Private Equity: the key to unlock ESG value creation?

Sustainability is no longer a nascent topic in Private Equity, it has in fact grown to be the focus of some Private Equity houses, in particular for some Impact Funds where ESG measurement has become one of the key metrics alongside traditional financial numbers*. Under current regulatory reporting requirements in the EU such as the Corporate Sustainability Reporting Directive (CSRD), the Sustainable Finance Disclosure Regulation (SFDR) and the EU Taxonomy, General Partners (GPs) should have a comparative and consistent basis for measuring ESG performance of their Portfolio Companies (PortCos), as well as their own fund level sustainability performance for reporting to their Limited Partners (LPs).

There are three topics I’d like to explore in this article:

1. EBITDA of ESG: Correlation between sustainability and financial performance
2. Risk Management and Value Creation: complementary or contradictory?
3. Listed vs private companies: are Private Equity backed businesses better positioned to capture ESG value creation?

EBITDA of ESG: correlation between sustainability and financial performance

‘The EBITDA of ESG’ is a lens through which companies seek to develop both revenue and cost strategies by aligning financial and ESG incentives. In Carlyle Group’s 2023 ESG report the firm emphasized the need to build connections between the often-nebulous concept of ESG and traditional financial line items, connect tangible near-term financial impact with often long-term ESG related components.

‘The fast movers in low carbon transition are often the companies that see direct customer pressure or incentives’ says Jack Azoulay. This point is very much echoed in Carlyle’s report which outlines sales increases by 1) meeting the sustainability requirements of major customers and prospects, 2) quantifying sustainability attributes of products and services that align with consumers’ preferences and 3) meeting government agencies’ sustainability requirements.

However, a baseline level of financial soundness is required to connect short term financial performance to long term ESG performance. ‘A financially distressed company would not care about sustainability performance if they don’t even know if they will make it past next month, let alone for the next five years – sustainability is a longer-term objective for companies that have growth mindset and views’ says Jack Azoulay.

Having worked in distressed debt restructuring as my first job, I cannot agree with Jack’s point above more. It is almost impossible to get the Board’s attention on sustainability issues if the company is facing major financial issues, unless the sustainability issue is the root cause of their financial issue.

My role was within the bank’s Special Asset Management team, dealing with clients (borrowers) that are experiencing major financial issues, often breaching their debt covenants. One of my clients at the time, was a UK offshore windfarm, which by book definition, should be a star child for bank financing decarbonisation solutions to combat climate change.

In reality, there was a pitfall with this windfarm caused by climate change physical impact. The plot of sea where the windfarm was originally approved for construction 15 years ago, has experienced significant changes in the atmosphere due to increased carbon dioxide emissions, so that the wind level is not the same as predicted. The wind turbines can only operate within a specific wind speed range, and due to the wind changes in that area, those wind turbines cannot operate as efficiently anymore. Therefore, there is not enough electricity being produced. This change in wind pattern, is also met with low prices of electricity prices pre covid, both combined resulting in poor cashflow for wind farm and breaching covenant ratios set by the bank for a prolonged period.

This might be a one-in-hundred case where you can point to the direct correlation between climate-induced issue and company’s financial performance. However, for renewable infrastructure projects, ‘while investments in energy transition inherently support environmental goals, advancing the social and governance dimensions requires dedicated management focus and financial resources, both of which may be constrained when a company faces financial challenges’, says Savvas Karatapanis.

There is strong argument and evidence that sustainability and financial performance are interlinked, on the basis that the company is operating ‘comfortable enough’ financially, and any investment made to improve its sustainability performance attributable to financial statement line items could yield even longer term positive economic benefits including those social and environmental externalities.

Risk management and value creation: complementary or contradictory

There are two main approaches to ESG integration in Private Equity: Risk management and Value Creation. Pre 2018, risk management plays a more dominant role as value creation is often considered an even less tangible concept.

It’s hard to attribute percentage exit multiple increase to solely ESG improvement. For example, if there is a 3x increase in Enterprise Value upon exit, it’s hard to attribute what percentage of that increase in Enterprise Value is because of ESG improvement solely, as there are other changes implemented during the holding period. However, in more recent years, the word ‘value creation’ might be the most used word by Private Equity, given the competitive GP landscape. Are GPs using the ‘value creation’ buzzword without implementing sound risk management? Or has risk management become a boring tick box exercise that blocks the jump to value creation? Shouldn’t risk management be complementary to value creation opportunity identification?

