5.5 years. During this period of time, bad ESG things can happen (risks) but this is also enough time to get the upside from better ESG performance leading to better financial performance (opportunities). In contrast, in 2015 the average holding period for stocks traded on the New York Stock Exchange was 8.3 months, its lowest since 1929. This market short-termism is one of the reasons public companies struggle with ESG integration since the benefits take longer to realize than a single quarter. Moreover, because the PE firm has control and takes an active approach to corporate governance, it can ensure that ESG integration takes place. Most public company boards are unaware of or are indifferent to ESG integration.
The interest of LPs in ESG information and, by extension, integrated reporting is growing. A 2013 survey of 103 PE firms in 18 countries, “Putting a price on value” by the accounting firm PricewaterhouseCoopers (PwC) found that 79% of them believe LP interest in ESG issues will increase in the years ahead. Indeed, most PE firms already recognize the importance of ESG information. PwC found that 62% of portfolio companies regularly report on ESG to their board and 88% formally report on ESG to the PE firm itself. Driving this interest in ESG, 36% cite risk management as the primary driver and 24% cite investor pressure. Less important at this point are opportunity identification (15%) and corporate values (8%).
The low percentage of firms citing opportunity identification matches the fact that less than 15% of these PE firms calculate the value they create from their ESG activities. One of the reasons for this is the difficulty in doing so. Until now we haven’t had high quality ESG information based on standards the way we do for financial information. In another post about the Sustainability Accounting Standards Board, I pointed out that it is now possible for companies to measure and report on the ESG issues that are material to their ability to create value for shareholders. Recognizing that what is material from an ESG point of view varies by industry (e.g., access to medicine for a pharmaceutical company, carbon emissions for a chemical company, and systemic risk for a bank) SASB has identified the disclosure topics likely to be material and associated key performance indicators for 79 industries. Although these standards were developed for public companies that have to file a Form 10-K report, they can be easily adapted to a PE context. Because the sustainability topics identified by SASB are based on the resource intensity and sustainability risks and opportunities inherent in a particular industry, they’re applicable to all companies of all sizes and regardless of their sources of funding.
And the benefits of adapting SASB’s standards in a PE context are enormous. In short, they will enable PE firms to go from a largely policy and ad-hoc approach to ESG (which still only 55% of PE firms now have) to a much more disciplined and analytical one (only 48% of firms report having tools to implement their policy) based on true ESG integration. PE firms can use SASB as guidance to improve the rigor of their initial screening and due diligence process in assessing ESG risks and opportunities in potential portfolio companies, and then in putting together the initial plan for how to improve the company’s performance to drive value creation. These standards can also be used to produce simple integrated reports for the board of the portfolio company, the GP, and all LPs. This will improve the management of the portfolio company, as well as the ESG risk and opportunity profile of the overall portfolio.
The standards can also be used to help management focus on the small subset of sustainability factors that are likely to materially impact the financial condition or operating performance of companies in their given industry. In fact, research from Harvard Business School suggests that this sort of focus can lead to significantly higher accounting and market returns, including return on sales, sales growth, return on assets, and return on equity, in addition to improved risk-adjusted shareholder returns.
The interest in ESG information is clear to see. A number of large pension funds I have recently talked to – all with large PE allocations – say they would be very interested in getting integrated reports at the portfolio company level. This will enable them to evaluate both the management of the portfolio company and the PE firm itself. It will also enable them to learn more about how ESG integration can be applied by companies in their public equity portfolios.
Integrated reporting using SASB’s standards will enable the PE firm to capture more value on exit, whether through an IPO or strategic sale, by better explaining how the company creates value and how it will be able to do so in the future. In an IPO, the portfolio company becomes a public company and investors are increasingly demanding ESG integration by companies whose stocks they own. In a strategic sale, the buyer is either a public company, already subjected to these same pressures, or another PE firm, which will understand the importance of this information. From my perspective as a “capital market activist” who wants to see the widespread adoption of integrated reporting and SASB’s standards, PE firms are a major leverage point in accelerating this movement which will benefit companies, investors, and society as a whole.
I believe this more disciplined approach to ESG integration will become “table stakes” for raising new rounds of capital from LPs. PE firms that do not have strong practices around ESG integration from initial screening and due diligence and all the way through exit will find it difficult, if not impossible, to raise money from LPs for future rounds. This too is a common theme in conversations I have with LPs who have major allocations in private equity.
Bronwyn Bailey, Vice President of Research and Investor Relations for the American Investment Council based in Washington, D.C. rightly notes that “While ESG is increasingly a common practice in private investing, there is no single standard for improving E or S or G.” She expects that “guidance will remain fragmented” since “firms are in different stages of ESG policy.” While this is all true and each PE firm must develop ESG policies and tools that fit its own strategy, more rigor is required when it comes to valuation. SASB’s standards alone won’t solve this problem but they can be a key part of the solution, and it could lead to the private equity world taking a leading role in ESG integration. Now that would be a big deal.