Environmental, social and governance (ESG) themes have been prominent in the headlines this year. From growing regulatory scrutiny of greenwashing and climate-related disclosures by the Australian Prudential Regulation Authority (APRA) and the Australian Securities and Investments Commission (ASIC), to a rise in activist shareholder activities pushing for better ESG performance; there’s been plenty of press attention around ESG. More broadly, making considered investments in ESG-friendly assets or investing to improve the ESG performance of businesses is paying off for businesses and investors.

Research and anecdotal evidence show that when investors embed ESG considerations into their strategies they achieve superior valuations. In fact, our analysis of the ASX200 found that ESG leaders significantly outperformed their lower-ranked peers when it came to value-weighted total shareholder return. This is in addition to a whole host of positive social and environmental outcomes from ESG action, as well as the investor appeal of good ESG ratings.

ESG considerations played an unprecedented role in driving deal activity in the Australian M&A market in 2021. What’s more, this is set to continue as more and more businesses and investors recognise that ESG is core to long-term value creation. We can expect a surge in the acquisition of assets that are addressing some of society’s biggest ESG-related challenges (think: health, renewable energy, oil and gas, recycling and waste, education, and childcare). At the same time, we’ll see a spike in divestments and spin-offs of those assets that fail to meet investor scrutiny. In short, ESG is being recognised by dealmakers for what it genuinely is – a business imperative.

Why Private Equity is in the driver’s seat to create value from ESG

Value creation has always been at the heart of Private Equity (PE) investment strategy; however, PE funds are evolving their approach to delivering value in a period when interest rates are heading in one direction, and credit is harder to come by. This is where the opportunity for ESG-driven value creation comes in. Our latest Global Private Equity Responsibility Investment Survey shows that, over the past seven years, PE firms have radically reassessed the importance of ESG to their businesses, shifting ESG from a compliance exercise to an overarching framework to inform investment choice, fund strategy and business transformation.

Increasingly, we are seeing leading PE firms consider ESG value drivers early in the deal process (i.e., during pre-acquisition screening and diligence). As part of this analysis, investors are assessing how they can avoid value erosion and drive ESG performance to, firstly, preserve current value and, secondly, create value through strategic initiatives. Our ESG value bridge (figure 1) illustrates some common ESG value levers applied across PE investment considerations.

In practice, we have found that when it comes to articulating the financial benefits, ESG creates value in 6 key areas:

1. Revenue growth: ESG action is valued by the market and can help reinforce brand positioning and grow market share, driving revenue growth. As organisations broaden their ESG focus (for example, to include the impact of their supply chains, as well as supplier investment in initiatives to decarbonise, reduce waste, and promote labour rights) this can deliver access to new markets, customers, and sources of income.
2. Cost efficiencies: Companies that lead on ESG enjoy cost efficiencies, most obviously via lower energy consumption (and associated emissions) and reduced waste. At the same time, they often see an uplift in productivity, with the current global landscape a clear example of why employee engagement and supply chain resilience are critical to business success.
3. Legal and regulatory landscape: By proactively responding to anticipated legal and regulatory changes (such as carbon credit projects through the Emissions Reduction Fund and rethinking packaging ahead of updates to the EU Packaging and Packaging Waste Directive), companies open up pathways to innovate and they can potentially access government subsidies and support.
4. Capital expenditure and optimisation: From an environmental standpoint, newer, greener, more efficient technologies offer asset owners the opportunity to create long-term value by aligning capital outlay with their ESG goals. There may also be co-benefits through reduced input costs (such as fuel and maintenance), or new revenue through circular economy opportunities (such as repair and resell models).
5. Cost of capital: Companies with well-managed ESG risks and clear commitments are well positioned to access sustainable financing – a market which reached US$1.6 trillion in 2021 and is continuing to grow rapidly. Products such as sustainability-linked loans typically include pricing mechanisms that tie interest rates to the borrower’s performance on agreed ESG-related KPIs, resulting in reduced cost of debt.
6. A strategic premium: ESG leaders (and even companies with positive ESG momentum) often attract high multiples when it comes time to sell. This has particularly been the case in the past 12 months, as some investors that were lagging in areas of ESG performance now look to address gaps and strengthen their position by acquiring companies with established ESG credentials.

