Making an impact
The emergence of ESG as a value creation lever
Sustainability has emerged as a critical consideration for private equity investors, not only for ethical reasons but also for its potential to drive returns and mitigate risks in an increasingly complex landscape.
Investments incorporating ESG factors perform better over the long run, with funds dedicated to environmental or social sustainability increasing during the past five years.
Research from CEE-focused private equity firm Abris Capital Partners shows that sustainable practices can bring an improvement of 3.4% in IRR growth for buyout and growth deals, partner Edgar Kolesnik tells Real Deals.
Key drivers such as regulatory pressures, consumer demand and value enhancement are changing the way GPs prioritise ESG implementation within their portfolios, with risk mitigation playing a significant role in driving sustainable investments according to Jo Daley, director, head of impact at Clearwater.
She says: “I think the risks are greater now than they ever have been with legislation, greenwashing and supply chain risk, with increasingly aware and conscious consumers, through to a workforce with higher demands than ever, which all have the potential to affect business continuity.”
As ESG matures in both the investment space and community, a growing recognition that mitigating those risks can create value opportunities is pushing ESG to become increasingly embedded in value creation teams.
ESG is becoming the norm in seeking opportunities and adding value to businesses. During the last five years, PE firms have updated their perspectives to integrate ESG factors into their investment processes, from initial screening to due diligence and throughout the holding period.
Fabio Ranghino, head of strategy and sustainability at Ambienta, highlights how GPs have begun creating dedicated sustainability teams responsible for ESG integration within their investment programmes. He notes: “Some teams are starting to focus on impact analysis and this is certainly a difference from five years ago – they have now become part of a common and necessary practice along the entire investment cycle.”
ESG factors are increasingly integrated into PE due diligence processes, with considerations such as environmental risks, social factors and governance structures becoming top priorities.
"If I go back 10 years, the order would be commercial, legal, financial due diligence workstreams, with ESG at the end. Today, ESG is much more fully integrated into an understanding of operational risks and opportunities, and after acquisition, which can be important in maximising value creation at the business,” highlights head of ESG at Triton Partners, Graeme Ardus.
Today, ESG is much more fully integrated into an understanding of operational risks and opportunities
ESG due diligence has become vital in almost every transaction. It allows the assessment of businesses’ ability to embed sustainability and ESG principles, particularly in areas such as analysis of risks in supply chains and diversification strategies, which are all key components in assessing how well managed and attractive a business is.
A blossoming regulatory environment that includes taxonomy regulations, SFDR and PRI reporting frameworks, to name a few, has increased transparency and disclosure, helping GPs to differentiate themselves in front of their LPs, and allowing more transparency on how GPs engage with their portfolio companies on ESG factors and the most material and critical topics for their businesses.
However, accusations of greenwashing remain. To mitigate those accusations, the management at portfolio companies needs to align with the regulations and embrace transparency. Daley notes: “[This could be] quite scary for a lot of boards to hear, because it requires them to publicly acknowledge areas where they still have work to do. But by owning that and by being transparent, the risks are significantly reduced.”
To meet these regulations, materiality assessments have now become a crucial practice for a sustainable PE strategy. The practice helps identify the most significant ESG risks and opportunities facing the target company and its industry – no matter the sector they are in.
Taking Triton as an example, Ardus says: “It’s about that materiality point. For example, we are invested in companies that handle personal data, so data management and cybersecurity are topics of high materiality. So rather than applying a one-size-fits-all approach, we focus on really aligning ESG considerations with a company’s business, its strategy and operations,” he explains.
As sustainability integration gains traction across portfolio companies, innovations are emerging across various industries and resulting in high potential for returns in Europe.
Decarbonisation linked to renewable activities lies at the heart of European sustainability drivers and, according to Ambienta’s Ranghino, it will continue its acceleration trajectory of the past two years, having made such a “clear and compelling case” of how it can drive returns and innovations.
“Decarbonisation of heating is the topic of the future – when it comes to reducing emissions we have always focused on cars and buildings, but 20% of energy demand and 10% of global CO2 emissions come from combustion in industrial processes, ranging from food pasteurisation at 200 degrees celsius to industrial processes that run at over 1,000 degrees celsius,” highlights Ranghino.
