Seven ESG challenges for portfolio companies

ESG experts reveal the issues GPs grapple with while implementing responsible investing standards across their portfolios.

Being able to demonstrate strong environmental, social and governance credentials is a mark of GP maturity, and many would say, success, but how exactly do you go about implementing an ESG strategy across a diverse portfolio?

The task falls increasingly to dedicated ESG heads and specialist consultants who work closely with deal teams, operating partners and the management of portfolio companies to ensure that increasingly stringent sustainability standards are met: “The best performing companies on safety and environment perform well financially,” says Adam Black, Coller Capital head of ESG and sustainability. “If you can’t manage those issues well, you can’t manage the business well.”

But managing those issues takes time, money and considerable tact, as we discovered when we asked Black and five other leading experts to name their top ESG issues that GPs face at portfolio companies.

Here are the top seven challenges:

1 Make the business case for ESG

Given that ESG touches on such a broad range of business operations, from labour rights to cyber-risk, one of the difficulties GPs face is conveying to management teams the commercial imperative for implementing ESG.

“When GPs do ESG properly, they view it as risk mitigation and a value creator – a commercial driver,” says Black. “Making sure that it is understood at the portfolio level can be a challenge.” Many portfolio companies need help to understand that and to see ESG “plays a role in risk-adjusted returns, it’s not a tick box exercise and it’s not all about PR,” he says.

First GPs themselves must understand both the technical materiality of ESG issues and the commercial consequences, says ERM partner Guy Roberts. “If they don’t, it’s difficult for a GP to present a justification [for its ESG policy] and make any progress engaging with a portfolio company. The ability to connect the technical to the commercial is key to driving ESG through the investment portfolio. It’s a challenge when people don’t see what can be achieved.”

2 Obtain management buy-in

Whether an ESG policy is successfully implemented depends on the level of board and senior management support. “Ultimately it’s through the deal team and those members that sit on the board that ESG comes to life,” says Roberts.

Without that engagement, the risk of failure is high. “If there isn’t a clear commitment from within the business it’s not going to be a success,” says Triton head of ESG Graeme Ardus. “You need to make sure the management team focuses on key issues and has a plan to affect change.”

“If there isn’t a clear commitment from within the business it’s not going to be a success”
Graeme Ardus

The direct involvement of the chief executive officer in ESG issues demonstrates its strategic importance to the entire business, says Candice Brenet, Ardian head of corporate and investment responsibility. In sectors with less obvious material ESG impacts – such as software, technology and services – and where ESG issues are rarely discussed, gaining employee engagement is more difficult, she notes.

However, in these cases, Brenet says the firm’s approach is to “leverage the opportunities behind ESG topics. When you support a technology firm, for example, usually its main asset is its people. Helping them work on their human resources strategy to attract, train and retain the best talent is part of our ESG mission.”

3 Speak the same language

While GPs vary in approach and extent of engagement with portfolio companies on ESG topics, being able to communicate their agenda is crucial. It is not always easy. “Terminology is often an issue,” says Black. “ESG is not often a term you come across in industry and it’s less common at the portfolio level.”

When talking about ESG with portfolio company management – who may refer to the same policies as corporate social responsibility (CSR), environment, health and safety (EHS), corporate governance, or simply risk – GPs need to be clear, Black says. “GPs need to listen and understand the management team and their business, work out where the synergies are, where the gaps are, and build rapport before they start pushing [on ESG topics] if a positive culture and sustainable ESG model is the goal.”

This clarity also applies to agreeing with management what ESG scenarios constitute a material impact. “It’s an issue GPs struggle with,” says Black. “Each portfolio company is different. What does a crisis situation look like? It goes back to terminology and scope and getting GPs and management aligned.”

4 Integrate ESG during M&A

GPs highlight the merger of business cultures during buy and build, as a key challenge to implementing a successful ESG strategy. While time is short in due diligence to fully comprehend the impacts of a range of complex ESG issues, disparities between businesses can present obstacles to pursuing a successful acquisition strategy. In the worst-case scenario, a mismatch can scupper a deal.

Differences in ESG approach can be “something simple like a charity of choice,” says David Olsson, associate partner at Beyond the Deal, an M&A specialist. Or, it could be an issue with significant material impact such as targeting an add-on with a second-tier supplier that contravenes the acquirer’s corporate governance commitments and destroys potential deal synergies, he notes.

