Sustainability and Private Markets: A Structured Approach to Value Creation

Is There a Connection Between Sustainability and Value?

In early 2022, the Harvard Law School Forum on Corporate Governance published an opinion by a prominent M&A law firm on just how important environmental, social and governance (ESG) factors have become in deal-making. Not to bury the lede, the authors call ESG a “lever for value creation.” At the minimum, they believe ESG amounts to proper due diligence and good governance, even if a definitive connection between high ESG marks and higher valuation numbers hasn’t been drawn consistently — yet.

Nevertheless, more than circumstantial evidence exists that investors believe the benefits are there: In 2006, only 63 organizations were signed onto the Principles for Responsible Investment, a United Nations affiliate made up of investment managers that formally introduced and continues to herald ESG. That number has grown to more than 5,300 signatories, with more than $121 trillion of assets under management in 2023. Further, in the run-up to the adoption of the European Sustainability Reporting Standards, nearly 100 investors called for reporting standards that are more strict, not less, underscoring the importance of that information to their decision-making. They must have a reason.^[i]

How Are the Rules of the Road Shaping Up?

In the public market sphere, companies are in the throes of figuring out how to respond to and incorporate stringent disclosure requirements from the European Union. Meanwhile, the International Sustainability Standards Board (ISSB) has completed its work on an initial set of voluntary standards for public companies globally, with provision for modifications per domestic interests by respective regulatory jurisdictions. In the U.S., the Securities and Exchange Commission is poised to adopt a highly anticipated climate disclosure rule this fall.

While private markets are exempt from public market regulatory scrutiny, they are not exempt from the deepening interest on the part of influential limited partners who want ESG principles integrated into their investments. Many private and public funds have integrated those principles into their investment strategies and are continuing to put their money where their mouths are. For example, CalSTRS, the world’s largest educator-only pension fund, with more than $315 billion in assets, has a goal of achieving a net-zero investment portfolio by 2050 — or sooner. One consequence is that the giant Sacramento public fund has stepped up its efforts to hold the companies it invests in around the world accountable for failing to address the risks of climate change.

They expect nothing less from the private equity (PE) firms with whom they invest their alternative dollars.

A Deliberate Approach to ESG Integration  

For investment committees and due diligence teams, ESG assessments should be part of the preacquisition due diligence checklist. In the most developed scenario, the PE company has defined clearly its own ESG strategy and objectives, and it communicates and clarifies sustainability requirements and targets to its portfolio companies, along with a roadmap for achieving them.

A framework can provide structure to these efforts. The framework places the deal thesis in context and helps ensure that everything — from the portfolio company governance to the PE firm’s portfolio-wide reporting — happens in a way aligned with investor goals and regulatory requirements.

The framework depicted below is useful in analyzing situations, pinpointing issues, and developing roadmaps and action plans to remediate those issues. It consists of six areas — strategy and planning; stakeholders and people; governance, risk and compliance; operations; data management and tools; and performance and reporting — that should be considered together for a comprehensive analysis. And while the utility of the framework extends beyond private investment, we are specifically discussing its elements in the context of PE value creation.

Integration of ESG principles starts with simply asking the right questions that matter most to a PE firm’s goals and objectives and those of its investors, clients and/or customers, using materiality as a guide. These objectives are tied to specific desired outcomes. Identifying how best to measure progress toward goals and putting in place the fund-level infrastructure necessary to position investments in the right ESG context delivers those outcomes.

The Six Elements of Sustainability Infrastructure

In this section, we suggest questions that need to be addressed around each element in order to achieve the desired outcome. Answering, or at least giving consideration to, these questions will ensure that the sustainability aspect of due diligence is strategic, purposeful and complete.

Strategy and Planning

Strategy and planning questions assess what strategic thinking the portfolio company has engaged in independently, and establish how well-aligned its ESG approach is with the fund’s objectives:

• What should the ESG strategy achieve through the PE investment lens?
• What is the company doing on a regular basis to achieve it?
• Is the ESG strategy documented?
• Which sustainability regulations govern this portfolio company?
• How could sustainability differentiate this portfolio company in the market?
• How could the portfolio company’s ESG infrastructure support continued growth post-exit?

POSSIBLE OUTCOME: Achieving strategic alignment between the PE firm and its target can open doors to new markets, products or services and improve reputation — and can make successful divestiture or IPO more likely.

Stakeholders and People

Stakeholder questions help identify who the external and internal stakeholders are, and their respective interests: 

External stakeholders

• Has the deal team identified all external stakeholders? Consider investors, regulators, creditors and the portfolio company itself.
• What are the ESG requirements of each external stakeholder? What is material to each?
• How does the portfolio company’s ESG maturity align with external stakeholder requirements?

POSSIBLE OUTCOME: Mapping and understanding all external stakeholders impacted by an acquisition or divesture provides the ability to expertly navigate their positions and expectations — resulting in informed deal decision-making. 

Internal stakeholders

• Does the workforce understand the firm’s ESG initiatives, and does it support them? Consider the board, the portfolio manager and PE firm employees.
• How do the firm’s managers encourage their teams to promote ESG?
• How does the firm maintain communication about and organizational alignment with the ESG strategy?

