Spokesperson: Isabella Calderon Hoyos, Partner, OMMAX
ESG is a familiar term in investors’ vocabulary that has evolved in recent years. It has progressed beyond a point of compliance into a strategic imperative for value creation. To meet the demands of regulators, as well as expectations of investors, customers and employees, private equity firms must transparently demonstrate their commitment to responsible and sustainable investment practices across their portfolio.
Additionally, we are seeing increasing examples of ESG benefits in the form of financial advantages. Organisations that authentically integrate ESG best-practices, significantly outperform their peers when it comes to revenue, CAPEX and cost of capital.
Assessing & Managing Potential Risk
Environmental, social and governance issues present significant risks to investments and their growth potential, whether it might be regulatory non-compliance, operational and supply chain disruptions, legal liabilities, or reputational damage. However, it is crucial for firms to ensure their ESG claims are authentic rather than leaving themselves exposed to, or inadvertently engaging in, greenwashing.
To this end, ESG efforts should be incorporated during the entire deal lifecycle, starting with the due diligence stage, to effectively identify, assess and mitigate any ESG risks early on to avoid later damages. Such thorough due diligence practices also ensure adaptability of the portfolio company to changing regulatory landscapes and evolving stakeholder expectations, enhancing resilience to ESG-related risks and uncertainties. For example, a manufacturing company may prioritise energy efficiency (environmental), labour practices (social), and board diversity (governance) in its decision-making process.
PE firms are also facing increasing ESG pressure from stakeholders. Stakeholders, including investors, customers, employees, and the public, expect to see transparent ESG strategies and how these factors are integrated into decision-making processes. As these expectations become standard for stakeholders and regulatory bodies alike, any decision to neglect ESG considerations becomes a bigger risk as time goes on.
Regulation Across a Portfolio
Regarding ESG reporting and disclosure, private equity firms must stay informed about the evolving regulatory landscape. For example, the EU Sustainable Finance Framework introduces new regulations for integrating ESG considerations into financial sector investment decisions and compliance is essential for private equity firms, necessitating processes for accessing and managing ESG data and integrating scoring into portfolios.
Private equity firms can also bolster reporting consistency by adopting voluntary standards like the Global Reporting Initiative (GRI) and introducing the ESG Sustainability Risk Score (ESRS) which considers both the financial impact of sustainability on businesses and businesses on sustainability. By identifying material issues, private equity firms can allocate their resources to areas with the highest potential for impact.
Using Technology
Technology plays a crucial role in facilitating ESG integration into the deal lifecycle. By integrating technology into a firm’s target operating model, efficiency and effectiveness can be achieved. For instance, technology enables the collection, aggregation, and analysis of vast amounts of ESG data through AI and ML which, in turn, can be leveraged for transparent reporting and informing improvement strategies.
Taking the example of carbon reporting, integrating one of the many carbon management solutions available enables companies to automate and standardise the ESG reporting process. This not only improves the quality of ESG disclosures but also enhances efficiency and cost savings.
Driving Value Throughout
By actively engaging with portfolio companies, setting targets, tracking progress, and measuring the impact of ESG efforts, firms encourage conscious and competitive inclusion of ESG principles. This not only helps firms work toward their own ESG goals and branding efforts but also enhances the long-term sustainability of portfolios.
To drive value creation, private equity firms can incorporate ESG considerations from due diligence onwards and work closely with portfolio companies to improve their ESG performance. This collaboration means implementing ESG initiatives, setting measurable targets, and monitoring progress.
By actively addressing ESG factors and through enforcing consistent reporting from portfolio companies, private equity firms can enhance long-term returns, build trust with investors, stakeholders and customers, and contribute to a more sustainable future.
