How ESG due diligence lowers risk and boosts value for private equity

The modern investment landscape is changing rapidly as ESG factors become an essential component of investing strategies.

In brief

• ESG due diligence is key to private equity firms; it enhances risk management, value creation and investment performance while meeting regulatory standards.
• Successful firms incorporate ESG factors into investment, ownership and exit strategies, resulting in lucrative exits and improved portfolio performance.
• Future investment landscape needs ESG due diligence, not as a trend but as a core part in private equity, focusing on sustainable and responsible investing.

The modern investment landscape is changing rapidly as environmental , social and governance (ESG) factors become an essential component of investing strategies, especially within the private equity (PE) sector. Due to regulatory requirements like the Sustainable Finance Disclosure Regulation (SFDR), a global focus on sustainable investing and limited partners investing explicitly in SFDR Article 8 and 9 funds, the importance of ESG due diligence has further amplified.

ESG due diligence is a critical examination of potential investments against their ESG performance. For PE firms, the SFDR and other ESG-related regulations have fueled a shift to sustainable investments, making ESG due diligence critical. Highlighting benefits like improved risk management, enhanced value creation and improved investment performance amplifies the significance of ESG due diligence. Moreover, it helps PE firms meet their ESG obligations to investors, aligning with the global trend of conscious investing and meeting expectations of the general public.

In conducting ESG due diligence, risks such as environmental hazards, unfair labor practices, or non-compliance with governance standards may surface. Ignoring these identified issues or missing them altogether can lead to a PE firm acquiring an entity that contains major ESG-related complications that can result in legal or reputational consequences, financial penalties and lower investment returns. Thus, a strong ESG due diligence process can mitigate these risks and maximize investment outcomes.

Our Climate Change and Sustainability Services team have identified that among entities in the Nordic region purchased by private equity firms, the greatest risks and impacts, recognized during ESG due diligences, lie within governance (43.2%), followed by social areas (36.5%) and environmental (20.3%) .

It is not surprising that the majority of risks are found within "governance." This topic encompasses the general management of ESG within the framework of structured and formalized policies. Generally, companies that become transaction targets are often lacking maturity, despite having potentially effective initiatives and actions. They often fall short in formalizing these actions. ESG due diligence serves as a tool to help such companies identify areas where existing procedures can be formalized into policies, thereby reducing risks. This represents the future of ESG: well-documented and formalized processes to mitigate risks. Regardless of the company size, it is crucial that some form of governance and procedural standards is to be established.

The subjects most frequently addressed in ESG due diligence, based on initial risk evaluations, include climate impacts, working conditions, business conduct, responsible supply chain management and talent management.

During ESG due diligence, we experience that investee companies typically demonstrate a high level of maturity in areas such as data privacy, the effect on local communities, education and training, workforce management and employee working conditions. This high level of maturity is evident through the established policies, effective oversight, internal controls and active measures. On the other hand, these entities often show low maturity in areas like circular economy, responsible supply chain management, business conduct (anti-corruption and business ethics) and climate impact, which suggests opportunities for improvement.

We provide assistance to a multitude of Nordic PE funds in performing ESG due diligences. Identified risks pinpointed during ESG due diligences incorporate, but are not limited to:

1. Misalignment of ESG visions: Discrepancies exist between the management of smaller target firms and the ESG ambitions of private equity companies.
2. Insufficient ESG resources: There is often a lack of dedicated resources or personnel for managing ESG issues, leading to inadequacy in overseeing and implementing ESG goals.
3. Non-inclusive practices: This encompasses a variety of issues, from restrictive dress code policies and non-inclusive language used by senior management to undisclosed instances of harassment within the workforce.
4. Supply chain risks: Significant risks are associated with certain suppliers, mainly in relation to working conditions, potentially jeopardizing the company's overall ESG compliance.
5. Data protection and compliance: This involves the vulnerability of personal and client data due to insufficient procedures and non-compliance with legislative requirements such as recording employee work hours.

While conventionally ESG factors were considered solely for risk management, recent trends see these factors incorporated into active ownership and exit strategies. ESG considerations can directly impact the valuation and potential exit opportunities of investments. Many successful firms have intertwined ESG factors from their investment, during their ownership and during their exit strategies , reaping benefits like more lucrative exits and improved investment portfolio performance.