ESG in private equity: what's coming and how can you be ready?

Even if you don’t know what ESG is, you know what ESG is. ESG stands for environmental, social and governance (as in the “corporate” kind) and has become a catchall descriptor for anything remotely associated with those categories. The private equity world is not immune, with interest in ESG investing growing exponentially, especially among younger and newer investors.

But what can investors and investment managers do as far as due diligence to avoid the possibility of a company misrepresenting or exaggerating its environmental activities, or “greenwashing,” and how can they prepare for anticipated federal and state regulations.

Attention toward ESG issues may seem to be a newer phenomenon, but, in actuality, investors have been watching some aspects of the categories for decades, particularly corporate governance. Over the years, we’ve seen the value of companies fall because of negative corporate or leadership behavior.

Still, awareness of a company’s environmental and social actions has undoubtedly increased, with investors noticing and voicing opinions on board diversity, sustainability efforts, employment practices, etc.

That pressure is driving investment professionals to push harder on their portfolio companies to step up what they are doing in the E, S and G areas in a meaningful and material way. They can no longer state they are doing certain things - investors want proof.

The problem for companies and their advisors is they have no easy way to measure the results of their ESG practices quantifiably, so even though stakeholders expect them to disclose and report the details of what they have done, many are still working out how exactly to do that.

Due to the lack of visibility from the companies themselves, investors may turn to ESG rating agencies for information. Unfortunately, not all rating agencies are the same. Some rating agencies are not transparent in how they determine the ratings they give companies. Some will only give credit for what is posted on the company’s website, which means the rating doesn’t reflect the degree of maturity in companies that are actually hitting their ESG marks.

It takes more diligence to understand what is going on behind the ratings, including how they are determined if the rating agency doesn’t have access to certain information.

One investment firm we work with ensured it was taking a common approach in gathering information on potential portfolio companies by creating a standardized questionnaire covering critical areas. The questions are reviewed over time and updated as needed. For example, the firm found that its initial questions for environmental diligence had to change to put a greater focus on climate change as well as its risks and vulnerabilities associated with transitioning to a low-carbon environment, like a carbon tax or change in consumer preferences.

Furthermore, the firm developed key principles to guide its portfolio companies, which are increasingly looking to the firm to help them formulate ESG policies. For the investment firm, leadership welcomes that. They want their portfolio companies to understand ESG is not just mentioned at the beginning of their relationship but will be addressed throughout the firm’s stewardship and engagement with the portfolio company.

Other investment firms echo that philosophy and appreciate that the current momentum around ESG formalizes certain decision-making processes, putting in place frameworks so ESG is considered in each opportunity before investing.

According to a recent Baker Tilly International survey of 60 global dealmakers, nearly 90% of respondents said ESG factors are being taken into consideration as a way to decrease investment risk and potential litigation. In fact, 83% of the respondents say they conduct due diligence over ESG issues during the investment or mergers and acquisition process. In addition, about 60% of dealmakers said they walked away from a deal as a direct result of a negative ESG assessment of a target.

The survey also found that more than half of respondents said ESG factors affected the valuation of a potential investment or M&A target, and 18% said a negative ESG assessment decreased the value of a target, indicating that considering and tracking ESG factors is a positive, and not considering them could decrease a company’s value.

As the popularity of ESG continues upward, expect to see these trends around M&A grow.

This past summer, European Union regulators started cracking down on companies that exaggerate their ESG credentials. If they cannot prove they meet certain standards, they will not be able to market themselves under the ESG label. While the Securities and Exchange Commission (SEC) has yet to release anything similar, SEC Chair Gary Gensler made clear that they are working on draft regulations that will stand the test of time.

There are some who believe the industry should take the reins in defining ESG metrics and the type of reporting that should be instituted, whether qualitative or quantitative disclosures. Then, the SEC and state security regulators can reflect those business practices in their regulations.

Over the years, ESG objectives have often been viewed as one type of the portfolio construct and pecuniary objectives as another, but there is a real correlation between the two.

Some newer investment managers are beginning to use some private equity techniques and focus them on achieving social and environmental goals. Investors are responding to strategies designed to address social inequality, transitioning to a carbon-neutral economy and other ESG issues. The hope is other investors will realize these objectives are fused. The future of not just our society and environment, but also our economy is dependent on an acknowledgment and integrated support for achieving these types of financial returns as well as social and environmental returns.

Whatever the reasons for it, more and more are recognizing ESG is good for society, good for the corporate culture and good for the bottom line.