Meanwhile, sustainable innovations in agriculture – including alternative inputs, recycling technologies, sustainable real estate, circular economy initiatives, eco-friendly consumer products and clean energy technologies – are also major sustainability drivers.
In terms of sectors, traditionally heavy production or manufacturing companies within industrials, consumer goods production and transportation have been focusing on environmental issues such as CO2 emissions. These sectors are striving to comply with regulatory requirements and meet stakeholder and consumer needs, positioning themselves ahead of the curve in areas such as energy efficiency, waste reduction, sustainable products and packaging, and water usage.
However, some sectors, including healthcare and technology, may face more challenges in sustainable implementation. On the other hand, a range of sectors including healthcare and tech might have a bumpier road to sustainable implementation.
“I think they see significant challenges, for example, workforce recruitment and retention is a huge issue to many sectors. Take tech for example, which is facing challenges around diversity, whether it's gender, ethnicity, or other areas. This is increasingly becoming important to investors because these areas represent risks to the growth and success of those businesses." Daley highlights.
While most GPs see the link between sustainability and value creation, cynicism remains in some corners.
On this point, Ashim Paun, head of sustainable investing at Triton, pushes back and explains that during the deal origination phase, GPs must question the long-term future of a target company if its products and services are not supported by sustainability tailwinds.
Paun emphasises the importance of considering ESG factors early in the deal origination process, as they can be crucial operationally and thematically to understanding the true risk-return profile of a potential investment.
Failure to address ESG issues early can simply waste time and effort during the investment process
"Failure to address these early can simply waste time and effort during the investment process," Paun says. To illustrate this strategic approach, he cites the example of IFCO, a provider of reusable packaging solutions for fresh foods, which implemented a circular economy business model to optimise the food supply chain.
“IFCO worked to quantify the environmental benefit of using its reusable plastic containers using lifecycle analysis. To further optimise the food supply chain, digital tracking technology was added to the containers. This helps to preserve and reduce both food spoilage and the levels of waste associated with disposable packaging,” he explains.
Ambienta also weighs the viability of a firm’s sustainability credentials at the deal origination stage. For example, the GP has backed Previero, a machinery specialist for the recycling industry, and Wateralia, a manufacturer of pumps and systems for water infrastructure and agriculture. For the latter, the GP approached the founding business seven years before investing.
Post-deal, sustainability can also be a key value driver. Abris accompanies its portcos towards success through internal initiatives that aim to consolidate value creation through a deeper understanding of ESG issues. Through its ESG Academy, the GP organises two-day workshops for portfolio companies where they learn more about sustainability, reflect on the best practices applied across its portfolio, and talk about new trends in ESG.
“Typically, it is not only bringing in external subject matter experts, but also engaging the C-level from our portfolio companies to share real-life cases, so the insights might be more relevant and applicable for the peer group,” Kolesnik explains.
An example of a successful collaboration between the GP and a portco management team is Poland-based stationery manufacturer Velvetcare, acquired by the investor in 2018.
During its five-year investment, the business grew sales by 2.5 times, Ebitda by more than five times and exports by five times, the investment professional highlights. Velvet Care was also accredited as a B Corp towards the end of its investment period.
While there is evidence to suggest that integrating ESG factors into investment decisions can contribute to long-term value creation, the direct correlation between ESG implementation and higher returns is not always straightforward.
According to Ambienta’s Ranghino, who has been in the industry for more than 20 years, it might take more than five years for GPs to accumulate “meaningful evidence” that sustainability pays off when talking about returns compared to more traditional investments.
We all have a responsibility to demonstrate that it is possible to deliver great returns alongside environmental impact
“We all have a responsibility to demonstrate that it is possible to deliver great returns alongside environmental impact and it would be unfortunate should GPs who have committed to this objective not achieve this,” Ranghino highlights.
Triton’s Paun, meanwhile, views things differently. He believes that questions about the value of sustainability are misguided. Paun states: “I would almost want the question asked the other way around: can anyone explain why sustainability wouldn't lead to better results and companies if we are de-risking and creating more value?” To him, the answer is self-evident.
Yes, I expect it to increase
No, I expect it to remain the same
No, I expect it to decrease
