Private equity: ESG’s natural home?
Private equity has been slow to join the ESG revolution. More firms are waking up to the opportunities on offer as well as the downside risks.
According to Andrea Bonomi, private equity is “a natural home” for environmental, social and governance (ESG) activities. “We are longer-term investors,” he says. “We have to be able to hold our businesses for 10 years and over that timeframe no one can ignore ESG.”
The chairman and founder of 31-year-old private equity group InvestIndustrial, which famously rescued Italian motorbike maker Ducati and exited an investment in Aston Martin last year, Bonomi was one of the first to bring sustainability into the mainstream of private equity.
InvestIndustrial signed up to the UN Principles for Responsible Investment (PRI) as early as 2009. Six years later, the majority of its investee companies – covering sectors from chemicals to hospitality – were producing sustainability reports.
The group implemented a carbon neutrality policy in 2016 and last year became carbon positive – for scope 1 and 2 emissions – across its entire portfolio. It also achieved B Corp certification and signed the Taskforce for Climate-Related Financial Disclosure (TCFD).
Bonomi insists this is not about achieving “impact.” “We’re not trying to save the world,” he says. “We’re just trying to see clearly the way the world is going.”
Not everyone in the private equity industry has been so enthusiastic. US firms have been notoriously slow to see the value in ESG, with sustainability and responsible investing being seen as the purview of dedicated impact funds.
Even in Europe, with a few notable exceptions such as EQT and Eurazeo, mid-market and larger private equity players have been reluctant to move beyond a narrow, risk-based approach to ESG.
An industry survey by PwC in late 2018 found that only a third of the mostly European respondents had an investment professional or team dedicated to ESG. The same proportion cited risk management as the main driver for focusing on the topic.
However, things are now changing fast. Leading US firms including TPG and CVC have been ramping up their sustainability credentials over the past couple of years and even holdouts such as Blackstone and Advent International are starting to embrace the concept.
Nothing focuses private equity groups more than the people giving you money
In early May, Reuters reported that Blackstone had for the first time asked the heads of all its portfolio companies to report to their boards on sustainability issues including climate risks, employee diversity and human rights commitments.
This shift is partly due to mounting pressure on firms from an increasingly diverse range of stakeholders. First and foremost among these are private equity’s own investors, the limited partners (LPs). As Bonomi succinctly puts it: “Nothing focuses private equity groups more than the people giving you money.”
European pension funds and asset managers have been focused on sustainability for years, which partly explains the continent’s relative leadership in the field. Elsewhere the concept has been slower to catch on, but industry players report a big shift in the attitude of US and Asian investors over the past couple of years.
“Two years ago, this was nowhere in their agenda,” says one fund manager. “If you tried to talk about it the response would be: ‘No interest. How much money do you make?’ That is not the case anymore.”
Reynir Indahl saw the first signs of this change when his firm, Summa Equity, raised its second fund in 2019. In its first funding round two years earlier, Summa’s focus on the UN Sustainable Development Goals (SDGs) had met with little enthusiasm from investors outside northern Europe and Scandinavia.
“In fund two, that mindset was already shifting quite a lot,” says Indahl. “Even US investors were starting to realize that the risk of having too much oil and gas in their portfolio was high.”
Today, he adds, the mindset has changed dramatically. “The US is probably a bit behind Europe, but even so, they now realize that externalities will impact the valuation and performance of companies,” he says.
“The pension funds have this almost as a must now and the family offices are getting there. The funds of funds and the university endowments are probably a bit behind the pension funds, but they’re there as well. It’s high on the list for all new investors we meet.”
Publicly listed private equity firms – which include industry behemoths Blackstone, Carlyle and KKR – are also facing increasing scrutiny on sustainability from shareholders, both institutional and retail.
The same consideration applies to firms looking to exit investments via the public market – although industry experts say ESG is becoming increasingly relevant for all exits.
“If you have a company that has ESG risks, you’re going to find it a lot harder to exit now than it was five years ago,” says Elias Korosis, head of growth investing and strategy at global private equity investor Hermes GPE.
