Unlocking sustainability value in private equity

VIEWPOINT 2024 UNLOCKING SUSTAINABILITYVALUEINPRIVATEEQUITY Anewtooltomovebeyondidentifyingredflags Privateequity(PE)isleavingbillionsofdollarsinsustainabilityvalueonthetable.Whilesomepractitionersfocusonthevaluepropositionof sustainability,thecurrentstatusleavesmuchtobedesired.Gapsincurrentapproachesinclude cumbersomeframeworksfocusedonriskcomplianceratherthanvaluecreation,difficultycapturingthefinancialbenefitsofasustainabilitystrategy,lackofclarityaroundwhichKPIstotrack,andsignificantcommunicationissuesbetweengeneralpartners(GPs)andlimitedpartners(LPs).ThisViewpointintroducesapowerfultooltobetteridentifyvaluecreationandrisk-mitigatingopportunitiesattheduediligenceandearlyholdingphases. AUTHORS FlorentNanseJulienMarcheseAlanMartinovichSeanMcDevitt TensieWhelan,NYUSternSchoolofBusiness INPARTNERSHIPWITH: Between2010and2022,assetsundermanagementofPEmorethanquadrupled.AsthePEindustrycontinuestoexpand,thereisagrowingopportunitytogeneratefinancialandsocietalvaluethroughsustainabilityinitiatives.Increasingtheavailabilityoffinanceisalsoakeylevertomovetheindustrytowardnetzerogoals;forexample,accordingtoBloombergNEF,onlyabout16%ofclimatefinanceneedsarecurrentlybeingmet.BecausePEfirmsoftenholdmajority controlovertheirportfoliocompanies,theywieldconsiderablepowertoimplementsustainabilityinitiativesacrossawideswathofindustriesattheportfoliocompanylevel. However,manyPEfirmsarecurrentlypoorlyidentifyingandcapturingsustainabilityvalue.BasedonnewresearchbytheNewYorkUniversitySternCenterforSustainableBusiness(NYU SternCSB)incollaborationwithArthurD.Little(ADL),weknowthatmostGPstendtofocusonidentifyingredflagsduringduediligence(withafewleadingexceptions,especiallyinEurope)butrarelylookintosustainabilityvaluecreation.Afterpurchase,GPsmaytrackafewenvironmental,social,andgovernance(ESG)reportingmetricsbutoftendonotimplementsustainabilityvaluecreationplans. ThisViewpointoutlinesanewtool(opensourceandavailablefreeofcharge)developedjointlybyNYUSternCSBandADLtohelpGPsbetteridentifyandcapturesustainabilityvalue,bothattheduediligencephaseandduringthefirstfewmonthsoftheholdingperiod. OPPORTUNITIES FORIMPROVEMENT TheresearchidentifiedseveralclearopportunitiesforimprovementinhowGPsapproachsustainabilityduringtheinvestmentlifecycle.UnderlyingtheseopportunitiesisthebasicpremisethatGPsstilltendtoapproachsustainabilityasprimarilyareportingissueratherthanapotentialdriverofvalueduringeachstage: Abouttheresearch NYUSternCSB,incollaborationwithADL,conductedaresearchprogramaimedatfacilitatingthePEindustry’stransitiontowardsustainableinvestingpractices. Thescopeincludedtheidentificationoftheissuesandbarriersaswellasthedevelopmentofanewframeworktoolandguidetoembeddingsustainability withinportfoliocompanies.Theresearchincluded40+interviewswithGPs,LPs,andotherstakeholders,alongsideseveral webinarswithhundredsofpractitioners.AworkinggroupoffiveGPsappliedfirsthandexperiencetohelpdevelopthetool,ensuringitspracticalityandeffectiveness.Anadditional10GPstestedthetooltoprovidefeedbackbeforefinalization. -Deal-sourcing/pre-duediligencephase. CurrentpracticefocusesonESGdatarequests,checkingagainstgeneralexclusions,andoftenapplyingagatingmethodologybasedonspecificcriteria(e.g.,animpactinvestormightusecriteriafocusedonqualityjobs).Thistypeofapproachmaybeadequateforthepre-phase,althoughknowinghowmuchdepthtoaimforcanstillbedifficult. -Duediligencephase.Thistypicallyinvolves reviewingmaterialissues,includingESGKPIsifavailableandanESGscorecard.ESGsensitivitiesmaybeappliedtovaluationanalysestoreflectpossibleimpacts.Themainshortcomingsareanemphasison redflagdownsiderisks,superficialityinunderstandingthefullextentofESGissues,lackofdata(especiallyforsmallandmedium-sizedenterprises),andlimitedornofocus onupsideopportunitiesfromsustainability(e.g.,thefinancialupsideofmitigatingrisksthatmaydriveimprovedperformanceorhowsustainabilityinvestmentscouldbuildcompetitiveadvantage). -Earlyinvestmentandholdingphase.Currentcommonpracticeincludesconductingabasic ESGmaterialityassessment,trackingsomeESGKPIs,puttinginplaceESGaccountabilitystructures,andcreatingannualsustainabilityreports.However,thereisoftenalack ofunderstandingofwhichESGKPIsandsustainabilityleverstofocuson.Therecanbeanemphasisonprocess,ratherthanoutcomeandmetrics,withoutenoughattentiongiventoreturnonsustainabilityinvestment(ROSI)andvaluecreation.GPsmayconductabasicESGmaterialityassessmentandtrackafewreportingmetricsbutoftendonotprogressthesefurther.ESGreportingmetricstypicallyfocusontheoutputorexistenceofapolicyratherthantheoutcomeorunderlyingperformance(e.g.,“check-the-box”reporting). -Exit.Attheexitstage,thelackofeffective ESGmetricsanddatameansthatvaluegrowthandROSIachievedarehardtodemonstrate. Researchindicatesthatthereissomeuplift inthevaluationsofcompaniesthatimplementstrongsustainabilitypractices,soinvestorsmightbemissingoutonhighervaluations. GPsreportedthatinvestorsareaskingforsustainabilitynarrativesatexit,butGPscurrentlylacktheunderlyingdatatovalidatethesenarratives. Sotherearesignificantopportun