Few issues shaping the private equity ecosystem promise to be as transformational as ESG. For the better part of the past decade, in one form or another, ESG has evolved from a “nice to have” item relegated to the final minutes of boardroom discussions and portfolio company management meetings to a new category of fraud risk and a material compliance requirement with enforcement teeth. And the tectonic plates keep shifting: FTI Consulting’s Todd Rahn believes we’re starting to discover that ESG may be the key to long-term value creation in private equity.
Has the private equity industry embraced ESG matters? My team and I confront this question every day. We partner with private equity managing directors and portfolio firm CFOs, COOs and CEOs to help them anticipate and respond to forensic and litigation challenges emerging from their firms’ approaches to ESG matters when things go wrong. Other FTI Consulting teams specialize in all other phases in the private equity lifecycle, from origination to exit. So, the answer depends on your perspective.
But regardless of where you come from on this issue, there can be little doubt that ESG has the potential to put firms ahead of their peers.
Signs of ESG uptake among PE firms
On one hand, I see many positive signs. Consider the United Nations’ Principles of Responsible Investing (PRI) initiative and its discovery that nearly 75% of its 633 private equity investors (598 investment managers and 35 asset owners) confirm that they assess ESG materiality on an industry basis as well as at the portfolio company level. Two-thirds (66%) of PRI’s private equity signatories confirm that they view ESG as adding value, not just mitigating risk, and actively identify value creation opportunities for most of their investments.
Here’s another optimistic indication. A recent survey of limited partners by Bain & Company and the Institutional Limited Partners Association (ILPA) found that most limited partners (93%) would walk away from an investment opportunity if it posed an ESG concern.
Room for ESG improvements
Given the nature of my work, however, my perspective and that of my team is naturally informed by 20/20 hindsight. Remember SOX? And how many companies initially paid more attention to the wording of their public statements than they did to their underlying data? The same thing is happening now with private equity and ESG. We see too many private equity firms and portfolio companies losing talent, treasure and time over ESG issues because they merely took a “check-the-box” approach. And we’re not alone in this view. In fact, on March 30, the Committee of Sponsoring Organizations of the Treadway Commission (COSO) released supplemental guidance for using the globally recognized 2013 COSO Internal Control-Integrated Framework (ICIF) to achieve effective internal control over sustainability reporting.
A recent Harvard Business Review article nods at private equity’s business model advantages — from ownership and governance control over portfolio companies to nearly unlimited access to information and a long-term view on value creation — but notes that “members of the PE industry have been slow to realize the importance of ESG for its future relevance, profitability and even license to operate.”
Pre-deal due diligence is one area of lingering weakness. In a poll of 330-plus private equity investors and in-house corporate M&A professionals, a recent ESG Today article found that about 50 of the investors need to conduct some form of ESG pre-deal due diligence. Two other emerging areas include (1) training — fewer than one out of three PRI signatories provide ESG training to portfolio leaders — and (2) tying ESG performance incentives to portfolio company management remuneration, which only one out of 10 PRI signatories report doing.
Anticipating new ESG regulation in the U.S. and Europe
ESG financial reporting requirements are emerging regularly, including the much-anticipated SEC required disclosures, with public company board audit committees incorporating ESG matters into their discussions. Yes, what happens with the SEC rule is yet to be seen. But waiting for it to drop and deferring ESG decisions until best practices have emerged is not the most prudent course of action. Not to mention the many areas of rulemaking and regulation in Europe which are farther along will have far reaching impacts in the U.S. and elsewhere. (I recently shared additional thoughts specifically on the SEC rule and actions to take today along with my FTI Consulting colleague Ben Herskowitz for CCI.)
ESG actions to start taking now
- Stop focusing on the regulation. It’s a distraction. Instead, think and act strategically. Whether or not you’re gearing up to go public, we suggest viewing ESG not just as a compliance mandate, or a due diligence exercise buried among many other tasks, or a headline to recruit new talent but instead as a strategic lever driving differentiation, impact and long-term value creation at both firm and portfolio company levels.
- Get strategic and decide what your ESG “message” needs to be: Don’t be caught flatfooted and open yourself to criticism from either inside or outside the firm that you “don’t care.” Determine what your point of view is going to be on ESG. Then champion your message via multiple communications channels. Get it out there and continue to educate yourself as the private equity ESG environment evolves.
- Understand your data and prepare to use it if necessary. If you make a statement, be ready to back it up in an audit and to present documents that support your position. Have outside experts and advisors validate your approach and confirm that you have not left your firm exposed to litigation, fines or penalties.
- Include energy and sustainability in your ESG lens. Many of us at FTI Consulting view energy and sustainability as megatrends: powerful, transformative forces that will attract some of the heaviest investment funding over the next 50 years. As a private equity stakeholder, understand where and how your business obtains, consumes and conserves energy. How do you prioritize these activities, and what sort of investment will that require over time? How does your energy strategy impact your boardroom conversations, long-term vision and reporting priorities? Know your point of view and be consistent in how you talk about it to stakeholders.
ESG as a driver of PE differentiation, impact and long-term value
As you pick your path forward in the post-pandemic private equity world, move ESG to the center of your agenda. You’ll be among leaders. Fully half (50%) of the limited partners, for example, responding to the Bain and ILPA survey, cite better investment performance as a key reason to incorporate ESG. And 66% of the UN’s PRI private equity signatories rank value creation as one of their top three drivers of responsible investing or ESG activity.
Rarely, if ever, has private equity had the opportunity to address so many key priorities — compliance, fraud and litigation risk management, financial performance, environmental sustainability and social legitimacy — with a coordinated, holistic focus on one area.