Debt investors are also adding to the pressure on private equity. Demand for ESG-labelled bonds has soared over the past two years, while sustainability-linked products that offer financial incentives for meeting environmental or social targets have proliferated across the bond and syndicated loan markets.
Meanwhile direct lenders, often prompted by their own investors, are increasingly requesting information on sustainability, as well as encouraging the take-up of ESG ratchets similar to those available in the public markets.
“We have seen very strong growth in the trend towards direct lending packages with ESG ratchets over the past year or so, both from us wanting to engage and from private equity firms looking to include them,” says Graham Rainbow, co-chief investment officer for liquid credit at debt investor Alcentra.
Private equity professionals confirm that the level of scrutiny is rising. “Two years ago, we weren’t getting any ESG questionnaires from lenders,” says one. “A year ago, we were getting a handful and they weren’t consistent. Now they’re more and more detailed with each refinancing or financing we do.”
The emphasis of enquiries is also changing. “Lenders are asking really thoughtful questions,” a private equity source adds. “At one point it felt like it was more of an exercise in paperwork – we need to ask a series of questions and as long as there’s no red flag then we’re comfortable.
“Now lenders really want to understand our approach and what we’re doing with our portfolio companies in order to get comfortable with lending.”
Again, European lenders are leading the way on both the implementation of ESG risk assessments and the inclusion of preferential rates for sustainability performance. US private equity firms report much lower engagement on the part of lenders.
Private equity firms active in consumer-facing sectors such as retail and hospitality are also facing rising pressure on sustainability from end users. “Consumers are becoming very sensitive to the ESG performance of a company, to the point that this is becoming a real risk factor on the revenue side for B2C [business-to-consumer] business models,” says Korosis.
Finally, like the rest of the financial sector, private equity players with operations in Europe are facing a tidal wave of regulatory requirements on ESG, including – but not limited to – the EU taxonomy, the recently implemented Sustainable Finance Disclosure Regulation and the upcoming Corporate Sustainability Reporting Directive.
US firms have so far avoided regulatory action on ESG in their home market, but that looks set to change. While the Biden administration is unlikely to match European levels of intervention, the Securities and Exchange Commission has made it clear that it has climate and sustainability reporting in its sights.
“With everything we do, we have to have an eye to ESG regulation because it is only going to increase,” says Bonomi.
Adding to the challenge for private equity firms is the rapid expansion of ESG topics under scrutiny. As one private equity professional puts it: “As soon as you get your head around one piece of ESG there’s always something else coming through. You get a bit of a handle on climate and then comes water, then biodiversity.”
The Covid crisis and last year’s Black Lives Matter protests have also inspired a renewed focus on social issues such as labour conditions and diversity, equity and inclusion.
At the same time, the urgency of the climate crisis and the focus on the issue in the run-up to COP26 in November – and particularly the recent proliferation of net zero commitments by corporates, banks and institutional investors – mean carbon emissions are top of the disclosure wish list.
“We are getting demand for carbon reporting from multiple angles,” says one private equity professional. “We’re getting it from investors and we’re getting it from lenders, and our portfolio companies are getting it from customers who’ve made their own net zero commitments.
“Everyone seems to be on a two to three-year time horizon, but they want to know that we’ll be able to provide that information and how we’re going to do it.”
We have arrived at an inflection point where people are realizing that there’s a huge investment impact to how they manage ESG
All of this has fed into a growing realization across the private equity industry that ESG integration, even from a risk perspective, needs to go beyond merely ensuring that investee companies are not involved in child labour or corruption.
“Over the past year or two we have arrived at an inflection point where people are realizing that there’s a huge investment impact to how they manage ESG,” says Korosis.
“When GPs [general partners or private equity firms] are running a company they focus on three things: the revenue line, the profit – ebitda and net income line – and the exit. And what they’re seeing is that ESG factors are starting to affect each of these.”
As Bonomi puts it: “In private equity we are paid to see trends and to make sure we don’t get into businesses that don’t fit the world as it will be. It’s not possible to pollute at scale and assume there will be no checks and balances.
