Addressing ESG in Private Equity: more than just a tick box exercise

Environmental, Social and Governance (ESG) regulations and agendas are increasingly influential in the operation of commercial organisations. What are the implications for Private Equity practices, and how are ESG strategies incorporated into their deal activity? How do they ensure it is more than a tick-box exercise?

Marcus Shah, a Partner specialising in Private Equity within our Interim Management practice, meets Maria Carradice, Managing Director at Mayfair Equity Partners, and shares the highlights of an illuminating conversation.

MS: Maria, how are PE-backed companies being impacted by the need to incorporate ESG regulations?

MC: ESG regulations are not just affecting larger businesses. The regulations may start off targeting publicly listed companies but, once these companies have started reporting, there is generally a move to reduce thresholds such that more businesses are pulled into the net.

Quite a lot of Private Equity funds and their portfolio companies are in scope of the various ESG regulations, especially if assets under management (AUM) are over £1billion or portfolio company turnover is greater than £36 million.

Certain legislation, such as Task Force on Climate-Related Financial Disclosures (TCFD) and Sustainable Finance Disclosure Regulation (SFDR) will affect many Private Equity firms, simply because the criteria are based on size.

They also have to consider the investor base. If they have very large investors who have to report themselves, then they too will need to provide information and will be looking at the GP to gather this from the underlying portfolio regardless of whether the GP is within a specific piece of legislation or not.

A lot will depend on the GP and what kind of deals they do, because something that might be quite material in one sector, such as waste generation and management could be insignificant in another so asking a portfolio company to collect irrelevant data might make little sense, and you might miss something more material that could lead to real value creation.

MS: So, when you’re looking at investment opportunities, are you able to make lenders comfortable enough to look beyond the immediate ‘tick boxing’ and see the potential to move the dial quickly?

MC: I would like to think that the banks are flexible enough to see beyond tick boxing. Under SFDR, for example, PE businesses have to select a category that best describes what they do:

  • Article Six: General Investment, but not in sustainable businesses

  • Article Nine: An impact investor

  • Article Eight: Everything in between. However, as an Article Eight fund, there is a huge amount of reporting to do, which may or may not be relevant for the businesses in which you invest, whereas for an Article Six fund, the level of reporting is minimal

The risk is that a bank, or even an LP, might say they are not going to invest unless you are badged as an Article Eight fund, because they want to tick that particular ESG box. If this becomes the case then, there will be a whole raft of good businesses that potentially will struggle to obtain mainstream finance at a reasonable cost. That’s where we have to be really careful, because legislation such as SFDR has the potential to become a tick-box exercise for the wrong reasons.

In my view, the real value of having an ESG agenda comes from finding good quality businesses that have rapidly grown and where there is potential to turn them into a good quality sustainable business with strong ESG credentials.

MS: How do you go about training people to think that way when assessing businesses?

MC: That’s a really good question.  Investment professionals can pick apart a set of financial accounts in minutes and work out what areas they want to question and diligence further -but the financial health of a business is only one part of that story. It makes more sense to be able to look at a business in the round and understand the non-financial metrics as well as the financial ones that will have an impact during your investment period.

Part of the overall due diligence should be looking at those non-financial indicators and maybe saying: “I agree that the valuation based on your accounts and your forecasts is X, but actually, you haven’t factored in any of these other things – and they are going to be significant and prevent me from selling this business in three, four, or five years’ time.”

The part that’s currently missing from most valuations is an assessment of non-financial metrics as well. As ESG takes more of a central role, we will all have to start thinking about valuations in that way.

For example, if we know that for instance, companies are going to have to pay for carbon credits and you know that the company you are considering investing in is likely to fall within the rules at some point in the future, but they are not aware and have done nothing about it so far – there’s potentially a significant price reduction to argue here as the cost of the credits is unlikely to be embedded into the forecasts .

Similarly, if they haven’t assessed their climate resilience, how do you think about factoring the risks and opportunities into the valuation of the company?

MS: Where do you turn to for expertise in generating this information?

