- Dylan Assi
Private Equity 4.0 - ESG Integration in PE
Updated: Jan 22
ESG Integration in Private Equity is Leading the Next Era of the Investment Class
Beyond the literal definition of private equity, Henry R. Kravis of KKR provides a quintessential description of the investment class, conveying that “private equity has been and always will be about building value over the long-term.”(1) This encompasses value creation for stakeholders from the general partner and limited partners or families depending on the firm structure, to portfolio companies and downstream communities, individuals, and other entities that they impact. Indisputably, this often presents itself as the highest return for the lowest cost, the fundamental objective of a private equity transaction. However, given the current stature of the global economy and widespread increases in stakeholder pressure, sustained returns will require innovative, proactive, and ethical action to mitigate risk and maximize value. Unquestionably, this is where the importance of environmental, social, and governance (ESG) factors must be integrated into private equity firms at the firm level. investment-level and portfolio company-level. The former explores internal development of programs such as energy reduction in the firm’s office(s) and implementing diversity, equity, and inclusion (DE&I) initiatives, while the latter two categories emphasize investment strategies such as impact investments, negative-screening tools, and ESG due diligence, amongst others, and postinvestment ESG integration in portfolio company operations (i.e., portfolio company ESG programs to enhance tangible and intangible value, contributing to increased exit price/multiple), respectively. A statement as such must be substantiated with quantitative evidence; thus, according to Gunnar Friede et al., over 2000 empirical studies on the impact of ESG propositions on equity returns revealed that 63% of findings were positive while a mere 8% were negative; this attests to the potential alpha generation of investments that incorporate ESG. The global private equity footprint is no longer in the version 1.0 phase where value was driven solely through financial engineering, it is no longer version 2.0 either where increased operating efficiency was the primary additional focus, and it is no longer only version 3.0 where large financial institutions began buying into this space. Welcome to private equity 4.0,(2) a new era of private equity investing where management of externalities through ESG integration must be a core competence for firms of all sizes to elicit a sustainable competitive advantage and incite long-term efficiency and value.
In advance of further discussion and analysis, a brief literature review will illustrate the core concepts of this paper. First, Private Equity 4.0: Using ESG to Create More Value with Less Risk, published in the Journal of Applied Corporate Finance by Reynir Indahl, Hannah Gunvor Jacobsen, and Summa Equity explores the outright urgency and necessity of ESG integration in private equity, providing prefatory insight into the vital nature of this advancement. Perhaps the most eloquent statement in this paper to provide colour to this development is that “the management of ESG risks and pursuit of ESG opportunities have become increasingly fundamental to the staying power and value creation potential of PE firms by reducing the risk of their investments, discovering new sources for growth, and increasing their resilience to changes in the political and regulatory environment.”(3) The paper educates the reader of this concept through the narrative of Nordic private equity firm, Summa Equity, and its progression of ESG into a core competence and competitive advantage which has bolstered the financial performance of its portfolio companies and created previously unrecognized value for stakeholders. It may come as a surprise to learn that the firm does not undertake a complex approach to ESG, rather, using the United Nations Sustainable Development Goals (UN SDGs) as a guide to “avoid investments that are ‘net negative’ on externalities and focus on deploying capital into firms that are tackling major environmental and social challenges. This single point of information reveals the importance of keeping ESG simple, especially in the initial stages of entering this private equity 4.0 phase and developing further integration subsequently. This paper does not, however, address the detailed implications of ESG in terms of its integration into investment processes and the resulting effects on those real assets being managed.
Therefore, I selected ESG Factor Integration into Private Equity by Maria Zaccone and Matteo Pedrini to substantiate the first paper and provide insight through this paper’s teachings into the reasoning, tools, and barriers faced by private equity firms with ESG integration. Despite this paper failing to explore the outcomes of value created by ESG, the ultimate goal of utilizing this additional research does provide a detailed understanding of how market value can be maximized through ESG and how we can view this as a real option to an extent.
