How Private Equity Can Profitably Tap into the Full Potential of ESG

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Andries Verschelden Co-founder & CEO
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In the wake of the 2020 coronavirus pandemic, record-breaking pools of investment capital poured into ESG funds to profitably combat the planet’s intractable social and environmental problems. Now double the ESG investment is expected to mobilize in the years to come. Due to mounting pressure from limited partners to minimize risk and to align their values with portfolios, private equity firms can no longer afford to view ESG as a distraction. ESG isn’t just the right thing to do, it’s essential intelligence for today’s investment performance and value creation. 

2020’s boom year in ESG investments digs deeper in 2021

ESG funds exceeded $1 trillion for the first time during the unprecedented, tumultuous Covid-19 pandemic. The Financial Times reported that the majority of ESG funds outperformed the S&P 500 during the first half of 2020 and the wider market over a ten-year period. Global ESG assets under management (AUM) grew from $6 billion in 2015 to $150 billion in 2020, while impact PE/VC fund assets grew by 154% to $28 billion between 2015-2020. Whether or not Covid-19 was a direct driver or not, 2020 put ESG on the mainstream investment map for good.  

One year later, ESG funds are raking in even more money and outperforming traditional funds by over four percent. In the U.S., where  one-third of all AUM are already sustainably invested, BlackRock iShares America claims their ESG ETF funds dominated flows, bringing in more than $21 billion just in Q1 2021—almost the same it pulled in over the entire year in 2019. BlackRock plans to have $1.2 trillion in ESG assets by 2030. Armando Senra, head of iShares America, noted in an interview with CNBC that “we’re just at the very beginning of what could be a decade-long growth story.” 

Fully integrating ESG is today’s private equity imperative

Goals and mandates in ESG Private Equity are largely motivated by Limited Partners (LPs). The growing trend of LPs and government pension funds toward long-term ESG funds rapidly accelerates credible, scalable ESG private equity strategies that demand high quality, standardized ESG data and disclosures by portfolio companies. According to the 2020 Edelman Trust Barometer Special Report, Institutional Investors, 88% of LPs globally use ESG performance indicators in making investment decisions, and 87% said that they invest in companies that have reduced their near-term return on capital so that they can reallocate that money to ESG initiatives.

According to PwC’s 2021 Global Private Equity Responsible Investment Survey results, 200 firms from 35 countries show that 72% of PE investors and managers always screen potential portfolio companies for ESG risks and opportunities before making the investment. Another 56% of those surveyed have refused to enter general partnership agreements or declined investments for ESG reasons. Nearly 40% consider climate change due diligence and nearly 50% set gender and racial diversity targets for their workforce.

Despite growing trends, there remains considerable room for improvement in ESG private equity. LPs and PE firms, who haven’t fully integrated high-quality ESG data into their operations and investing strategies, miss tremendous opportunities for value creation. Some firms lightly screen ESG initiatives or collect limited data on Diversity, Equity, and Inclusion, without realizing that a permanent, comprehensive ESG framework is the absolute exception. Other firms remain reluctant to mature their ESG strategies, latching on to decade-old criticism that ESG is a distraction, using superficial data to produce little returns.

The 2020 ESG boom year has proven that ESG in private equity is no longer nice-to-have, it’s a critical element in gaining market share, competitor differentiation, engaging employees, and raising capital. The savviest PE firms use ESG to their fullest advantage by launching and growing impact funds. Committed to both strong returns and impact, their success is sharpening due diligence, advancing optics for ESG metrics, building stronger value-creation plans, and preparing the most compelling exit stories. 

Given that ESG private equity firms are profitably outperforming their non ESG peers, forward-thinking general partners now assume that the pressure from their investors will continue to accelerate. According to Bain & Tree’s 2021 Global Private Equity report, proactive firms aren’t waiting for ROI studies to pan out before incorporating sustainability and social responsibility into how they invest and operate. Profitable ESG funds set the standard, where leading firms position themselves in the LP community as ESG forward to grow fund size.

The power of private equity through the ESG lens

PE’s edge has always been to create value by driving transformation more quickly and deeply than other owners can. Just like we’ve seen in the digital dot com boom and Diversity & Inclusion in the previous decade, ESG private equity is functioning as an accelerant of existing trends, holding today’s competitive edge. A study by Morgan Stanley’s Institute for Sustainable Investing indicates trillions of dollars of wealth are shifting from carbon-intensive assets to climate-safe assets, and from baby boomers to millennials, who are twice as likely to buy products from sustainable businesses. The ESG values-based investment approach is proven to profitably flip reputationally damaged companies into sustainable companies, deforestation into regeneration, discrimination into equity, and climate risk into carbon-neutrality.

“Decarbonization paves the way for an ESG era of economic transformation, while PE acts as ESG muscle

Of all the global challenges, the rising cost of carbon is most profitably transforming ESG. Known as a critical tool to decarbonize, ESG safeguards investment decisions against transition risk, climate risk (intensification of drought, wildfires, sea level rise), and stranded assets (coal, smelters, and oil tankers). Investment companies like BlackRock have set goals to reduce emissions in new acquisitions by 15%. Morgan Stanley committed to mobilizing $1 trillion by 2030 for sustainable solutions to climate change. In recent months, the Biden Administration’s climate agenda designated $2 trillion in green infrastructure improvements, which will drive more PE firms to promulgate emission reduction for their portfolio companies, regardless of sector and geography. 

The time for private equity firms to act on ESG is now

Markets are facing risk challenges more than ever before and ESG is in high demand. PE firms that haven’t integrated ESG standards into their investment strategies, are fielding uncomfortable calls from their LPs and employees asking why not. The time to act is now, and Good.Lab can help.

Good.Lab’s expert ESG leaders specialize in embedding ESG throughout the investment value chain, from deal sourcing and due diligence to exiting. Our ESG performance packages for private equity tailor strategic solutions for your firm to profitably transform ESG outcomes and fund strategies across your entire portfolio and operations using a clear timeline. The Good.Lab network facilitates technology adoption necessary to aggregate, analyze, and monitor transparent ESG data using quantitative targets. We also employ best-practices ESG playbooks to measure KPIs across your ecosystem informed by current ESG performance and competitive benchmarks. At the fund level, our ESG services will begin by helping you:

  • Define a clear ambition for how your firm intends to balance financial returns and ESG impact
  • Define your investment approach
  • Measure and monitor results, qualitatively and quantitatively
  • Engage and communicate with stakeholders 
  • Drive ESG reporting and performance disclosures using your portfolio companies’ ESG data

Now is the time to tap into the full potential of ESG. To learn more about Good.Lab ESG performance solutions for private equity, get in touch with us today.

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