“At some point companies will be asked to pay for this, so we have to integrate that into our decision making.”
At the same time, as Bonomi has long argued, sustainability can be an opportunity for private equity as well as a challenge – a viewpoint that is rapidly gaining traction across the industry.
“Private equity funds are coming round to the view that ESG factors are good for profitability,” says Jeffrey Greenip, global head of financial sponsors at Jefferies. “Five years ago, it was LPs putting pressure on GPs. Now we’re seeing a far more proactive effort on the part of GPs that sometimes goes beyond what LPs are asking for.
“They are embracing the opportunity ESG represents for their firm as a whole, for their ability to recruit and build teams, and for their perception in the marketplace with LPs.”
Hermes GPE, which invests in private equity firms and their investee companies on behalf of global pension funds and other institutional investors, has been another early advocate of the upside of sustainability.
“We are very focused not only on the risk management aspect of ESG but also the opportunities,” says Korosis. “These come with the not immediately financial benefits that can accrue to companies that do this well, which we think will translate into financial benefits.”
Others point to growing evidence that ESG integration is already having a positive effect. “We have seen over the past year that companies that are aligned positively with externalities and SDGs are more resilient in difficult times,” says Indahl. “And they also get a value premium because investors see them as more future proof.”
Our perspective on ESG has evolved from risk management
This may help to explain moves by more traditional firms to adopt a broader interpretation of ESG. Until very recently, Advent International took a strictly risk-based approach to the issue – as evidenced by the fact that its head of ESG, Jarlyth Gibson, comes from a compliance background and is also head of risk management.
Today, however, the firm is enthusiastically touting the benefits of sustainability. “Our perspective on ESG has evolved from risk management into identifying opportunities, value preservation and value creation,” says Gibson.
“We have grown to a place where we think of responsible investment and ESG as being key from a deal perspective and in terms of supporting our portfolio companies. We want to help them think not only about risks but also about how ESG aligns with, and is material to, their value creation plans and how Advent can bring resources to help support them.”
That this is becoming an industry trend is confirmed by PwC’s latest Global Private Equity Responsible Investment Survey, the results of which were published in May.
For the first time, respondents were able to choose “value creation” as one of their top drivers of responsible investing and ESG activities – and two thirds did, making it a clear winner ahead of “corporate values”. Risk management, which headed the table in 2019, sank to fourth place.
Unsurprisingly, private equity players’ views on how to take advantage of sustainability trends such as net zero, the circular economy, inclusive recruitment and natural capital vary widely, depending on their background, location and market position.
Nicolas Chavanne, Advent’s head of retail, consumer and leisure for Europe, is keen to explore opportunities in recycling, upcycling and reselling clothing.
At Hermes GPE, Korosis tips cybersecurity as a key sector. “It’s a risk faced by all companies operating in the digital space, but it hasn’t necessarily been captured in historical ESG analysis,” he says. “We see an opportunity here in investing in those companies and funds that understand this evolution.”
Meanwhile Bonomi sees a chance to leverage his firm’s industrial expertise in what he dubs the era of “infrastructure 2.0”. He notes that, for example, the entire electrical infrastructure and water system of London will need to be restructured to bring the city up to speed on sustainability.
“That will create amazing opportunities in smart grids, EV [electric vehicle] charging, micro-renewables and smart water solutions for mid-market companies, and for us as a leading mid-market investor,” he adds. “These companies will need a lot of money, but they’re too big for the impact funds and too cutting-edge for the big groups.”
Some firms have even spotted opportunities in the ESG industry itself. In January 2020 CVC invested $200 million in EcoVadis, a leading global provider of sustainability ratings.
Many private equity players are also looking at the potential for value creation through improving the sustainability credentials of more traditional businesses.
I live in a tree-hugging world, so I assumed everyone was tree-hugging with me. But there are fewer of us than we’d like to think
In their 2021 Global Private Equity Report, sector experts at Bain & Company noted that GPs: “Are recognizing that the next buyer will often pay a higher multiple for a company in an environmentally questionable industry that has become more sustainable and responsible than its competitors.”
