How ESG due diligence is influencing private equity deal-making

Climate-driven risks have gained significant attention from Private Equity (PE) firms, with environmental, social, and governance (ESG) diligence playing a key role in their investment decisions. Integrating impact investing considerations provides a comprehensive risk shield, creating a secure investment that promotes long-term sustainability and financial returns.

ESG regulatory compliance, including the European Union Sustainable Finance Disclosure Regulation, requires PE firms to report their ESG integration in their investment strategies. In 2024, the European Union introduced the Corporate Sustainability Due Diligence Directive (CSDDD), which mandates companies to identify, assess, address, and report on the impacts of their operations and supply chains on human rights and the environment. This includes developing action plans to mitigate negative effects, establishing grievance mechanism for stakeholders, aligning business strategies with the Paris Agreement, and publicly disclosing due diligence efforts¹.

In India, the Securities Exchange Board of India (SEBI) has mandated specific companies to publicly disclose ESG-related information. Having come into effect in 2023², the disclosure framework is based on standards like GRI and TCFD³ and is quite comprehensive in coverage—from environmental protection to inclusive growth to stakeholder responsiveness. The Reserve Bank of India (RBI) has also issued directives and circulars addressing environmental and social risks, green deposits, and financing sustainable projects⁴.

Seen especially against this regulatory background and augmented by the increasing frequency of climate-related hazards, as well as issues in employee and community relations and occupational health and safety concerns, PE firms are increasingly recognizing the vital role ESG due diligence plays in their deal-making. Imbedding ESG considerations into deal-making presents several challenges like the constantly changing ESG landscape, lack of clarity, and the need to direct ESG due diligence toward identifying and addressing material deal issues.

Analyzing data on a target company’s ESG performance—such as actual production compared to permitted production issued by pollution boards, fulfillment of extended producer responsibility (EPR) obligations, permitted versus actual abstraction of groundwater and safe disposal of wastewater, biomedical waste, and hazardous materials to avoid soil and groundwater contamination—helps uncover issues that may affect long-term profitability.

Instances of manufacturing plants abstracting significant quantities of groundwater to meet daily manufacturing process requirements, either without valid approvals or beyond the permitted levels, have pushed transactions back to the drawing board, especially when the manufacturing locations are situated in water-scarce zones without alternative sustainable sources of water.

Adequate operational fire safety infrastructure, including water sprinklers, fire exits, fire hydrant systems, and fire extinguishers, is essential in all industries, especially in educational institutions and hospitals. Limiting the diligence process to merely verifying the availability of a valid fire clearance and other certificates often fails to highlight inadequate non-operational fire safety infrastructure, usage deviations from the approved building layout plans, unauthorized constructions, etc. All of these factors can sometimes put human life in avoidable danger.

Firms are structuring deals and documents to foster better ESG practices and are investing in initiatives that enhance operational efficiency, such as minimizing greenhouse gas emissions, improving working conditions, and optimizing resource management to enhance a company’s profitability and brand reputation while negotiating appropriate protections in transactions to boost customer loyalty. Integrating ESG factors into the due diligence processes helps in identifying both risks and opportunities that could impact financial outcomes.

Additionally, when preparing for an exit, portfolio companies with strong ESG profiles are more appealing to prospective buyers, which can increase a company’s valuation during a sale or initial public offering. According to an ESG report⁵ published in 2024, 73% of PE investors have established a strong ESG framework. Furthermore, a research⁶ highlights that ESG funds in India have outperformed traditional benchmarks like the NIFTY 100 ESG Total Return Index, demonstrating that sustainable investments can generate competitive financial returns. It is essential to establish a robust governance framework to monitor ESG regulatory compliance, making portfolio companies responsible for their ESG performance. For firms to successfully create value through ESG, a long-term commitment to sustainability and a focus on measurable outcomes are necessary. By integrating impact investing into their strategy, firms can not only generate financial returns but also contribute to broader social and environmental goals.

Several PE firms have established their own climate risk assessment frameworks to integrate ESG factors into their investment processes. These sustainable PE firms demonstrate a growing dedication among Indian PE firms to integrate responsible investing strategies to help their portfolio companies contribute positively to the environment and society while upholding robust governance practices.

In the last five years, PE firms have undergone substantial changes in their approach to ESG due diligence, driven by evolving regulations, post-COVID realignment, investor expectations, and shifting market trends. Initially, PE firms viewed ESG and sustainability-related matters primarily as part of risk management. However, there has been a notable shift, with investors now considering ESG as a significant driver of value. ESG considerations in PE have moved from optional to essential.

ESG integration is no longer a trend but a core component of PE deal-making. Firms that proactively adopt structured ESG strategies gain a competitive edge, attract capital, and drive long-term, sustainable growth. As investor and regulatory demands intensify, embracing ESG will be crucial for PE firms aiming to build resilient and high-value portfolios in the coming years.