Expert Commentary: ERM on ESG as a value driver

Responsible Investment (RI) has become ‘business as usual’ for the financial sector. Driven by societal demands, fiduciary responsibilities, regulation and a better understanding of the potential materiality of issues, Environmental, Social and Governance (ESG) consideration is now approaching mainstream. It’s not about risk management alone, good ESG performance can provide a significant opportunity to create business value. However, recent industry and client discussions have focussed on the ongoing challenges of unlocking the full value of ESG factors in investments.
The general consensus remains that ESG issues can materially impact the value and operations of invested companies, with wider implications for the portfolio and investment manager.

Material value enhancement can be achieved when General Partners’ (GP) focussed engagement with invested companies is informed, not only by in-depth understanding of strategic ESG drivers that may impact the companies’ value and growth plan, but also the experience of being able to actually unlock these ESG performance improvements on the ground and communicating success stories transparently and credibly.

However, ESG does not always get the attention it warrants especially where it has to compete with other business initiatives, and where stakeholders within the GP and invested company are unfamiliar with the additional business value that can be created.

In ERM’s experience, “ESG value” can be created in a number of ways at both a transaction and portfolio management level, for example and as highlighted in the case studies presented in this article; through improving the asset valuation process; enhancing early risk identification and post-acquisition risk mitigation; identifying upside opportunities, associated with business improvement through efficiency or innovation; and albeit less tangible, creating value through reputation enhancement or brand management.

ERM is currently surveying GPs and Limited Partners (LPs) who make direct investments in order to better understand how those with established ESG policies and processes have been able to benefit from value created within their invested companies, and to measure and quantify these impacts.

By learning about both the ESG successes and the setbacks experienced by investors, ERM can demonstrate what is being done well, and what lessons investors can apply for improved success in the future.

While it can be challenging to quantify the value of good ESG management, it is clear that investment firms which explicitly consider ESG issues are realising clear financial and non-financial benefits, both during portfolio ownership and at exit.

This view has been reinforced by various studies, including a 2015 Harvard Business Review article (1) presenting the results of a study on the types of socially responsible investments that make firms more profitable. In this article, the author concluded that “firms making investments and improving their performance on environmental, social and governance (ESG) issues exhibit better stock market performance and profitability in the future”. He further suggested that for investors, there is substantial value to be gained from analysing non-financial data and incorporating it into decisions. The research also highlights the importance of focussing on the company-specific material ESG issues in order to enhance valuation, “firms making investments on material ESG issues outperform their peers in the future in terms of risk-adjusted stock price performance, sales growth, and profitability margin growth. In contrast, firms making investments on immaterial ESG issues have very similar performance to their peers suggesting that such investments are not value relevant on average”.

Through a systematic portfolio approach, ERM has worked with its financial sector clients to unlock value throughout the investment lifecycle. The following are examples of how clients across asset classes, at both the portfolio and company levels, are working to realise the value from good management of ESG issues.

• Improving ESG performance supports fund raising: a European GP achieved top decile ESG performance amongst some of its key LPs based on initiatives they had put together with ERM’s support over the preceding two years; this helped the GP to exceed its fund raising target.

• Including ESG within the asset valuation process creates commercial negotiation opportunities: an ERM GP client bought an industrial company at a discount, through significant price chips, after identifying material ESG issues during the due diligence. Other buyers were put off but this GP embedded ESG issue management in its 100 day planning. Through an in-depth understanding of these issues the GP was able to find effective solutions to the problems during its ownership and then sell the business at a significant premium. Overall, this approach to ESG through the investment process resulted in $30 million savings.

• Focus on improved portfolio company ESG performance mitigates risk and also reduces business interruption: costs in the order of $8 million, as well as business interruption, were avoided through enhanced health and safety performance within a manufacturing company. The safety performance improvement was represented by a 68% reduction in lost time incidents.

• Reputation enhancement can deliver real returns for the portfolio business and for the investor: ERM worked for a GP client to support a newly invested Asian seafood restaurant chain with removal of International Union for Conservation of Nature (IUCN) listed critical and endangered species from its menu, and with implementation of supply chain monitoring and management. This reduced portfolio risk exposure and demonstrated commitment to respond to changing societal expectations around social and environmental issues, both protecting and enhancing brand reputation.

