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ESG in Private Equity: A Complete Guide

FigBytes

Private equity looks to maximize return by finding proven winners and uncut gems in their respective fields. But the number on the bottom line can’t be the only deciding factor. More and more, investors and their partners are demanding a holistic look at business operations. Everything from environmental impacts to employment equity to leadership ethics is on the table.

Programs like Environmental, Social, and Governance (ESG) reporting for private equity are a way of providing a deeper dive into the things the balance sheet doesn’t always show. It can set apart rockstar opportunities from those that are lagging behind, while also highlighting new possibilities to drive growth.

But while ESG gets talked about a lot in boardrooms, it’s often only vaguely understood. General partners don’t always have confidence in ESG data quality, and while both investors and businesses agree issues like climate change need attention, they don’t want to see it affect their returns.

In this article, we look at what ESG is, how it’s used in private equity to drive decision making, and where businesses and investors can work together to bridge the data quality gap.

What is ESG?

ESG falls under the umbrella of sustainability reporting, focusing on the areas of Environmental, Social, and Governance activities and impacts of a business’s operations. There are a number of international frameworks and standards for ESG reporting, with guidance available within these documents for individual sectors. The areas for reporting include:

  • Environmental
    • Carbon accounting and greenhouse gasses
    • Water stewardship
    • Deforestation
    • Energy consumption
    • Waste management
    • Air quality
    • Biodiversity
  • Social
    • Data protection
    • Human rights
    • Labor standards 
    • Gender inclusivity
    • Customer satisfaction
    • Diversity
    • Hiring practices
  • Governance
    • Board composition and membership selection
    • Shareholder rights
    • Executive compensation
    • Ethics, bribery and corruption policies
    • Accounting and auditing procedures
    • Lobbying and political contributions

Although most ESG frameworks are voluntary, they are increasingly supported by legislative requirements or becoming part of mandatory reporting programs established by investors or other stakeholders.

How Do ESG and Private Equity Overlap?

Of the impacts that fall under ESG, climate change gets a lot of visibility, and while heavy industry like mining and oil & gas exploration have long been the target of discussions around understanding and managing carbon emissions, the role private equity plays in climate change is receiving more scrutiny now.

According to PwC, between 2016 and 2021, the percentage of asset and wealth management CEOs who participated in their Annual Global CEO Survey and said they were concerned about the threats posed by climate change went from 39% to 70%. And while the greenhouse gas emissions of a private equity firm’s offices may be negligible compared to other sectors, the financed emissions in a portfolio can be significant.

When choosing investment opportunities, private equity expects transparency in a company’s financial and operational disclosures. They want to be able to analyze and compare opportunity to risk. But that analysis extends beyond options to reduce costs and increase profits. Investors want to know what environmental, social, and governance risks exist.

Companies seeking investment who already have a strong ESG reporting program in place can be more attractive for three reasons. These are:

  • Reduced financial risk
  • Improved IPO and valuation
  • Higher portfolio returns

Companies with robust ESG reporting have already undertaken a detailed analysis of their financial and operational risks as they relate to sustainability, using internationally-recognized methodologies. They are actively measuring and managing their environmental impacts, making sure their workforce is equitable and ethical, and their leadership is engaged and supportive of these activities.

Essentially, these companies are future-proofed. Bank of America estimates that ESG-related controversies, whether they be environmental spills or unethical business practices, cost American businesses an average of $100 billion each year. By proactively identifying these risks and taking steps to mitigate them, ESG-savvy businesses are potentially a lower-risk and higher-return investment.

Balancing ESG and Investment Returns

Choosing businesses who already have ESG programs isn’t a guaranteed return for private equity investors. And in fact, while those 70% of CEOs say they’re concerned about climate change impacts, 81% of respondents to a recent PWC survey expressed reluctance to pursue ESG goals if it meant taking more than a 1% hit.  

While ESG reporting has the potential to future proof a business, the problem is that the future is changing and the legislation and frameworks around ESG are a moving target. One-third of investors think the quality of ESG data they’re seeing isn’t good enough. With so many standards and methodologies to work with from one company to the next, it can be hard for private equity with ESG policies and requirements to know they’re comparing apples to apples.

For companies starting to think about courting private equity investment, having an ESG program is important, but it can be hard to know where to start. According to PwC, investors prioritize reporting for Scope 1 and 2 carbon emissions over all other elements of ESG reporting. Yet many of these same investors don’t have the knowledge or resources to assess Scope 3 data, which can account for anywhere from 65% to 95% of a company’s broader carbon impact. 

In short, while ESG is acknowledged as being important both for private equity and portfolio companies, there is still a gap when it comes to successful implementation and showing value. There is a greater need on both ends to come to a common methodology and offer greater transparency.

Making ESG Work for Private Equity

In order for ESG to be more than an ambiguous make-work project with little impact on business operations, investors are looking for the following:

  • A program that starts with the C-suite. The risks and impacts determined through ESG reporting need to be understood and acted upon at all levels of the organization. Support for ongoing reporting and management needs to start at the board and executive level. In fact, many investors are now attaching C-suite compensation to ongoing ESG success.
  • Seeing ESG as a part of a business’s holistic story. An ESG report shouldn’t only live as an independent document on a company website or file sharing service. It should be integrated into documents like investor and financial reports. As a result, the ESG team should be integrated with a company’s financial, risk analysis, and investor relations teams.
  • Using ESG to drive business toward common standards, greater transparency, and more reliability. Investors have said they need better clarity around ESG standards and methodologies, and in the absence of a unified framework, this clarity will fall to reporting companies. 

Transparency in ESG reporting can make some companies nervous, particularly when it doesn’t always show them in the best light. And while some investors use third-party ESG scores to support investment decisions, a moderate or even a poor score isn’t always seen as a non-starter or immediate disqualification for investors.

Where ESG programs have identified deficiencies in an otherwise strongly-performing company with a high potential for growth, these deficiencies can be seen as an opportunity for investors to drive that growth even higher. By finding efficiencies and reducing negative ESG impacts, these businesses will look even more attractive for future investment and acquisition.

Harmonizing ESG Reporting for Private Equity Investment

At the end of the day, confidence in data quality is what will help integrate ESG reporting into business growth and private equity investment. Until that happens through standardization of frameworks and legislation, it will be up to businesses and investors to bridge the gap.

One way to do this is to use an ESG reporting platform, like Figbytes, to have all portfolio companies complete their annual reporting and updates. ESG software ensures that reporting is compliant and clear, so that investors can make confident decisions. It also streamlines the resources needed for reporting, since the platform is built on validated methodologies, cutting down the learning curve and time needed to build the first year’s report and subsequent updates.

The demand for high quality ESG reporting will continue to grow in the future. If the number of CEOs looking for climate change data has jumped from 39% to 70% in the last five years, it will only increase going forward. Building future-proofed ESG-focused businesses based on validated and high-quality data will yield positive returns for those businesses and their investors both in the short and long term.

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