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A holistic approach to ESG is the best chance of success in a competitive private equity investment market

By James Tetherton, Senior Partner and Melissa Borschnack, Director, at GRAPH Strategy

James Tetherton, Senior Partner GRAPH Strategy

The value of companies is at an all-time high in 2022, with investors competing intensely to acquire strong, high-growth businesses. The market continues to challenge private equity firms, with large amounts of capital available yet great opportunities becoming increasingly scarce. 

In the “traditional” deal making environment, most investment decisions were driven by financial returns. Today, there are more comprehensive measurements of success to consider, including not only financial returns but also environmental, community and social impacts. Firms are experiencing a cultural shift in which ESG begins to affect almost every aspect of a deal, and is a priority to build stronger businesses.

Investors must continue to move quickly to complete deals and avoid losing out in competitive processes. They also need to ensure investments meet their risk profiles and prove worthwhile in the long run. Firms that leverage ESG frameworks and incorporate them into decision-making processes are positioned to not only mitigate risk, but identify and capture value-generation opportunities in this competitive environment.

Melissa Borschnack, Director, at GRAPH Strategy

Viewing ESG as a driver of value creation

Traditional deal analysis tended to treat ESG as a “tick-the-box exercise” – primarily concerned with managing risk, rather than identifying new sources of value. 

In today’s environment, there is a significant opportunity to use ESG for value creation. Driving meaningful impact should not come at the cost of driving financial returns, despite what some seem to think. Instead, it creates a virtuous cycle that helps companies deliver better results and experiences for their customers, communities, and stakeholders. This in turn helps improve brand equity, leading to stronger revenue and returns, creating a win-win cycle.

The importance of ESG in 2022

The tide has turned on the perception of ESG and its importance within a business. Many limited partners (third party investors) have begun asking and expecting private equity firms to have a philosophy and measurable outcomes with regards to ESG. There is also increasingly complex regulation, including articles 8 & 9 in EU’s Sustainable Finance Disclosure Regulations (SFDR). 

It is no secret that younger generations are generally more interested in ESG than their older counterparts. Generations Y and Z are increasingly demanding businesses to incorporate ESG practices, both as employees and customers, in alignment with their personal values.

Commercial due diligence and ESG

From a commercial due diligence perspective, the most effective firms are those that seamlessly incorporate ESG considerations into their broader commercial diligence process.  

Private equity firms typically have a limited amount of time to execute deals. Consequently, it can be easy for these firms to select businesses, simply because there is a perception of strong ESG practices (greenwashing). However, the commercial due diligence process is the best way of ascertaining a company’s current standpoint, as well as its potential. Private equity firms are seeking to strengthen their ESG approach, and several are doing so with the following:

  1. Establish an ESG policy and philosophy that outlines how the firm integrates ESG into its diligence process, which helps employees and partners contribute to meet firm objectives.
  2. Integrate ESGs effort across workstreams, recognising the multifaceted impacts that it has across commercial, operational, management, and financial diligence streams
  3. Institute a measurement standard for ESG metrics, and during the diligence process, ensure the standards are met or determine what it will take to meet the outlined metrics.
  4. Incorporate rigorous analysis into the ESG metrics – some metrics come directly from available data (e.g., amount of pollution, diversity among board members) but others require proper “Voice of Customer” research to verify performance. By conducting investigative interviews with customers, industry experts, former employees, and others, primary research can uncover several insights around ESG (e.g., inclusive culture, workforce safety, customer equity, community impact)
  5. Ensure a balanced approach to consider factors across the full ESG spectrum. Private equity firms traditionally over-index on the environmental component of ESG, sometimes at the expense of social and governance factors. A more balanced approach allows for a broader assessment of not only the ESG risk factors and mitigation opportunities but also value creation.
  6. Understand there are a set of ESG metrics that will work across industries and companies while also realizing that there will be several types of industries that require unique metrics and/or approaches to ESG.
  7. Allow for flexibility especially as you conduct diligence across cultures – there are different expectations between regions and countries (e.g., UK, EU, and U.S.) It is important to consider these cultural standards and expectation differences when looking at a specific asset, comparing it to peers in the industry, understanding regulations, or planning for expansion to new geographies.

A holistic view is key to success 

Beyond incorporating ESG into the commercial due diligence at the time of acquisition, private equity firms are best served when they institute an ongoing ESG monitoring program into their portfolio operations. This means firms have an opportunity to assess progress on key ESG metrics and identify additional improvements for their portfolio companies. 

Therefore, when it comes time to sell, private equity companies can highlight how ESG priorities and improvements contributed to the financial success of their investments. Ultimately, this virtuous cycle allows the firms to demand higher returns upon exit.

It is an exciting time in the industry as the private equity community is embracing ESG’s ability to drive positive impact across the ecosystem of investors, employees, customers, communities, and stakeholders. 

About GRAPH Strategy:

GRAPH Strategy is a specialist strategy consulting firm that supports leading global corporations, private equity and credit investors invest in and build stronger businesses. We adopt a rigorous, evidence-based approach to identify market opportunities, conduct commercial due diligence and design winning growth strategies.

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