Investor lens review: Using ESG as a proxy of readiness for exit.

Farsighted investors evaluate businesses based on human, social, and environmental capitals. Explicitly highlighting their value boosts exit Enterprise Value and performance.

Excutive summary:

• Responsible investing emphasizes the importance of timely exits for optimal value extraction.
• Utilising ESG data for exit readiness in Africa is an untapped potential, contrasting European practices.
• An ESG Vendor Due Diligence (DD) enhances exit valuation by integrating sustainability, providing evidence-based impact, and aligning with core business strategies.

“Winners know when to stop”  - the responsible gambling by-line – is a good mantra for responsible investing too. 

Knowing when to sell is about striking a trade-off between leaving value on the table for the next investor versus when one’s value extraction has peaked. It’s a tricky balance and every decision-making tool available to an investment committee should be utilised to inform their decision.

One tool that has not historically been utilised at all in Africa is using ESG performance as a proxy of readiness for exit. This is surprising as almost all Private Equity and listed investments in Africa have been generating ESG performance data for at least a decade given the importance of ESG to European DFI[1] investors and domestic pension funds. Over over 80% of PE capital is sourced from these sources (EY-SAVCA, 2023).

It seems as though in Emerging Markets, almost all ESG DD’s are performed for the Buyer (“buy-side”). Over 400 buy-side ESG DD’s have been performed by EY Sustainability[2] in the last decade, but zero vendor ESG DD’s (i.e. on behalf of the seller). This is contrasted with the European market, where vendor DD’s make up more than 90% of ESG DD’s performed by EY.

In a subsequent article, we will unpack our thinking on why buy-side ESD DD’s tend to dominate in emerging markets whereas vendor DD’s are the preferred approach in Europe. For now, though, we will unpack the reasons why an ESG-Impact[3] focused exit readiness exercise performed 18 to 24 months prior to exit provides a solid foundation for an optimised exit.

What does ESG tell us about the portfolio company?

Mature management systems will exhibit the following:

1. Resilience: ESG initiatives are generally less urgent than other more pressing business priorities, especially in a high-inflation environment. Deep ESG implementation implies that all other “normal” management interventions have already been considered.
2. Humility: just as Enron and Lehman Bros proved that no company is too big to fail, the asset operates with deep stakeholder engagement and integrates ESG up and down their value chain. Management has developed tools of listening to their markets and responding timeously to equip their whole ecosystem to succeed. Shell and Greenpeace both had to learn new skills to meet each other halfway.
3. Agility: as the latest newcomer to the C-Suite, the Chief Sustainability Officer will be flagging emergent risks and opportunities never considered before in traditional business school curricula. There is an interesting principle of sustainability called the “precautionary principle”, which recognises this. Since  science is always playing catch-up with nature, the Precautionary Principle recognises that humans are always behind the learning curve and should therefore be cautious in their decision-making and broad in their consultation. Winning companies will therefore always be curious about what new risks and opportunities are on the horizon, and will be able to quickly pivot on new information.

Why an ESG Vendor DD should enhance exit valuation

If management has been sufficiently broadminded during the holding period, sustainability initiatives should highlight the following 3 key characteristics of an exit:

1. ESG initiatives will be well-integrated into operations, and are often “blurred” with traditional HR, legal, operational, maintenance, resource security, risk and other “non-ESG” aspects of the business
2. ESG/Impact performance is evidence-based: i.e. any claims of impact or “making a difference” are well supported by multi-year datasets, usually in the form of ratio parameters which are benchmarked against peers. Green washing holds no flame to such progressive companies.
3. Sustainability forms part of the core strategy of the business, either by

a. broadening capital markets (hence lowering the cost of capital),

b. growing market share by adding tangible added-value to customers,

c.  improving margins through improved efficiencies of transformation of capitals (as per the six capitals model), or

d.  boosting talent attraction and retention.

Common pitfalls in ESG Vendor DD’s

The following are the most common errors when considering ESG as a value-booster prior to exit:

1. Green washing: while apparently obvious, it is remarkably prevalent especially in poorly regulated markets such as Africa. EY research showed that green washing is the single biggest risk to sustainability implementation (quote …..). While your average investment banker wouldn’t know the difference between a good or bad ESG report, it doesn’t take much for an investor to poke holes in a poorly-constructed ESG value creation model that isn’t based on solid data.
2. Low-materiality: too often management espouses aspects of their sustainability performance which are not linked to core cost- or revenue-drivers. Typical examples here include:
   • Overstatement of CSI with no link to the core business of the business (e.g. an unsecured lender sponsoring health clinics);
   • Reporting on progress towards meeting Sustainable Development Goals. SDG’s are increasingly being regarded by the international investment community as a government wish-list with very limited application to the private sector.
3. Confusing risk management (ESG) with value-addition (Impact): in general, all ESG standards deal with protecting shareholder value through mitigating ESG risk. Minimising downside risk does not equate to creating upside value.
4. Missing or incomplete hygiene factors: operational control procedures, management systems, culture, depth and width of appropriate ESG skills, maintenance, housekeeping, stakeholder engagement, integrated reporting, et cetera are all examples of the basic foundations of any ESG system worth its salt. There should be no low-hanging fruit when getting your investment dressed up to go to market.
5. Going through the paces: it is critical for any successful ESG program to have a significant degree of disruption associated with it. For example, it’s inevitable that preparing for a decarbonised future involves ditching old business practices which relied on a cheap and abundant source of fossil-fuelled energy. Any prudent investor will be looking for evidence of management having applied a rigorous process to re-evaluating the assumptions underpinning their “business as usual” scenarios. In fact, one could say that any mention of “business as usual” in the 10-year business plan offered to investors should be highlighted as a red flag in any to diligence, so radical are the changes which will be brought about by climate change.

Different perspectives

Forward-looking investors will assess any business in terms of the three intangible capitals: human, social, and environmental. If management can explicitly highlight the value of such externalities, how they may be included in any exit Enterprise Value and how they will contribute materially to any out-performance during the next investment cycle, this will result only in upward pressure on the Enterprise Value.

Footnotes:

1. Development Finance Institutions
2. including EY SaT Sustainability’s operations as EBS Advisory prior to acquisition by EY in May 2023
3. At EY, we refer to:
   • ESG to include ESG risk management, i.e. protection against shareholder downside, e.g. reduction of carbon taxes by implementing energy efficiency measures), and
   • Impact as the upside potential to shareholders, also known as value creation, ESG Alpha, Impact Alpha, etc. (e.g. improved margins from energy efficiency).