When it comes to environmental, social and governance risks, private equity funds often find it easy to talk about but difficult to do. However, LPs are now pushing GPs to demonstrate their ESG credentials as a prerequisite for fundraising due to their growing understanding of how control of these concerns can help GPs maximise value. In this sense, ESG is much more than a superficial gesture, but rather a practical and process-led method of driving performance.
Fundamental to this practical approach to ESG is that it is an issue of risk, with a potential tangible economic impact that needs to be managed. Unlike other investment managers, however, private equity firms can go much deeper: as a highly active and long-term oriented ownership model, private equity has the potential to make significant, sizable and rapid improvements to businesses. As a result, the industry offers one of the most effective approaches to push the implementation of ESG principles.
By paying close attention to internal structures in portfolio companies, operational risk can also be substantially reduced, which not only benefits the company financially, but also limits potential reputational damage. The same holds true for encouraging environmentally and socially sound procurement and production. In general, following ESG standards can improve the company’s relationship with stakeholders, shareholders and employees, which can lead to a higher company value due to more efficient processes and a stronger reputation.
In addition to the mitigation of risk, management of ESG issues has more direct, practical benefits through increasing operational efficiency and improving competitive advantage. For example, actively managing a company’s use of natural resources by ensuring quality and sustainability of materials used, as well as reducing CO2 emissions, lowers operational costs. Likewise, the introduction of social policies has the potential to reduce staff turnover and the associated recruitment costs. Furthermore, actively raising ESG awareness in a portfolio company can be a brand enhancer, aiding product development and increasing differentiation. Customer loyalty can be improved and new markets can be accessed, potentially enhancing both earnings and margins.
The return enhancement that ESG provides is evident, with PricewaterhouseCoopers research showing that compliant companies are typically much easier to sell. We firmly believe that ESG should be reassessed in these practical terms. It must be recognised that management of ESG factors is not just a ‘green’ initiative, but is actually about the sustainability of returns over the long-term – precisely what private equity funds should be delivering to their investors.
Tim Creed is a managing director at asset manager Adveq.