The report cites the example of Polynt-Reichhold, a specialist chemicals group created by InvestIndustrial via multiple acquisitions over the past decade. Through various sustainability measures the group reduced its carbon intensity to a level 40% below its best-performing peers. InvestIndustrial in January picked Morgan Stanley to manage its exit from the firm, which is expected to fetch around €1.5 billion.
An interesting side effect of this broader push for sustainability is an increasing convergence between impact funds and traditional private equity funds.
Nearly half of the respondents to PwC’s latest survey said that, while they did not have a dedicated impact fund, they were already either measuring and managing for impact or using a screening framework to seek out investment opportunities associated with positive impacts.
“All the themes in an impact fund are now permeating throughout private equity, so that will blur the distinction,” says Greenip.
Yet while many firms are moving in that direction, some say it is too early to hail the wholesale conversion of private equity to the sustainability cause.
Korosis notes that many in the industry still approach the topic with a risk mindset. “They treat their ESG review the same way they treat their legal due diligence review – as a hurdle to be overcome to get the deal done,” he says. “The fact that GPs still allow that mindset to exist in their investment teams is the biggest challenge our industry faces.”
Bonomi points to data produced by last year by the UN PRI and information provider Preqin, which shows that, out of 8,810 global private equity firms, just 703 have signed up to the PRI.
As well as the likes of InvestIndustrial, Hermes GPE and Summa Equity, signatories include big players such as TPG, CVC and KKR – but not Advent International or Blackstone.
Even among the signatories, active implementation of the PRI’s principles is patchy. Just 304 firms have a responsible investment policy, while a mere 98 report that more than 90% of their companies have an ESG or sustainability policy.
Bonomi says he was shocked by the data, which is included in InvestIndustrial’s latest sustainability report. “I live in a tree-hugging world, so I assumed everyone was tree hugging with me,” he says. “But there are fewer of us than we’d like to think.”
PwC’s responsible investment survey also highlights the gap between awareness and action. Of the 209 respondents, a self-selecting group made up largely of small and mid-market European firms, 47% said they hadn’t done any work to understand the climate exposure of their portfolios – and only half of those said they planned to do it in the next year.
Yet, as the report’s authors warn, the risks of ignoring sustainability are high. “Private equity firms putting ESG at the heart of their business strategy will be the game changers in the new sustainable economy,” they say. “And just as there will be leaders, there will also be laggards. Those firms that fail to embrace ESG will risk significant value erosion.”
Korosis agrees. “As private equity, you should go in with the assumption that you’re going to own something for the medium to long term,” he says. “A five-to-10 year hold perspective is obviously not a 100-year hold, but in that timeframe you should expect that the long term will be visible.
“Private equity definitely has to have the mindset that the long term can hit you in the short to medium term and that will get reflected in the exit environment for companies.”
Proponents of sustainability also see it as opportunity to rehabilitate a sector that has often struggled with reputational issues and even give it a new sense of purpose. “I think sustainability will be good for private equity,” says Bonomi. “It will bring our industry back to creating businesses that are needed and that other people don’t do.”
Summa Equity: Measuring impact
One of the biggest challenges for sustainability-minded private equity firms is how to measure and report on the impact of their portfolios on society and the environment, as well as the potential impact of social and environmental factors on their investments.
At Stockholm-based Summa Equity, founder Reynir Indahl has taken a multi-pronged approach to the problem.
With the help of analytics provided by Swedish start-up Normative, the firm already reports scope 1, 2 and 3 carbon emissions for all its portfolio companies in accordance with the requirements of the TCFD.
It has also for the past two years made use of a framework developed by the Impact Management Project, a global project aimed at standardizing impact reporting. This year it will also report on its portfolio companies using an accounting methodology developed by Harvard Business School called Impact-Weighted Accounts.
Indahl argues that this system, which puts a monetary value on environmental and social externalities, is something the whole private equity industry should move towards.