In my conversation with Jack, he said ‘Risk management and value creation are just as important but the focus is more on value creation for us’ he continued, ‘Risk management is carried out as part of standard Due Diligence (DD), but we go a step further in our DD for value creation by setting even more specific criteria to quality investments within the Climate Action Fund’.

As an advisor to many Private Equity funds, I find there is a big differentiation to Private Equity’s ESG DD approach and deal team view. There are mainly two camps: ESG DD is a tick box mandate vs ESG DD is an opportunity for value creation identification. The driver behind those two camps is fund level ambition and operating cadence of firm level ESG strategy including individual accountability on ESG.

Cases where ESD DD is outsourced or treated as ESG manager’s responsibility, deal team members are less fluent in ESG and see it as a tick box data collection exercise. But the real integration comes when deal team has individual accountability for the investment’s ESG performance, aligned to fund’s overall ESG ambition and strategy. For some ESG progressive funds, deal team’s compensation is tied to specific ESG targets within their PortCos, and those are leading in ESG value creation.

Thus, risk management and value creation comes hand in hand, but trying to achieve real ESG value creation before sound risk management is like trying to run before you can walk.

Public vs private companies: are Private Equity backed businesses better positioned to capture ESG value creation?

In the past 2 years or so, I’ve witnessed many Private Equity backed businesses able to transform rapidly and embed sustainability as a core part of their strategy and operations, especially when management can see real financial benefits through revenue growth and cost savings. On the other hand, I’ve also been part of an investor group where we collectively filed a shareholder resolution at the AGM of a large publicly listed European chemicals company, asking the company to set Paris-aligned scope 3 reduction target of and failed to obtain enough votes. I personally would argue smaller Private Equity-backed businesses can outperform their larger counterparts on sustainability credentials and capturing more market share in some sectors, but the pre-requisite is that the business has chosen the right investor partner who can bring commercially focused sustainable change to their business.

‘It really depends,’ Jack says ‘larger publicly listed companies have more resources in terms of people and money to spend on ESG initiatives, but it takes much longer for them to manoeuvre to see a small percentage of change. But smaller private companies, may have a lower ESG maturity and less resource to start with, with a receptive Executive team and the right external support (from Private Equity investor or consultants), they could potentially turn the ship faster than their public counterparts, by building ESG at the core of their operations.’

Consumer sector consideration is quite different from infrastructure investments. Some large infrastructure investments were traditionally backed by government grants and schemes, but those from approval to operational would take almost 10 years in the UK, while private backed infrastructure have the advantage of being much shorter in lead time – this is evidenced by the growing private renewable infrastructure developments across the EU and China.

'Smaller, agile private companies backed by sustainability-focused sponsors can significantly advance the ESG agenda beyond the capabilities of rigid, government-backed public procurements.’ Savvas added ‘Their flexibility and swift implementation of sustainable initiatives enable them to innovate beyond the minimum requirements of centrally planned tenders.’

Those three topics we touched on are barely scratching the surface of ESG in Private Equity. The recent developments in regulatory reporting, especially CSRD phased in approach across EU will bring better transparency in the years leading up to 2030, as well as China (one of the largest emitter and renewable energy producer in the world) rolls out Corporate Sustainability Disclosure mandatory requirements by 2030.

Private Equity’s focus on ESG value creation represents a paradigm shift in how private capital is directed towards to a more sustainable and low carbon economy. But this is only a small part of the equation, with the collective effort across public and private markets. We can expect to see a positive feedback loop soon where sustainable business practices become the norm, driving a more resilient and equitable economy for generations to come.

^* ‘ESG’ is used interchangeably used with ‘Sustainability’ in this article

Acknowledgements

I want to extend my sincere gratitude to Jack Azoulay (Senior Partner at Argos Wityu) and Savvas Karatapanis (Associate Director at InfraCapital), for sharing their practitioners’ views. For the purpose of this article, their views are personal and not representative of their respective funds.

Author

Claire Zheng is a Visiting Fellow at the Centre for Business, Climate Change and Sustainability