The value in ESG

Consumer and employee attitudes towards environmental and social issues are having a growing impact on private equity’s approach to value creation.

Rémi Carnimolla, a partner and managing director at 3i Group, has had some tricky conversations with chief executives at his portfolio companies over the past year. Beyond the usual talk of data, the pandemic and financial metrics, Carnimolla has been doing something relatively new: he has been asking them about sustainability.

“I was challenging one of my CEOs and I said, ‘Do you think you’ll attract millennials and a new generation of workers if you tell them you are just compliant?’ That is not enough,” he explains. “We have said, ‘You need to figure out what sustainability means for your company, beyond just publishing a nice report.’ Because it’s going to be a winning factor to attract talent and it can be a decisive factor to win contracts.”

That conversation was part of a broader push by the listed private equity firm to prioritise environmental, social and corporate governance at its portfolio companies, with the firm setting up a working group last year to encourage portfolio companies to examine what sustainability means to them and their business. 3i hopes this will help boost profitability and create value at the companies it owns.

You need to figure out what sustainability means for your company, beyond just publishing a nice report

Rémi Carnimolla

“We were very disciplined. All our companies had to go through this journey. In Europe, we are much more advanced on this than in the US,” says Carnimolla.

Sustainability and ESG have been rising up the agenda for private equity firms over the past decade. But for the most part this has been driven by investors, which are keen to ensure firms are not buying up unethical or risky businesses that might end up splashed across the headlines for the wrong reasons. However, over the next decade buyout firms are expected to use ESG not just to manage risk, but as a value creation tool to boost profits at portfolio companies.

Increasingly aware

It is still early days when it comes to using ESG to improve operations but the landscape is changing rapidly. In 2016, just 10 percent of respondents to a survey of private equity firms by ESG consultancy ERM found that ESG factors helped boost exit multiples, but by 2020 that had reached 28 percent.

Christophe de Vusser, a partner at Bain & Company, predicts that as valuations are unlikely to increase at the rate they have since the financial crisis, firms will need to work harder to boost returns through operational improvements in the coming years.

“We don’t foresee that it will remain possible for the coming 10 years to drive growth through multiple expansion,” he says. “So, for private equity to continue to drive superior returns versus the public markets they will have to up their game on value creation. That is clear.”

He points out that over the past five years, there has been a sea change in attitudes towards sustainability and ESG. An increasing focus on climate change, achieving the target of reaching net zero, as well as social movements like Black Lives Matter and #MeToo, have all put pressure on companies to show they are acting sustainably and ethically. It means customers are changing the way they shop and employees are unwilling to work for companies that do not prioritise ESG.

De Vusser predicts that while traditional value creation levers will remain important, portfolio companies will need to up their game on ESG matters if they want to attract younger workers and grow ahead of the competition.

“What we see is that consumers are starting to shift behaviours because of ESG. They start to buy from company A not company B because of ESG. It’s also the case with business-to-business customers,” he says. “Employees are also starting to look at ESG. If a company is not at the forefront of ESG anymore, young talent doesn’t want to work there. That means that ESG has become important as a driver of market share, so it’s become a value creation tool.”

“Employees are also starting to look at ESG. If a company is not at the forefront of ESG anymore, young talent doesn’t want to work there”

Christophe de Vusser
Bain & Company

Duncan Ramsay, a partner at mid-market private equity firm ECI Partners, agrees that ESG is “coming up the agenda” on value creation plans.

“We do a regular ESG review of all our portfolio companies and collate performance data because it’s important to us and our investors,” says Ramsay. “It’s not something that we’ve done in a super structured manner with the portfolio companies to date, but it is something that is starting to bubble up.”

He is working with a portfolio company on how it should position itself in relation to net-zero carbon emissions targets because “we all see it as becoming more and more important in the future”.

It is not just consumers that are pushing businesses to focus on ESG. B2B clients are also taking note. 3i’s Carnimolla has seen this at portfolio company Evernex, which maintains IT equipment and often uses old equipment as spare parts, effectively recycling redundant equipment. “Their typical clients are very large clients, banks, telecoms companies. Those companies are more and more keen on sustainability and ESG and in [tender documents] it is an area that is very important. The fact that we do use recycled spare parts is a big plus.”

The focus on ESG is also feeding into a focus on governance at portfolio companies. Ted Bililies, a managing director at consulting firm AlixPartners, says there is a “growing appreciation for culture and how important it is” when it comes to value creation.

He says some buyout firms are introducing key performance indicators for senior managers that attempt to measure and prioritise culture because they understand how important a company’s culture is to attracting and retaining top employees.

Compensation schemes

“Private equity investors are becoming more sophisticated in that they are making sure they tie financial rewards [for management] to things like employee engagement, retention rates, morale and the like,” says Bililies. “You’ve got so many social media platforms where CEOs and companies are rated minute to minute, and the generational workforces are all very literate with social media. Private equity investors are savvy to that and are making sure that their compensation schemes reflect that.”

Some firms are also looking beyond the traditionally important CEO and chief financial officer roles, looking to boost the skills of chief marketing officers, HR directors and revenue officers and, in the process, improving the talent and governance of the companies they own.

Richard Swann, a partner at private equity firm Inflexion, says these sorts of roles are now increasingly important to improving operational efficiency and that the firm was focused on improving the skills of executives in those positions.

“There is that rising cadre of importance at the board level of chief technology officers, chief revenue officers and HR directors, which we are seeing more and more,” says Swann.

“If you look at what we do as an organisation, some of our leading forums [for portfolio company executives] are around the non-traditional areas. Sure, we get the CEOs and the CFOs together, but we get the chief technology officers, the chief revenue officers together, the chief marketing officers together.”