Increasingly, company case studies which quantify the enhanced return on investment due to ESG, are being used by GPs to bring their responsible investment policies and processes to life and build trust with their LPs. LPs, through their increasing direct and co-investment with GPs, are now facing similar ESG and responsible investment challenges and case studies are a useful means to help LPs get comfortable with the credibility of their investment partner’s ESG assertions and to differentiate between GPs.

Where GPs can provide such assurance of robust ESG risk and opportunity management programmes alongside meeting other financial and operational goals, ERM is starting to see LPs commit additional funds, or funds in preference to other GPs who have similar financial performance but which do not have similarly robust ESG programmes.

For any business it takes senior management leadership, as well as time and resources, to develop a mature approach to responsible growth, which encompasses and derives value from the ESG agenda. In our view we consider a ‘mature’ company approach as one which moves beyond environment and social compliance and value protection (environmental and social risk management), to one that embeds ESG in the core business strategy, such that the value of ESG is recognised and linked to the company’s overall business performance in a systematic way. The leadership and supporting processes which a GP demonstrates and implements with its portfolio companies can play a very significant part in this journey for example; through embedding robust investment processes (2) which identify as part of due diligence for each invested company, the material ESG risks and opportunities, and ensuring that where relevant these issues are pulled into 100/300 day planning and valuation exercises, and form part of ongoing performance monitoring and associated communications.

Whilst each company will have its own priorities and journey to responsible revenue growth, ERM sees shared characteristics amongst our GP clients and their invested portfolio companies.

Both ERM’s experience and recent research recognise that companies which identify the material ESG issue(s) and build these into their core business strategy are able to proactively manage risk and increase their value. Barriers to ESG value enhancement should not be underestimated: firms need the right skills to identify ESG opportunities as well as risks, and to identify which are the material issues that should be prioritised; building and communicating a robust business case for ESG and integrating this within the company strategy requires vision and leadership. However, these barriers play to the strengths of the private equity responsible investment model, where value creation is driven by strong governance and active ownership.

It is ERM’s belief that GPs are well placed to truly deliver operational value from ESG. For those that take up the challenge, we see not only the potential for direct financial rewards, but an increased ability to meet ESG data requests from institutional investors, for example as investors set sustainability targets for their investment portfolios, and the ability to develop enhanced relationships with investors.

In summary, the investment community is increasingly realising that ESG should not be considered as a distracting add-on or a compliance check box, but should instead be a core part of any business strategy that materially enhances existing investment models and helps to create environmental, social and governance success stories. ?


2 For example, per those set out in the Professional Standards Handbook, Invest Europe, November 2015.


– More than 25 years working with Private Equity (PE) firms and Limited Partners (LPs)
– Over 250 ESG related projects annually for PE sector
– Four years working with Invest Europe (formerly EVCA) on ESG training
– Over 100 financial sector clients supported in the last two years
– More than 40 years supporting corporate leaders in embedding sustainability
– 5,000 multi-disciplinary professionals globally
– Over 160 offices in 40 countries

Adding value across the investment lifecycle
ERM offers the following Environmental, Social and associated Governance (ESG) support across the investment lifecycle.

Raise funds and meet LP expectations
• ESG strategy and policy development
• Bolster ESG management framework
• ESG communication support

Explore opportunities
• Guidance to deal teams to identify ESG opportunities
• ESG capacity development and training

Pre-investment due diligence
• Holistic ESG Due Diligence on material issues that could impact investment thesis

Post-investment planning
• Investment integration support via 100 day planning to drive business value from effective ESG management

Enhance value
• ESG Portfolio review and monitoring
• Strategic Portfolio Assessments e.g. impacts of climate change
• Reporting process development and implementation
• Enhancement of portfolio company ESG policies, systems & performance

• Vendor disclosures to provide assurance to bidders on adequate ESG management
• Demonstrate value achieved through enhanced ESG performance

This article is sponsored by ERM. It first appeared in Private Equity International's Responsible Investing Special supplement, published February 2016.