Why Private Equity Firms Should Have an Environmental, Social and Governance (ESG) Strategy
Article

Why Private Equity Firms Should Have an Environmental, Social and Governance (ESG) Strategy

by John Kogan, Drew Armanino
April 30, 2021
Updated November 30, 2021

Environmental, social and governance (ESG) standards have been picking up steam for years, but a confluence of investor pressure, impending regulation, environmental crises, social justice movements and COVID-19 have landed ESG squarely on center stage, and rightly so. The time for ESG action on behalf of private industry is now.

A spin through the top of Private Equity International’s list of the largest 300 firms provides a clear picture of the value that private equity leaders place on ESG and sustainable investing. Virtually every website features some level of commitment to/investment in implementing ESG principles. 

In an unapologetically return-driven industry like private equity, you may be left asking why? What is so captivating about ESG that it has all the biggest players paying attention?  Below we define ESG and provide five core reasons why these factors need to be a focus for private equity.. 

What Is ESG?

ESG refers to three categories where businesses can focus efforts on corporate social responsibility:

Environmental - What is a business doing to reduce its carbon footprint? Environmental criteria include anything an organization may be doing to minimize waste, use renewable energy, reduce water or air pollution generated by operations or source raw materials responsibly and ethically.

Social - Social criteria cover what a business does to improve social relationships with employees and with the public. This may include wages and benefits, employee professional development, supply-chain management, workplace diversity and charitable causes the business takes part in.

Governance - Governance criteria measure how C-suite leaders manage and respond to the interests of stakeholders, including the board of directors, customers, employees, shareholders and vendors. Transparency in financial reporting and executive compensation are key considerations.

Five Reasons Why Your PE Firm Should Have an ESG Strategy

If you have yet to adopt an ESG framework, consider these business benefits:

#1: ESG improves returns and reduces risk

To date, ESG principles have been applied primarily to reduce risks and costs. For example, redesigning product supply chains to exclude unethical suppliers helps reduce reputation and business disruption risk related to the supply chain. 

There is abundant research backing ESG as a risk- and cost-reduction mechanism. McKinsey estimates that out of 2,000 relevant ESG studies, 70% find a positive correlation between ESG scores and financial performance, with higher scores translating to a 10% lower cost of capital. 

More specific to the investment community, ERM found 93% of their survey respondents agree that focusing on ESG themes will generate good investment opportunities. On top of that, 50% of respondents believed that ESG credentials are a factor in winning deals.

#2: Sources of capital increasingly mandate that ESG be deeply embedded in their investment strategies

According to the 2020 Edelman Trust Barometer: Institutional Investors special report, 88% of lending partners use ESG performance indicators in making investment decisions, and 87% said they would invest in companies that reduced near-term return on capital to invest in ESG initiatives. Limited partners are also more participative and want more transparency in reporting, heightening the scrutiny on not only setting ESG goals, but actively taking steps to achieve them.

#3: ESG regulation is inevitable

In March 2021, the U.S. Securities and Exchange Commission (SEC) announced they would be working towards a “comprehensive ESG disclosure framework.” In April 2022, after his appointment as chair of the SEC, Gary Gensler asserted that ESG disclosure regulation would be a central focus of his tenure.

Recently, the SEC has been examining money managers over their standards for classifying funds as ESG focused. By all accounts, the SEC is primed to act on ESG. Private equity funds that take steps now, in a proactive and strategic manner, will minimize disruption when (not if!) the SEC mandates ESG disclosures.

ESG mandates are already beginning outside the United States. Starting in 2022, the Singapore exchange will require that listed companies report climate-related disclosures in line with the recommendations of the G20 task force. Singapore officials anticipate that not only will the commitment to environmental accountability help achieve targets agreed to as part of the Paris Agreement, it will also attract capital.

#4 Top talent increasingly demands that their companies actively address ESG

Increasingly, top young recruits want their prospective employers to care about ESG principles. Capital Monitor calls a clear ESG policy a “baseline” for hiring young talent. It’s also critical for retention. Gone are the days of grinding early career employees through the mill with a promise of economic rewards to come. Today’s workers expect active diversity and inclusion efforts, and quickly become disenchanted with companies that conduct “greenwashing” as a practice. 

Visibility regarding employee satisfaction is critical (and unavoidable). The New York Times found that employees at purpose-driven companies are 1.4 times more engaged and enjoy 1.7 times more job satisfaction.
Private equity, as a historically male-dominated industry, is particularly susceptible to criticism regarding the social aspect of ESG. Firms that are strategic about embedding ESG create the opportunity to be standouts in the industry in the eyes of promising young talent.

#5: ESG drives value and creates lasting competitive advantage

ESG principles go beyond risk reduction and cost savings. Firms that successfully embed ESG principles in their investment theses also unlock value via avenues such as brand reputation, customer loyalty, recruiting, product and process innovation and marketing. Entrepreneurial firms that capitalize on ESG as a strategic value creation lever can build lasting competitive advantage, particularly in private equity, which has trailed other industries like technology in embracing ESG principles. 

Companies are seeking partners with shared values. Evidence of your firm’s conduct through action, such as achieving B Corporation status (a leading framework that measures corporate responsibility), lends credibility and relevance when advising portfolio companies on decision-making. You can be seen as a forward thinker, helping companies move from a focus on the bottom line to considering the impact of choices on all stakeholders, from employees to the planet.

Final Thoughts

Future market leaders recognize that ESG is not another reporting or compliance hurdle. Businesses can do good, while doing well. Strategic, forward-thinking firms will harness the inevitable wave of change that ESG will usher in to drive value, while those that see it as just another regulatory check-box increasingly risk being swept away.

Armanino is the only top 25 accounting firm to achieve B Corporation status. To learn more about creating and measuring ESG programs and policies for your organization, reach out to our ESG experts.

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