Considering the aforementioned discussion, it is imperative to further understand the tangible value that ESG generates, driving instrumental stakeholderism. To frame this, let’s draw on the business model canvas that the corporate world has built upon and propose an addition to the value proposition category, an ESG proposition. An effective ESG proposition for a business, investment firm, or any entity is rooted in an approach that intertwines the environmental touchpoints with social and governance counterparts. According to McKinsey,(5) the first key impact point of a strong ESG proposition is top-line growth as it assists companies in entering new markets and expanding in existing ones. In parallel, this is a factor of an attractive leveraged buyout candidate that would appeal to a private equity firm and increase return on investment as an operational improvement of a portfolio company once bought out. Secondly, cost reductions are another facet of an ESG proposition that can influence an investment process or business operation; the execution of such strategy can help to combat rising operating expenses which ultimately boosts free cash flow and return on an investment by a private equity firm; the outcome is appealing to all stakeholders involved and increases the inherent value of the investment (or real option). Thirdly, a strong ESG proposition will enable a private equity firm or portfolio company to achieve strategic freedom and ease regulatory pressure. McKinsey stated that “typically one-third of corporate profits are at risk from state intervention”(5) which increases with investment firms as exemplified by recent scrutiny on firms such as Goldman Sachs and BNY Mellon for their unsubstantiated ESG actions in certain funds. Fourth, employee productivity uplift was identified as another key factor of a strong ESG proposition which ultimately assists in attracting and retaining top talent. In terms of private equity, the results of this are two-fold; according to Alex Edmans, employee satisfaction is positively correlated with shareholder returns6 and attracting top talent in private equity has historically and undeniably fared better for firm performance over time. Overall, this all leads to a strong ESG proposition enhancing investment returns by strategic allocation of capital to sustainable opportunities. This assists private equity firms in avoiding stranded investments due to ESG issues, improves the bottom line by capitalizing on industry tailwinds, and bolsters the sustainable competitive advantage of the firm.
Unifying the previous elements, an understanding of ESG integration at various levels of a private equity firm, specifically, in its investment processes is vital. The firm-level ESG integration factors are relatively straightforward, including action items such as energy-efficient lights in offices, diversity, equity and inclusion hiring efforts, and a board with individuals of minority, amongst others; thus, further discussion regarding investment- and- portfolio-level ESG integration will be the focal point. According to Zaccone and Pedrini, during the initial sourcing stages of the investment process of 23 prominent private equity firms, 63.6% of respondents excluded non-ESG-friendly sectors/industries from investment opportunities. This is a relatively antiquated and baseline method of ESG integration in the investment process, however, it remains surprising that a mere 63.6% of respondents partake in it. Nonetheless, respondents also indicated that the due diligence stage of their potential acquisitions has control minimum ESG standards and 40.9% of respondents stated that they assess ESG value creation opportunities in the same stage. Moreover, during exit, 31.8% of those firms surveyed mentioned that they evaluate ESG pilots and use cases to be included in vendor due diligence. Additionally, according to this research, 59.1% of respondents utilize the target company’s business model as a primary tool for assessing and integrating ESG. This is followed by 45.5% considering industry ESG maturity, and 22.7% scrutinizing the type of ticket (i.e., minority or majority investment). Overall, the trends are supportive of the widespread integration of ESG factors at the investment level as we enter the inflection point of private equity 4.0. Furthermore, at the portfolio company level, this survey indicated that 68.2% of respondents ensure that portfolio companies implement ESG policies and plans once acquired. Similarly, 59.1% stated that they implement ESG business value creation initiatives such as increasing revenues and cutting costs through ESG-specific initiatives. Evidently, all stakeholders of the private equity investment process have benefitted and will continue to benefit from ESG integration at all levels of their operation.
To further illustrate the impact of the value maximization and risk mitigation elicited by ESG integration in private equity investment processes, real-world context is compulsory. An exemplary model of ESG integration in an investment firm at a global scale is Blackstone.
Foremost, the firm has built out numerous ESG teams at the investment, firm, and portfolio company levels including groups such as Real Estate Asset Management ESG, Alternative Asset Management ESG, Energy Transition Partners Private Equity, Portfolio Ops ESG, and Corporate ESG. As such, Blackstone has excelled in effectively all arguments made in this paper, integrating ESG by priority which the firm has identified as decarbonization, diversity, and strong governance.(8) Furthermore, touching upon a value creation point previously discussed, Blackstone has placed a heavy emphasis on attracting top talent to drive these initiatives. Thus, the firm has hired Jean Rogers, the founder of the Sustainability Accounting Standards Board, as the Global Head of ESG. In addition to this, most business units have dedicated ESG team leads at the Managing Director level who have led the internalization of sustainability processes from reporting requirements for portfolio companies to carbon footprinting and reduction targets. As CEO Stephen A. Schwarzman stated, “ESG is aligned with our core mission of creating longterm value for our investors. We seek to embed it within our investment process and operating policy;”(9) an ideal model for private equity ESG integration in traditional investment classes. Furthermore, it is imperative to also consider a non-traditional investment vehicle of direct sustainable investing, specifically, KKR’s Global Impact group. The business unit deploys capital across four investment themes including climate action, sustainable living, lifelong learning, and inclusive growth, encompassed by the team’s mission “to invest behind scalable, commercial solutions to solve critical global challenges.”(10) With over $1bn of investment into 15 companies that provide solutions to critical global challenges and contribution towards the UN SDGs, KKR has taken impact investing to mass scale. The group has also co-invested alongside other KKR strategies to surpass a threshold of $5bn of SDG-aligned investments since 2019. Evidently, ESG can be integrated at virtually all levels of the private equity investment process and across asset classes, work to enhance market value and mitigate risk, as well as contribute to and surpass the expectations of all stakeholders.