“If you monetize all the externalities, that is a number that you can compare with the profits or revenues of a company,” he says. “That way you will see if your portfolio is really future proof and whether a company would be profitable if it had to pay for all of the externalities.”
Measuring impact is particularly important for Summa, which has raised €1 billion from global investors on the promise of achieving positive impact on at least one of the UN SDGs with each of its investments.
In practice, this means investing in lower mid-market companies that are providing solutions in one of three areas: resource efficiency, changing demographics and tech-enabled businesses. Indahl describes this as a “thematic megatrend approach”.
“Our story is that we live in a volatile and uncertain world with climate change, social unrest, an increasingly polarized political landscape and stagnating economic growth,” he says. “However, there are some certainties.
“We are going from seven to 11 billion people and they need more food, so salmon farming is a good place to invest. We are running out of resources, so waste and recycling is a good place to invest. We are getting older as a population, so healthcare is a good place to invest. We need to transition on the energy side, so energy efficiency is a good place to invest.”
Indahl is keen to stress, however, that Summa is not an impact fund. “We’ve never labelled ourselves as that because the idea around impact funds was that there’s a trade-off between the financial performance of companies and the impact they have,” he says.
“We’re looking at this the other way around. We want to provide positive impact by scaling up companies that have the right solutions. We don’t see that as a trade-off.”
So far, his approach has been proved right. Summa’s first fund, which closed in 2017, has delivered more than 30% yearly returns to investors, putting it in the top 5% of private equity funds globally. The second fund, closed two years later, is reportedly doing even better.
In March the firm sold recycling company Sortera at twice the exit multiple it paid in 2016, after transforming it into the 11th most sustainable company in Sweden, and also achieved a $265 million Nasdaq listing for proteomics platform Olink.
Private equity and sustainable finance
The rise of sustainability-linked financing has opened up opportunities for firms in a wide range of sectors and private equity is no exception.
As with most sustainable finance trends, the pioneers in the field have mainly been European. Last summer, EQT and InvestIndustrial announced inaugural ESG-linked subscription credit facilities within a month of one another, both referencing environmental, diversity and governance metrics. EQT followed up in May this year with the first-ever sustainability-linked bond from a private equity firm, with targets covering greenhouse gas emissions across the Swedish firm’s portfolio and gender diversity targets within the firm itself and on the boards of its portfolio companies.
Also in May, AlpInvest became the first private equity fund of funds to sign a sustainability-linked loan facility for its latest co-investment fund. Key performance indicators for the transaction related to ESG reporting and due diligence, as well as the Dutch asset manager maintaining a leadership rating from the PRI.
US private equity firms have so far shown less interest in sustainability-linked structures. Standard Chartered last year arranged a groundbreaking syndicated facility for KKR that set conditions relating to the UN SDGs for investments in the firm’s Global Impact Fund.
Direct lenders such as Alcentra have also started introducing sustainability-linked elements into financing packages for private equity, partly in response to demand but also as a way of improving their own ESG performance.
“When we are giving our investor presentations, it will be increasingly useful to be able to disclose how many of our portfolio companies report emissions data and how many have ESG margin ratchets,” says Graham Rainbow of Alcentra.
Yet while some private equity firms have embraced the concept, it remains a relatively niche product – and opinions are divided on whether that will change in the near term.
Jeffery Greenip at Jefferies is cautious. “We’re in the very early stages of sustainable leveraged finance,” he says. “I think we could see the market focusing on binary outcomes on ESG factors, so credit investors simply avoiding certain industries they view as challenging, but I don’t see a model in the near term where you have pricing ratchets based on hitting certain ESG targets as the market standard.”
Others are more optimistic. “I think preferential rates for ESG metrics will go very quickly from being a niche concept to something that marks you out as best-in-class to the industry standard,” says one private equity professional.
“So far, the numbers haven’t been huge, but conversely this isn’t a heavy lift. This is stuff our portfolio companies are doing anyway, so why wouldn’t we take credit for what we’re doing? Why wouldn’t we take the discounts when they’re offered?”