“You need to make sure the ESG work-stream is accountable at the highest level”
David Olsson

Incorporating ESG standards into due diligence screening and testing the operating model pre-acquisition are ways to mitigate that risk. “The transaction will be safer. [Like other elements of the deal] you need to make sure the ESG work-stream is accountable at the highest level,” Olsson says.

Expanding geographically presents a portfolio company with another set of ESG benchmarks to get familiar with. “Going overseas, there is always going to be differences around ESG policies and practices,” says Olsson. “An acquiring business has to be aware of what its policies are first. If it isn’t, it can’t apply them to screening criteria,” he says.

During the integration of businesses, attention to ESG is crucial to “create the cohesiveness between the add-ons,” says Brenet. “Every time you have an ambitious buy-and-build strategy you have to pay attention to HR topics.”

Ultimately, GPs need to assess whether the existing team responsible for ESG at the platform company is competent, sufficiently engaged with the issues and large enough, says Black. “It’s easy to grow a company and let ESG get left behind and that’s a huge risk I’ve seen many times before.”

5 Tackle an expanding agenda

The range of topics viewed as ESG priorities is growing, stretching GP awareness and expertise.

GPs need to be clear on the scope of their ESG policy, says Black, adding that many investors may see certain issues, such as cybersecurity and data protection through the lens of ESG but for a company, this is simply an IT or business continuity concern. Tackling cybersecurity from an ESG perspective is complicated by the fact that most ESG executives do not have a cyber background. The solution is to talk to consultants, IT specialists and peers, he says.

At the same time, GPs are broadening their perspective to look not just at the impact of business operations on ESG priorities, but the impact of an ESG issue on a business. This reversal in thinking increases number of businesses placed under the ESG microscope.

“A software business doesn’t look like a company for which climate change is going to be a risk if you look at it from an emissions perspective, but turning the thinking around raises a new set of questions,” says Stacey.

Examining how the software business is impacted by climate change could include investigating the extent to which its clients are exposed to emissions policy changes, for example. “As GPs increasingly recognise the need to subtly shift the mind-set from how a business impacts upon ESG, to how ESG impacts upon the business, they quickly recognise the breadth of sectors exposed and the value of evaluating these issues,” Stacey adds.

Ardus notes that it is both a challenge and an opportunity to keep abreast of ESG developments while driving the agenda forward across all the firm’s investments. He adds: “When it comes to exit, we believe other buyers will ask the same questions we’re asking and if we don’t address them that could present a risk to a successful exit.”

6 Allocate sufficient resources

“You can’t expect portfolio companies to take on dozens of initiatives every year”
Candice Brenet

Each portfolio company presents its own unique set of ESG issues and ability to address them. Resources in terms of people and time can be limited, particularly at small and medium-sized companies, says Brenet. “It’s important for management to be committed but it’s more efficient to bring in resources to help them engage on this work,” such as an ESG consultant to assist drawing up a roadmap for change, she says. 

Goals must be realistic. “You can’t expect portfolio companies to take on dozens of initiatives every year. There are some quick wins but there are changes that will require time,” says Brenet. For instance, health and safety is not simply a matter of providing a helmet and security shoes. It’s also about training people, raising awareness and sometimes even shifting the business culture,” she says.  

7 Wield in-house expertise

In the face of increasing scrutiny from LPs, regulators, customers and the media, some GPs seeking to implement ESG standards are working against resource constraints. “Many GPs now have excellent ESG expertise in-house, though sometimes in limited numbers,” says James Stacey, partner at ERM.

For ESG policies to be implemented effectively, a GP needs to dedicate resources, have a consistent approach and a structured programme, says Triton’s Graeme Ardus. At the same time, ensuring all portfolio companies have diverse workforces can be challenging. “The private equity sector, so far, has not done as much as other sectors [to improve gender diversity and inclusion],” says Ardus, who notes that Triton has set diversity targets for itself and its portfolio companies and their boards to drive change.

GPs without dedicated staff rely on consultants and the quality of company reporting to meet standards, says Adam Black of Coller Capital. Some businesses may never have had to compile ESG data before. “As a GP you don’t want to ask for too much, you want to be pragmatic and focus on what is important and material,” he says.

Monitoring ESG impacts can be tough. “There is definitely a challenge [for GPs] in tracking progress and what they are realising in terms of benefits,” says Roberts, who adds that ERM is working with the UN Principles for Responsible Investment to write guidelines for LPs on monitoring and reporting on GP activities around ESG.