Strengthening the investment thesis through ESG-led value creation thinking

In a recent transaction within the retail and consumer industry, we worked with an Australian PE house to consider ESG-led value creation levers in the development of their investment thesis. This involved a deep dive into the supply chain to identify risks and opportunities, linking these to ESG value levers and estimating valuation impact. The business had grown rapidly over the past 3 years to capture both local and international market share, and benefited from the surge in e-commerce during the COVID-19 pandemic. A key opportunity existed to drive revenue growth to conscious customers (particularly in the EU) through the adoption of certified sustainable materials, the verification of ethical manufacturing practices, and the implementation of a repair and re-sell model.

Pre-deal diligence also identified opportunities to optimise distribution hubs, freight routes and transport modes, to not only reduce costs but also cut carbon emissions from freight.

Importantly, given its global distribution network, we found the business to be well positioned to respond to regulatory and legal developments, with robust modern slavery controls and a transition to recyclable packaging already in place. Finally, and as is the case for many Australian retailers tackling the decarbonisation agenda, fleet electrification and energy efficiency measures in warehouses were identified as ways to reduce emissions, with a focus on prudent capex investment and optimisation.

Post-acquisition, the PE firm is working closely with the management team to uplift ESG performance and bring value creation opportunities into fruition. This structured approach to ESG improvement and risk management can also drive value via a lower cost of capital (for example, by linking the business’ emissions reductions targets to a sustainability linked loan at a discounted interest rate). Ultimately, the implementation of a holistic ESG strategy empowered our client to realise value and command a strategic premium down the line. See figure 2.

How can PE investors successfully embed ESG in value creation planning?

We work closely with PE funds on ESG matters across the investment lifecycle. This includes everything from pre-acquisition due diligence (where we provide a detailed upfront assessment of available ESG value creation levers, as well as an assessment of the risks that exist and their mitigation options), right through to realising ESG value upside on exit. So, what are some common themes we see?

PE funds successfully embedding ESG in value creation planning generally:

Set an ESG strategy, as a company and an investor

Embed ESG into your business strategy, including setting a clear roadmap and targets. At a portfolio level, understand specific portfolio ESG risks and opportunities, and engage with portfolio companies’ management teams to integrate ESG into their transformation.

Level up in terms of public commitments and disclosure

PE funds that lead on ESG tend to share some key traits. To follow their lead, funds should consider: becoming a signatory to the Principles for Responsible Investment; making a public commitment to ESG-related conventions or frameworks that align with your stated goals (e.g. UN Sustainable Development Goals , Science Based Targets initiative); and publicly disclosing policies related to climate change, modern slavery, reconciliation action, responsible procurement, workforce diversity and more.

Invest in human capital

Firms need to recruit the necessary talent to deliver sustainable value creation, and operational training for investment teams is a must. The good news is that firms demonstrating a robust ESG agenda are best placed to attract and retain the best talent. This is further promoted by linking executive pay to ESG factors.

Shift the collective mindset

Foster ESG awareness across your entire team, starting with the board. Is ESG genuinely being discussed at board meetings? If not, why not? Is ESG integrated into your investment processes? Where is the business falling short on ESG in terms of policies, processes, and data? And what do you need to do to address these gaps in the first 100, 200, and 500 days?

Benchmark on material topics

How do you gauge your ESG maturity compared to your competitors? Aim to measure yourself only on topics that are material. Similarly, invest in those material topics to build capability.

Where data doesn’t exist, start sourcing it yourself and establish a baseline so you’re able to set targets.

Seek assurance and guarantee integrity

Get independent reviews or assessments of the integrity of your data to guarantee your ESG credentials, and to prepare for future disclosure requirements.

These hallmarks were seen first-hand during a recent Australian transaction, where ESG-lead value creation thinking helped the investment team further strengthen their investment hypothesis.