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Asset class / Equity

Why private equity has started taking ESG seriously

To ensure a safe exit, influential private equity houses are showing signs of embracing ESG within their investment practices. There is a stronger conviction that sustainability will create greater value over time. Entrepreneurs need to take note.

private equity ESG
Christophe De Vusser of Bain says we can expect to see more private equity funds with net-zero commitments soon. (Photo courtesy of Bain)
  • Private equity firms are increasingly integrating ESG considerations across the investment cycle.
  • Around one in three general partners have now hired sustainability officers, almost double the number from two years ago.
  • Firms that fall behind are likely to face pressure from limited partners and lenders to get back into line.

It was not so long ago that sustainable investment was confined to a small, dedicated corner of the private equity market. But over the past few years, a combination of factors has meant sustainability is permeating almost every aspect of the private markets.

“ESG is a way to transform companies to help them prepare for the future, so they are competitive and contribute,” Candice Brenet, Ardian’s head of sustainability, tells Capital Monitor.

Ardian has a uniquely broad view of the private equity market. It is one of Europe’s largest buyout houses and the world’s biggest fund of funds manager with €59bn in its portfolio (€112bn across its various fund programmes).

In the latest survey of its general partners (GPs, or private equity managers) focused on assessing ESG credentials, Ardian found that 30% have at least one full-time corporate social responsibility officer, up from 14% two years ago. The results took into consideration the responses of 198 GPs covering 90% of the fund of funds portfolio.

“They are devoting more time to train their people. More are using the [Sustainable Development Goals] and setting formal targets,” Brenet says. And it is not just the number of GPs taking ESG seriously that is going up – they are integrating ESG across the entire value chain.

Brenet says Ardian’s ESG “champions” achieved internal rate of returns (IRRs) above 25%, adding: “It shows working on sustainability is good for performance.”

ESG has become a value driver rather than just a compliance or purely reporting topic, says Christophe De Vusser, head of private equity practice for Europe, the Middle East and Africa at the consultancy Bain. “Customers do shift their buying behaviours, it can be B2B or B2C, but people increasingly shift to firms that are better placed on the ESG side,” he tells Capital Monitor.

“It increasingly impacts cost structure. We see an increasing amount of ESG-backed loans. You can attract better talent if you have the right ESG profile. If you look five years down the road, it’s going to be bigger. It’s important to work on this now.”

Risks and opportunities

ESG and sustainability are changing the way that private equity looks at risks and opportunities around a target.

The big mindset shift is that now ESG risk is as important and as central to a company as any other type of financial risk, such as leverage risk. That’s happened for many GPs,” says Elias Korosis, a partner at Hermes GPE, which manages £6bn of direct and fund of funds investments.

More attention is also being paid to how the management thinks about ESG and whether it is actively trying to measure and improve their company’s ESG credentials.

Korosis adds: “It reflects better management of the company, and better managed companies tend to perform better.”

On the opportunities side, more GPs are keen on using sustainability as a value driver, much like how private equity firms have viewed digital and ageing demographics.

“People either look for sectors that are on the good side of energy transition, waste, water usage, et cetera – or you’re in an industry that may not be the best on the ESG side, but you’re backing the winners in that industry, the ones that have the best ESG profile,” says De Vusser.

This sort of risk-opportunity thinking around sustainability has now become so embedded that many private equity houses are no longer branding dedicated funds as ESG or sustainability funds, but are incorporating it into all their investment activities.

De Vusser says we can expect to see more private equity funds with net zero-related commitments, but that, especially in Europe, ESG will be everywhere: “It will be such a core part of buyouts funds that we cannot separate it out. If your core buyout fund is not an ESG fund it will not drive a high return.”

Measurement and development

With a greater focus on sustainability, an increasing attention to metrics naturally follows. More scrutiny of potential greenwashing – where funds market themselves as ESG-friendly but do not provide the transparency and data to support this – is forming the backbone of private equity firms' due diligence. A careful eye on how to exit the investment will always be on their mind.

De Vusser says: “The leaders are tackling it with real skillsets, facts and talent, and it will be very obvious if in three to five years, when these companies come to exit, who will be able to put their outcome in a factual way – here’s where we are on emissions, diversity, and so forth.”

GPs are still developing standards, and many have signed up the UN Principles for Responsible Investment, which commits them to include ESG as part of investment decisions and reporting, and Initiative Climat International, which so far includes 90 GPs managing $700bn in assets.

Many firms will use external rating agencies, a popular one being EcoVadis, which provides an overall ESG rating for a company. These are often being used on top of detailed carbon accounting.

LPs’ ESG pressure on private equity

While some GPs have been ahead in terms of integrating ESG into their investment strategies, some will be responding more directly to pressure from their LPs (limited partners, or investors), which are keen to understand the ESG impact of their portfolios.

“Initially, most ESG questions came from French, Dutch and Scandinavian LPs, but in Europe we have seen a general spread of interest,” says Brenet.

“In North America, we see interest coming mainly from large pension funds. But we also see that high net worth individuals and family offices have a lot of interest in ESG and sustainability topics.”

Five years ago it was a lot of box-ticking questions," Brenet adds. "Now we have people who really see ESG as a value protection and creation driver, so they want to see how ESG is considered when setting an allocation, an investment decision, how the sustainability team works.”

Ardian has seen ESG enquiries from LPs rising at around 60% a year for the past decade, she says.

LP pressure comes on top of more favourable lending from banks and investors to private equity firms and private equity-sponsored companies incorporating ESG aspects.

Leveraged loans are increasingly incorporating terms relating to the ESG performance of the borrower, as Capital Monitor recently reported. With private equity sponsors accounting for a large slice of leveraged loan issuance, a lower cost of borrowing is incentivising them to take sustainability seriously.

Moreover, buyout giant EQT, with €47bn under management, issued a €500m sustainability-linked bond in May, the first ever from a private equity firm. The bond has key performance indicators that cover Scope 1, 2 and 3 emissions with targets approved by the Science Based Targets initiative. The coupon also steps up if EQT fails to hit diversity targets across its portfolio.

Regulatory requirements

Another driver of the sustainability trend in private equity is regulation. Bain said in its 2021 private equity report that the EU taxonomy would “force asset managers in the EU to disclose their share of taxonomy-aligned assets under management, inevitably creating an incentive to raise that share to remain competitive.”

Whether they’re trying to add value, impress buyers, placate LPs and regulators, or get a better deal from lenders, GPs are finding more reasons to take a serious approach to ESG and sustainability. Entrepreneurs should take note.

Chris Papadopoullos

A well-respected economist and writer, Chris Papadopoullos is responsible for building out Capital Monitor’s data intelligence service.