POSSIBLE OUTCOME: Having engaged internal stakeholders allows a company to maintain an edge in a competitive environment by ensuring long-term sustainability through current and future customer and talent loyalty.

Governance, Risk and Compliance

To become an element of every acquisition, ESG considerations need to be part of a PE firm’s governance structure and due diligence process. Ask the following questions to ensure that that’s the case:

• Is ESG consistently included in the PE firm’s due diligence checklists?
• In what jurisdictions does the portfolio company operate and stand to be held to standards set by regional or sector-specific sustainability best practices, the practices of competitors, and/or disclosure requirements of public companies operating in the portfolio company’s sector?
• How complete is the PE firm’s access to the portfolio company’s governance, risk and compliance (GRC) information prior to acquisition?
• Does the PE firm require at least 2–3 years of data related to ESG performance?
• Who at the portfolio company is responsible for ESG attainments and compliance?
• Does the portfolio company have a steering committee or task force focused on guiding its ESG efforts?
• Does the portfolio company’s enterprisewide risk management framework incorporate all relevant ESG considerations?
• How does the portfolio company continue to improve its ESG attainments and performance?
• Does the portfolio company monitor and incorporate best ESG practices as they evolve?
• Does the portfolio company conduct benchmarking to ensure that it meets or exceeds peers’ ESG performance? How often does it conduct benchmarking exercises?

POSSIBLE OUTCOME: Beyond good regulatory standing, accurate and transparent disclosures and stakeholder engagement lead to good governance. Good ESG governance is good corporate governance, period.

Operations

Operations-related questions assess the portfolio company’s maturity regarding ESG in its operations:

• Does the portfolio company adapt or redesign its operational models to maximize ESG performance?
• Can the portfolio company attest to ESG compliance for each of its products or services across their lifecycles?
• Does the portfolio company describe ESG performance and attainments in an annual ESG report? For public companies in the U.S., is such information included in their 10-K filing?

POSSIBLE OUTCOME: Adopting more efficient operational practices and disciplines can build goodwill among leadership through bottom-line gains and earn consumer trust in communities facing climate change-related risks, enabling a strong authentic reputation and positioning a company to secure more funding or be set up for divestiture.

Data Management and Tools

Data management and technology questions dig deeper to establish the validity of a company’s ESG claims:

• What technology does the portfolio company use to gather and analyze ESG data? Does the company innovate as new technological opportunities arise?
• Are processes to gather and validate ESG data automated?
• How is ESG data mapped to material topics? (For instance, if a business identifies three topics in a materiality assessment, does it provide data-driven reporting for all three of them?)
• Are ESG performance and attainment reported publicly, or in response to inbound requests?
• Does the portfolio company avoid overdisclosing? (External disclosures should be limited to material topics unless otherwise required by law or regulation.)
• How have ESG data security and privacy been established? What controls exist to ensure privacy and security?

POSSIBLE OUTCOME: Data management is a core discipline, like any other good business practice. If data is at the center of ESG-informed investment decisions, the data is the means by which valuation is validated.

Performance and Reporting

Progress toward sustainability may be characterized by leaps and stalls in the beginning. It can help to establish longer-range targets in three-, five- or 10-year increments and report attainments against those such as “By 2030, we will achieve greenhouse gas emissions reductions of 25%.”

• Which sustainability framework(s) will the portfolio company follow to establish progress toward and track sustainability goals? The principles of the Task Force on Climate Related Disclosures and the Sustainability Accounting Standards Board’s voluntary, sector-specific standards are widely accepted by public companies around the world and followed by many nonpublic companies.
• Are the portfolio company’s key ESG performance indicators aligned with the sustainability expectations of the PE firm and the company’s industry profile?
• Does the portfolio company make its sustainability reports public? Are those reports audited by an independent third party that is recognized as an ESG assurance provider?
• What ESG information is included in the portfolio company’s financial disclosures and investment packets? Is there a credible and consistent effort to link the disclosed information to materiality or financial significance for the business?
• Are ESG attainments reported regularly and consistently to senior management and to the board?
• Do portfolio companies benchmark their ESG programs with peers and competitors?

POSSIBLE OUTCOME: Transparent reporting at both the company and portfolio level provides decision-useful, material information expected of investors — and sustainability reporting is no different.

The Bottom Line

With increasing global environmental and social uncertainties, it is incumbent on investing fiduciaries — general partners and investment managers — to risk-proof their portfolios against financial and nonfinancial risks. They should also view sustainability as a value proposition; strengthening prospective acquisitions’ ESG posture through the structured approach proposed here ensures that an important element is in place for favorable returns upon exit.

Analysis and integration of ESG factors is also a way for investment managers to act more nimbly on opportunities that occur in the course of looking at a PE firm’s portfolio in new ways. In a larger sense, incorporating ESG principles is also about helping investors get as much information that’s material to their investments as possible. Having access to this information and, more importantly, assurance of sustainable performance of the invested capital inspires confidence — and confidence, after all, is the sine qua non of a mutually beneficial investor relationship and, by extension, robust capital markets.

Jeff Miller from Protiviti’s Business Performance Improvement practice contributed to this content.