A&M’s Environmental, Social and Governance (ESG) Advisory team joined private market leaders in sustainability at Private Equity International’s Responsible Investment Forum in New York City last week and present seven key takeaways that every private equity fund should keep in mind when integrating sustainability and ESG. 

1. EDCI emphasizes progress over perfection in data collection

The ESG Data Convergence Initiative (EDCI) is growing as the common framework and language for ESG data reporting and analysis across the private equity industry. By joining EDCI, General Practitioner’s (GP) can benefit from harmonized and standardized ESG data collection and aggregation processes, as well as access to best practices and benchmarks for ESG integration and value creation. The advice: done is better than perfect. Simply starting the process allows GPs to show commitment and progress to Limited Partner’s and other stakeholders, while also identifying gaps and areas for improvement in their sustainability strategy. In addition, ‘practice makes perfect’ helps build muscle memory for portfolio companies.

Action: Set a baseline data footprint, identify where you want to be in 12 months’ time, and start executing a practical performance plan.

2. Consider and measure the value of avoided costs 

Quantify the tangible benefits of ESG in dollars. This helps portfolio companies align financial goals with sustainability objectives and demonstrate the value of ESG to investors, customers and other stakeholders. It also allows deal teams to measure and optimize ESG performance and identify opportunities and risks for value creation and preservation in the long term. Deadweight analysis – or what would have happened otherwise – is a great way to show avoided costs and demonstrate how EBITDA has been positively impacted.  While data aggregation and benchmarking can’t create a story – it can certainly support it. 

Action: Connect your value creation story to operational optimization, commercial strategy and risk management.

3. We need a ‘more humble’ ESG

Not all ESG activities drive direct improvement in EBITDA or an increase in exit valuations – and that’s ok – we just need to stop pretending it does.  Yes, it’s still important to quantify and communicate progress, but ESG does not always need to dominate a company’s narrative. ESG can be behind the scenes, strengthening company processes and creating a more sustainable business without the limelight. ESG plays an important role in aligning stakeholder interests, but the benefits of activities should not be oversold if they cannot be quantified. 

Action: Build your ESG narrative around what ties to real improvement and don’t overstate the benefits if it cannot be quantified in financial terms. 

4. Unlike other parts of the world, regulations are devolving across the United States

Deal activity has increased in Q1 2024, but historic levels of dry powder mean the level of ESG due diligence undertaken may not be to the level it should be. The checklist approach to assessing ESG performance may not dig deep enough to answer the questions posed by the IFRS S1 Standards, which focuses on topics that could reasonably be expected to affect the entity’s cash flows through the examination of sustainability governance, strategy, risk management. GPs are becoming more sophisticated with their integration of ESG on both the buy- and sell-side, but as funds rush to sale, don’t get caught on the wrong side of a greenwashing accusation or – worse yet – buy a lemon.      

Action: Consider a more integrated approach to ESG diligence, embedded within existing commercial and operational workstreams.

5. ESG-related litigation is on the horizon   

There is increased risk of ESG-related litigation as the lines between sustainability and fiduciary responsibility are becoming blurred. As such, companies need to be cautious with their unsupported ESG disclosures. DEI goals have already come under scrutiny, and greenhouse gas commitments will be the next area at risk of litigation. Does your target have a carbon reduction goal and how is it progressing? If numbers are going in the wrong direction, why is that, and what can you do about it? 

Action: Incorporate thorough diligence of your acquisition’s commitments and targets early in the diligence process. 

6. No one is truly “anti-ESG” – it just depends on how it’s positioned

The concept of being "anti-ESG" is a misnomer when we consider that the underlying principles of ESG align closely with the core tenets of a healthy business, such as resource efficiency, health and safety, workforce engagement, and good governance. Take for instance, Just Transition, which emphasizes mitigating the social and economic impacts on workers and communities during the shift towards a low-carbon economy. Far from opposing ESG, critics often emphasize the need to protect those adversely affected by sustainable transitions, thereby supporting the foundational principles of responsible business practices.

ESG with a focus on co-benefits and ‘pay-for’ scenarios can help to provide opportunities to subsidize future business growth – the Inflation Reduction Act is an example in the United States that helps to provide added economic incentive for ESG initiatives.

Action: Position ESG in terms of co-benefits, and look to leverage additional sources of capital to lower project NPVs.

7. ESG is about reconciling the different voices of LPs 

Sustainability is not a one-size-fits-all concept for limited partners (LPs). It is therefore crucial to understand their expectations, pressures and objectives for ingesting ESG information. This is not to say general partners (GPs) should be talking out both sides of their mouth, but a robust governance structure and reporting framework will help funds ensure they have the information they need at their fingertips.

Action: Engage your LPs regularly to understand what they want and where they want to see improvement – disclosure may simply be enough. 

Conclusion

Alvarez & Marsal ESG Advisory Services works with private equity clients and portfolio companies across all industries to drive value creation, value optimization and value preservation.  Please reach out to our team to learn how we can support you.