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3 reasons why private equity can lead the charge on ESG strategy

Vindi Banga discusses how private equity can lead in the creation and propagation of ESG best practices.  Originally published as part of the The Davos Agenda

Hand holding a seedling.
Monday, February 7, 2022
  • The conversation about private equity and environmental, social and corporate governance (ESG) has been largely around reporting guidelines and metrics.
  • We believe private equity is well-positioned to drive and scale ESG best practices.
  • The motivation to lead the charge on ESG performance improvement can be grounded in strategy and operational excellence.

It isn't a surprise that the majority of recent discussion around private equity and environmental, social and corporate governance (ESG) has centered around reporting guidelines and metrics as firms are rushing to meet their investors’ rising expectations on ESG compliance.

While metrics and compliance are clearly important, the private equity sector is missing a far greater opportunity within our reach: we can lead in the creation and propagation of ESG best practices across global portfolios.

And why not?

For one, private equity has a perception problem. It's known for its ability to drive operational improvement, especially growth and productivity, which can fuel attractive returns for its endowment, foundation and pension fund investors. 

But I believe the flip side to such investment success is the incorrect perception that the asset class is purely oriented toward the short-term, overlooking the evidence that many private equity managers build in long-term value aligned with ESG objectives.

In my opinion, private equity ownership is uniquely positioned to drive transformations in best practices while aligning with the values of shareholders, management, and other stakeholders. 

Here are three reasons why.

1. The private-equity target is ultimately growth.
Private equity firms aim to create value when they exit, not when they invest. In order to generate a return, they must build a better business than they bought. A lower cost structure (such as decreasing overhead) alone is insufficient. 

Lower cost will, of course, increase margins and provide some value. However, I believe growth is valued far more than margin; hence, high performing private equity owners seek to increase the trajectory of growth in a sustainable manner during their period of ownership.

Those that are successful are generally rewarded with a higher valuation.

2. Management and shareholders have a close relationship.
Transformations are usually complex and involve investment, which may depress short-term profits. It's important that shareholders and management are aligned for the duration of the transformation. 

However, rarely do transformations run to plan -- they're often impacted by the market and competitive dynamics. 

Quality management will counter these forces by nimbly adjusting their plans and efforts, thereby achieving longer-term goals albeit with shorter-term volatility. 

Private equity shareholders, being fewer and closer to management, are able to understand better such volatility and support such mid-course corrections.

3. Private equity managers can ground ESG in strategy and operational excellence.
I believe ESG considerations need to be incorporated into strategy and are closely linked to operational excellence, which is a core part of many private equity value-creation models. 

Private equity understands the imperative of operating successfully with consumers and customers, partnering with suppliers, working with regulators and NGOs and building a diverse, healthy, safe and productive employee base and culture.

They understand that following a responsible ESG strategy has the potential to do more than reduce reputational risks, thereby creating the perception of a well-led and managed company with a concomitant premium valuation.

I believe such firms can incorporate ESG into their business-building tool kit -- as much as growth, productivity and cost reduction. And they recognize when this is done well, it could lead to an ESG-embedded value multiple, just as firms talk of high growth companies securing a growth multiple.

Of course, some private equity firms feel unable to make a lasting impact on ESG matters, because they are transitional owners with a typically five-year hold period. I believe these transitional owners underestimate the fundamental value unlocked by good governance, and neglect the value derived from improving diversity and inclusion in a workforce, improvements that have been linked to greater creativity, productivity and profits.

Driving a step change in the ESG footprint of a company in five years is as achievable as pursuing innovative growth avenues or altering the cost base.

I believe that private equity firms can be catalysts of constructive change and the engine for the rapid implementation of good ESG practice. The net asset value across private equity portfolios is about $5 trillion and growing, turning over every four to five years. 

This means that private capital could touch a third of the global economy over the next two decades. With that kind of scope and influence, it has the potential to drive ESG practices into company strategy and execution with great impact.