Sustainable Deal-making: Private Equities & Environmental, Social & Corporate Governance

Impactful Partnerships That Create Value & Promote Sustainability

Key Takeaways:  

• ESG assets are expected to surpass $41 trillion this year, indicating rising demand for more sustainable practices.
• Companies that follow the ESG framework are more likely to receive higher returns with lower risks.
• A survey of private equity firms shows that 66% feel value creation is the reason to invest in ESG companies.
• PE firms can help portfolio companies achieve their sustainability goals, driving long-term success.

In the 1960s, Rachel Carson's Silent Spring spoke to the environmental damage caused by the use of pesticides, resulting in policy changes, the creation of the Environmental Protection Agency (EPA), and a newfound green movement. The same period introduced the Civil Rights Act and the Justice Equal Pay Act, which further advanced long-fought issues regarding gender and racial inequality.  

Decades later, these conversations are still on the table, visible in legislative proposals and corporate deal making. One way these many complex conversations unite is in environmental, social, and corporate governance (ESG). This framework has quickly become the standard for companies, causing a notable shift towards sustainability-driven funds and investments.  

For private equities, this change has reshaped how they approach acquisition—further pressing businesses to adopt ESG principles.

Defining Environmental, Social, & Corporate Governance (ESG)

The ESG framework is a decades-long culmination of ethical concerns, such as climate risks, labor standards, and diversity. By definition, ESG is an acronym for Environmental, Social, and Governance issues. The investment process involves applying these non-financial, ethical values to the financial components of investment decision-making.

More to the point, these values help to better determine the future financial performance of a company by considering its impact on the environment and society, as well as its governance practices. ‍

• ‍Environmental factors indicate how a company works to conserve nature (recycling, using eco-friendly materials, allowing telecommuting) ‍
• Social factors consider a company’s treatment of people, from customers to employees(having data security, championing diversity, satisfying customers) ‍
• Governance factors examine a company’s leadership and the transparency of its operations(no lobbying, corruption, or retaliation against whistleblowers)

An ESG-conscious company shows that it’s progressing alongside society, valuing how its actions affect the world.These criteria help to better determine the future financial performance of a company by considering its impact on the environment and society, as well as its governance practices.  

And there’s data to prove ESG’s increasing value. Investing in ethical issues has become part of the mainstream market, with an exponential growth rate. According to Bloomberg Intelligence, global ESG assets are projected to surpass $41 trillion this year, with notable impacts on the worldwide economy.  

Lucrative Ethics & Sustainability

Aside from supporting sustainable practices, ESG investing is also profitable. Evidence suggests thatESG-conscious companies may have higher returns and lower risks. Adhering to these values affects every level of the supply chain, potentially leading to more profitable results:

1. ESG-conscious companies are better positioned to manage risks and opportunities, such as mitigating environmental issues or capitalizing on shifts toward more sustainable products and services.  
2. ESG data provides a broader view of a company’s performance, potential risks, and opportunities. This allows investors transparency for better-informed decisions, yielding long-term returns.
3. Consumers and employees can choose which companies align with their values, influencing sales, reputation, and ability to attract and retain top talent.

While there’s no guarantee that companies with strong ESG practices will consistently outperform their peers, they may still be better positioned to generate high returns and avoid significant risks.

More Private Equities Are Going Green

Historically, private equities have always placed value on the “G” in ESG. Since it began in the 1980s, the PE industry’s business model has been to improve the governance of acquired portfolio companies through better leadership.

But the increasingly high value of ESG has changed how PE firms execute investment decisions, causing them to consider the acronym’s other two letters. In particular, the past few years have indicated that the PE industry is becoming more interested in ethical values. One survey confirmed this new direction, showing that 56%of respondents either turned down a potential investment or refused to do business with a company that was lax on ESG issues.

Notably, 66% of these respondents also identified ESG as a source for value creation, or opportunity enhancement, departing from previous years’ responses that risk management was the main driver for ESG activity. These significant statistics suggest a growing opinion that the ESG framework presents genuine business opportunities.

The Mutual Benefits of ESG Partnerships

As a result of this growing opinion, there’s been an increase in ESG-driven mergers and acquisitions (M&A). In fact, a 2022 M&A report points to the fast growth of ESG deal-making, noting that these deals increased from roughly 5,700 in 2011 to an astonishing 9,200 in 2021. This 60% uptick indicates higher demand for “green deals.”

When ESG-driven PE firms acquire portfolio companies, they analyze how these companies manage their ESG risks, tailor a diagnostic specific to their market priorities, and provide them with resources they otherwise wouldn’t have:

4. Guidance and support: PE firms can offer guidance and support to portfolio companies on improving theirESG performance by providing access to resources, such as expert consultants.They can also help them develop and implement strategies to address key ESG issues.

5.  Solid investment decisions:PE firms can consider ESG factors when evaluating potential investments and in ongoing monitoring of portfolio companies, which can involve assessing a company’s environmental impact, labor practices, and governance structure, among other things.

6. Better Behavior: PE firm scan use their position as shareholders to influence the behavior of portfolio companies concerning ESG issues which can involve engaging with management, participating in shareholder votes, and advocating for policies that supportESG goals.

Overall, private equity firms can help portfolio companies improve ESG performance through a combination of guidance, monitoring, and engagement—creating value through sustainability.

Responsible Investments That Make a Difference

With ESG investments continuing to grow, it’s clear that companies’ critical financial decisions and well-being now rely on their reactions to these issues. Working together to help society and the environment is now an expectation.    

And there’s a lot to be gained from conforming to ESG values: The companies that adhere to the ESG framework can find benefits in more investors, talent, and consumers. M&A partnerships—like private equities and their portfolio companies—can combine strengths and come together to solve ESG issues.  

Eric Leaver, CEO of PracticeTek, shares his thoughts on how meaningful these partnerships are:

“PracticeTek believes in delivering sustained positive impact to our communities and the world. We are values-driven and take pride in knowing that many of our investments have the potential to be instruments of change. We invest with a returns-first mind set understanding that commitments to society and our planet can connect directly to profound growth and financial success.”

Thus, given the shared financial and ethical gains that come with ESG investments, the data trends that point to their growth are likely to resume moving upward—encouraging companies to be more sustainable and contribute to global health.

References

As 2022 M&A ActivityReturns to Pre-Pandemic Levels, Green Dealmaking Gains Steam. (2022, October 24). BCGGlobal. https://www.bcg.com/press/24october2022-m-a-activity-returns-pre-pandemic-levels-green-dealmaking-gains-steam

Benson, A. (2022, March 14). WhatIs ESG Investing and How Does It Compare? NerdWallet. https://www.nerdwallet.com/article/investing/esg-investing

Brownstein, A. R., & Lu, C.X. W. (2022, January 24). ESG and M&A in 2022: From Risk Mitigation toValue Creation. Corpgov.law.harvard.edu. https://corpgov.law.harvard.edu/2022/01/24/esg-and-ma-in-2022-from-risk-mitigation-to-value-creation/

Eccles, R. G., Shandal, V.,Young, D., & Montgomery, B. (2022, July 1). Private Equity Should Take the Lead in Sustainability. Harvard Business Review. https://hbr.org/2022/07/private-equity-should-take-the-lead-in-sustainability