Ultimately, ESG has rapidly catapulted into the spotlight for private equity investors with an increased global focus on climate change, social matters, and related technology disruption. This concept of integrating ESG can be viewed as an inflection point for private equity as we transition from the previous stages of the investment class to the 4.0 phase and previously unrecognized firm value, market value, and encompassing stakeholder value is being created and captured while mitigating risk. To conceptualize this, the notion of a real option can be employed, taking on the perspective that ESG integration is an “economically valuable right to make or abandon a choice that is available to a [firm];”(11) however, as we progress into 2023, it is likely that the gradual right or choice in doing so will become an obligation, rendering ESG an inherent factor in market value generation and related valuation methodologies of firms, projects, and returns, amongst other touchpoints. In review, the literature discussed in this paper accentuated three primary themes to takeaway; first, Private Equity 4.0: Using ESG to Create More Value with Less Risk provided the understanding that ESG integration need not be complex, particularly in the early stages as the most important step is action. This led to my creation of the following acronym that models ESG integration at a high level, TOMS:
To create encompassing stakeholder value through ESG
Overtly state it
Make sure you deliver on it
Systematically report it
Secondly, ESG Factor Integration into Private Equity provided the core takeaway that private equity firms have focused on identifying minimum levels of ESG integration necessary to protect their investment and dry powder, however, this indicates that uncaptured value remains and further ESG efforts are required to seize it. Third, both papers ultimately conveyed the conviction that ESG integration will not only bolster returns and long-term stakeholder value creation, but also play a fundamental role in assisting to retain a strong reputation, attract top talent, and improve firms operationally. In parallel, further research into lower-to-middle market private equity ESG integration and cost-benefit analysis at this level is required, however, I confidently hypothesize that the findings with global-scale firms are transferable and arguably more impactful due to reach. All in all, with 2023 looming, private equity ESG integration is more vital than ever as macroeconomic and industry tailwinds are propelling the urgency of sustainability in business; welcome to a new era of private equity investing.
#esg #sustainability #privateequity #esgintegration #esginvesting
(1) Zeisberger, C., Prahl, M., & White, B. (2017). Foreword by Henry R. Kravis. In Mastering Private Equity. Wiley.
(2)(3) Indahl et al. (2019). Private Equity 4.0: Using ESG to Create More Value with Less Risk. Journal of Applied Corporate Finance. 31. 34-41. 10.1111/jacf.12344.
(4) Gunnar Friede et al., “ESG and Financial performance: Aggregated evidence from more than 2000 empirical studies,” Journal of Sustainable Finance & Investment, October 2015,
Volume 5, Number 4, pp. 210–33; Deutsche Asset & Wealth Management Investment
(5) McKinsey - How Does ESG Create Value. (n.d.). Retrieved from https://www.mckinsey.com/~/media/McKinsey/Business%20Functions/Strategy%20an 20Corporate%20Finance/Our%20Insights/Five%20ways%20that%20ESG%20creates%20 value/Five-ways-that-ESG-creates-value.ashx
(6) Alex Edmans, “Does the stock market fully value intangibles? Employee satisfaction and equity prices,” Journal of Financial Economics, September 2011, Volume 101, Number 3, pp. 621–40, sciencedirect.com.
(7) Zaccone, M. C., & Pedrini, M. (2020, July 16). ESG Factor Integration into Private Equity. MDPI. Retrieved from https://doi.org/10.3390/su12145725
(8)(9) Blackstone - ESG. Blackstone. (n.d.). Retrieved from https://www.blackstone.com/ourimpact/an-integrated-approach-to-esg/
(11) Hayes, A. (2022, October 17). Real option: Definition, valuation methods, example. Investopedia. Retrieved from https://www.investopedia.com/terms/r/realoption.asp