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How PE can put ESG at the heart of their portfolio

PE’s ESG strategy should target the right assets as well as improve the ESG performance of businesses they already back.


In brief

  • PE is shifting their mindset from risk management to value creation as the ESG discussion matures
  • When exiting emission-intensive assets, PE must ask themselves why they looking to exit and what improvements will help deliver a green premium on exit

Much of the responsible investing conversation has focused on where general partners (GPs) should invest going forward; however, there is a more pressing conversation to be had about emission-intensive assets already in portfolio.

These assets unlikely underwent an ESG due diligence on acquisition, however they likely will be subject to an ESG due diligence on exit, potentially impacting exit valuations.   Addressing material ESG matters early will allow private equity (PE) to not only meet stakeholder demands, but also provide the time needed to mitigate ESG risks or capitalize on ESG value-adding opportunities.

There are two key questions that PE firms should be asking themselves when looking to exit emission-intensive assets:

  1. Why are we looking to exit?
  2. What improvements will help deliver a green premium on exit? 

The human factor

The PE industry is the largest employer in the world, so how it approaches transforming emission intensive assets is critical as it has the potential to have a profound impact on both the people they employ and the communities they live in.

By investing in innovation and new technologies to transform a company, there is an opportunity to retrain & upskill employees to evolve along with the sector while at the same time still benefitting from cashflows and profits in the existing business. This is especially important today because there is a war for talent and good people are hard to come by, so investing in your employees can create loyalty, build brand and be a critical retention lever. From a community perspective, the continued employment of its people benefits local businesses and supports the lifeblood of the community so that it can continue to flourish.  Additionally, for those communities that have been built around emission intensive sectors, transforming these companies to be greener can have positive impact on the surrounding ecosystem, giving the people in its community cleaner, healthier spaces to live and grow in.

Two emerging trends in PE’s approach to asset identification and due diligence

The first is a mindset shift from risk management to value creation. From an origination perspective, as it relates to carbon emissions, we help clients identify and assess targets through two lenses: (1) targeted finance to carbon-intensive industries, to finance decarbonization transformations rather than starve it of capital; and (2) increasing the flow of finance to innovative, lower-carbon alternative companies that are disrupting their sectors.

The second is general partners (GPs) leaning into the ESG data challenge. PE firms are looking for alignment between a target and a GP’s firmwide ESG strategy or commitments. GPs are increasing signing up to industry alliances, committing to targets and disclosures, and adopting ESG KPIs that they’ll report against year over year. As such, an increasingly important consideration during target identification and due diligence is the time, capabilities, and cost associated with ensuring the asset can meet GP ESG reporting requirements. This is no small undertaking. ESG measurement and reporting is well behind its financial equivalent in maturity. As ESG increasingly becomes core to the private equity value creation narrative, ESG indicators will need to be of the same veracity as financial figures to ensure the insights they deliver are equally trustworthy and actionable.


Summary

PE can maximize both value protection and value creation through improved ESG performance.


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