MC: There are a lot of very good sustainability experts who have been doing this for a long time who are keen to be involved in Private Equity. A good example is carbon foot-printing analysis, which has been going on for many years.

When we look at a business, we work out what we think is material to the business from an ESG perspective, and we find experts that can help us with those particular aspects.

For example, I work with experts who can help me on supply chain management and sustainability, on plastics and the circular economy.

One of my bugbears is that ESG reporting hasn’t really been standardised yet so people report on similar metrics in different ways, which makes comparison difficult but also that different interested parties require you to report on, say, 10 pieces of data, whilst another will want similar but not exactly the same data.

Now that there are projects under way, like the Data Convergence Project, which looks at six categories and 15 sub-categories of data to standardise, this will hopefully enable us to have a more systematic approach to data collection and reporting.

Until we’ve got to a point where as an industry, we’ve figured all of that out, it is going to be a little disparate -but if you don’t start somewhere, you’ll never go anywhere.

MS: Have you seen a shift in board meetings in terms of the focus on ESG?

MC: Yes, particularly when you are looking at an exit and your exit strategy might be an IPO. When you do an IPO, there is a lot of focus now on ESG. You have to be able to demonstrate what you’re doing, what your plans are in terms of sustainability going forward and how you are measuring it all and this gets significant board focus.

Also, I’d say that people are generally more aware of ESG today. Businesses are being asked more questions by their customers, suppliers and banks so they have to think about ESG and its impact on the business, they have to have an ESG strategy, and they have to give it due time and attention at their board meetings.

MS: I’ve heard the phrase “No ESG, no capital”

MC: Yes, banks are getting pressurised by the government to do more on ESG. They have products now which require some ESG KPIs as well. They still tend to be quite ‘tick-boxy’ and would be more beneficial if they were more tailored to the material issues affecting a particular business.

It would be better to look at a business in the round and say, it has good credentials but if you can demonstrate X, Y and Z on the ESG front in the near future, we’re going to lend to you because you can turn the business into something much more sustainable.

Many very good smaller businesses are run on a shoestring by a very lean management team who are ultimately trying to grow that business. ESG hasn’t until now been at the forefront of their minds.

You don’t want to let these businesses fail by not lending to them, because they could be our future unicorns.

MS: What is your message to a founder-led business about the importance of ESG?

MC: We spend quite a lot of time pre-deal talking to management teams and making sure they understand what’s expected of them in terms of ESG.  It is actually good business sense to ensure the business is well governed, things are properly documented, the business is compliant with various laws and regulations and treats its staff, suppliers and customers well. With consumer businesses, the management teams are generally much more aware of ESG and sustainability issues because they’re being asked these questions by customers, shareholders and suppliers.

Management often looks to us to help them to navigate through the reems of legislation so that they are doing the right things and can get there quickly or do them in a way that’s most efficient for the business and its growth strategy.

The first thing you need to do is understand what’s material to your business in terms of suppliers, customers, staff, competitors and product and work out where you see yourself and how differentiated you are.

There’s no point ticking ESG boxes for the sake of it if it’s not going to make any difference to the business. I would recommend getting a good sustainability or ESG materiality study done for the business that will look at all aspects and help you determine what you should be focussed on.

MS: What is your advice to any business owner concerned about ESG?

MC: If you’re new to this, do the materiality study to work out what your top two or three issues and opportunities are going to be, put strategies in place to manage them, together with some milestones and KPIs, and take it from there.  You will be surprised how many of your staff want to do more and will be happy to be a part of a sustainability group at work to help you achieve your goals.

It’s also key to have a sponsor in the C-suite. You’ll find that when you start talking about your own business and sustainability, people get quite enthusiastic and come up with some great ideas.

Remember, if you don’t change anything, nothing will change but everything around you is changing rapidly and you’re potentially going to be left behind.

Putting that into a strategy doesn’t take too much effort – and you’ve taken your first step, you’re on your way.

Marcus Shah

Partner
Interim Management
CFO & Finance


Marcus is responsible for delivering interim management solutions for Private Equity clients by supporting both funds and their portfolio throughout the investment lifecycle.