Five Steps to ESG Best Practice for Private Equity Firms

For an increasing number of our clients, ESG has evolved past the point of being a compliance or reporting exercise and is forming an integral part of the firm’s investment and value creation strategy.

For Private Equity firms seeking to join their peers in building out a more mature approach to ESG, Holland Mountain ESG expert, Connor Goodings, has outlined 5 steps to ESG best practice.

1. Firms need to build and institutionalize internal ESG knowledge

Private Equity firms must establish their own, internal ESG expertise. Many firms are using outsourced knowledge to define their ESG  strategy, conduct investment due diligence, and actively monitor the portfolio.. Given the dynamic and complex nature of ESG considerations, working with third-party specialists is vital, but these should supplement and be managed by an internal ESG capability. Total reliance on external providers will limit the firm’s ability to drive real change.

The first step to making ESG part of a firm’s DNA, is emphasising its importance to the firm as a whole, both top down and bottom up. ESG must become part of the entire investment lifecycle, and the concern of all business teams, not only, for example, IR. If managed successfully, ESG strategies can flow through the investment lifecycle. Forward-looking GPs are using diligence findings to highlight their ESG competency as a differentiator to potential portfolio companies, then actively working with the portfolio companies to implement and maintain the ESG strategy.

2. Successfully implementing ESG strategy requires smart use of data and technology

To establish a comprehensive ESG strategy, Private Equity firms should work with stakeholders to define what is most critical to the organization and its underlying investments. Once understood, the firm’s ESG strategy, accompanied by robust materiality assessments, will provide the framework through which data requirements can be defined. We work with managers to select and implement the best-suited technology to automate the data collection process, invariably enhancing the quality of this data and streamlining the investor and regulatory reporting processes.

There is an additional duty of care to investors which involves sourcing opportunities, identifying and mitigating risks and creating value. However, GPs must be mindful of benign practices such as the collection of data that isn’t material – it may feel like progress, but it doesn’t correspond with a duty of care unless the data can purposefully be used for risk management. It is especially important for the firm to ensure that technology is supporting the data strategy, not defining it.

3. Managing stakeholder expectations is crucial

Once ESG policies and strategies have been defined, the focus should be on managing expectations for stakeholders such as LPs, underlying investments and regulators.

• • Transparency with LPs: Define the ESG reporting that investors will be provided with. Consider rejecting an LP request if further irrelevant petitions could cause portfolio companies to become disengaged.
  • Establishing trust with portfolio companies: Be clear on what the requirements are from investments and outline these requirements in the transaction documents.
  • Keep contracts comprehensive: Ensuring that the legal contracts along the investments’ supply chains are thorough will significantly reduce the portfolio’s exposure to hidden and uncontrollable risks.
  • Utilise regulations: In addition to ensuring compliance, ESG regulations and reporting frameworks, if used properly, can enable GPs to set robust expectations with investors.

Regulatory risk has the potential to be dwarfed by litigation risk. Misrepresentation and greenwashing have caused litigation risk to grow, and two of the top 10 law firms are already working on preliminary defences that target GPs managing underperforming funds where investors feel ESG characteristics were oversold and misrepresented.

4. Leveraging ESG as a value creator

To encourage deal teams to take ownership of ESG, firms must share real-world examples of the ways in which ESG data can identify potential improvements, support risk management and create value.  Three examples shared at the Real Deals ESG : Explore, Strategise Grow conference were:

• • Reducing energy consumption to reduce carbon footprint, which has led to significant savings, particularly during periods of heightened energy costs
  • Improving employee welfare, which consequently reduced absenteeism across the organization, leading to a significant reduction in operating costs
  • Increasing the provision of recyclable packaging, which helped to market the product and resulted in an uptake in sales

Staying ahead of the curve is often a competitive advantage in itself, even if it’s not always possible to directly connect ESG improvements with tangible value creation. For instance, firms are increasingly adopting measures to improve their carbon footprint by reducing their dependence on fossil fuels and transitioning to renewables. As a result, many firms have made significant savings following increases in energy prices due to geopolitical issues in Europe, after moving away from oil and gas. By telling a compelling story about the link between sustainability and financial performance, firms can create interest and provide a powerful incentive for stakeholders to engage with their ESG strategy.

5. Start small but get started

Improving the availability and accuracy of ESG data may seem like a daunting task, but the most important step is to get started. Rather than viewing regulations as an obstacle, firms should leverage them as a starting point for their data collection efforts. Once regulatory compliance is ensured, managers can build on these foundations to develop their own ESG data capabilities.

A common mistake that firms make is placing emphasis on quantity over quality of data.  The focus should be on collecting material, high-quality data that can be used to uncover insights, better understand risks, and drive value creation. This effort can then be expanded and scaled up over time to improve the provision of data available to the organization.

Fortunately, there are numerous resources available to assist managers in their journey to transforming ESG data into a critical business asset. We assist many Private Equity firms to use technology to facilitate this transition, leveraging tools to automate the collection, monitoring, and reporting of ESG data. Additionally, data and rating providers can help firms supplement their proprietary data with benchmarks, ratings, estimates, and proxy data.

Conclusion

Overall, private equity firms are recognizing that ESG is no longer just a compliance exercise, but an essential part of investment strategy and value creation. By embracing ESG, private equity firms can drive sustainable growth, mitigate risks and create long-term value for stakeholders.

Holland Mountain’s specialist Private Capital ESG Practice is working with increasing numbers of firms to define their ESG data collection requirements, and to select and implement the best-suited data collection, monitoring and reporting tools.  Get in touch today to speak to one of our experts.