A new symbiotic relationship is emerging: private equity (PE) investors have a growing interest in businesses with strong ESG credentials and new research suggests that companies are looking at how sustainability can make them stand out.
A new Investec study, conducted among 500 mid-market firms in the UK, has found that two-thirds (65 per cent) of companies with backing from PE investors believe strong ESG performance makes them more attractive to potential partners and acquirers. As such, more than one-third (39 per cent) with a strategy in place expect to increase investment in ESG enhancing initiatives over the next 12 months.
Three opportunities in one
PE firms now regard ESG opportunities as multi-faceted, says Callum Bell, executive committee member and head of direct lending at Investec. They see portfolio companies that are top ESG performers as having increased potential to deliver strong investment returns. They expect to unlock additional value by working with companies to enhance ESG performance using best practice across their portfolio. And they see their ESG credentials as a means by which to compete against other potential investors during deal processes and auctions.
“There is a real opportunity to pick up businesses that haven’t had the time, the resources or perhaps the governance to be a leader in this area,” Bell highlights. “And PE firms also see this as another way to attract companies to their platform, where they tap into their best practice in a cost and time effective manner.”
To secure those advantages, many PE firms are making significant investments in their ESG capabilities, building teams to provide support to businesses across the portfolio, creating improved performance in key areas such as establishing net zero target frameworks and sustainability governance systems. More than one-third of the mid-market companies with an ESG strategy said support from external advisers had been the biggest single source of positive strategic impact.
Ian Webb, CFO of schoolwear company Banner, says that a PE investor taking a lead on ESG can help set the direction of a company. “We agreed with our owner that we would change our articles to reflect an equal commitment to people, planet, community and profits. We’ve also joined the Better Business Act and have applied for B Corp status,” Webb says. “I would like to think, as a PE-backed business, that our sector leadership on ESG is nudging [our valuation] multiples upwards.”
PE firms confirm this financial motivation as a significant factor in the pivot towards ESG. Research published in autumn 2023 by consultancy PwC found that 70 per cent of PE investors now see ESG as one of the top three potential drivers of deal value.
Separate research by Investec found that 60 per cent of PE fund managers (also known as general partners, or GPs) believe the implementation of ESG best practices adds to the value of a portfolio company. Around one in five (18 per cent) said they believed ESG created a valuation uplift of more than 10 per cent. The results came from Investec’s annual survey of GPs, due to be released in its 2024 Private Equity Trends report.
Why ESG creates value
Independent evidence suggests that superior ESG performance can drive value-accretive commercial improvements. A joint review conducted by New York University and Rockefeller Asset Management, which looked at more than 1,000 studies on ESG, found that 58 per cent identified a positive relationship between ESG and financial performance. The review pointed to particularly encouraging metrics in areas such as return on equity, return on assets and share price.
Many mid-market businesses acknowledge these conclusions. More than half of the companies in Investec’s mid-market sustainability research believe ESG is now fundamental to how a business should operate. What’s more, 44 per cent of those with PE backing see revenue-growth opportunities following the full implementation of their ESG strategies.
The data suggests that many businesses are now going beyond conventional thinking on ESG (i.e. that it requires attention to avoid reputational damage and regulatory issues) and instead perceive improved ESG performance as a potential source of new revenue and profitability.
“This is why PE companies are spending a lot more time on establishing ESG strategies, KPIs and data management within their portfolio companies,” adds Investec’s Calum Bell. “And when they go looking for the latest entrepreneur or the latest business in a sector that's outperforming [on ESG], they are keeping a very sharp eye out for CEOs and management teams who are leading the way.”
According to Investec’s upcoming Private Equity Trends report, for the vast majority (83 per cent) of GPs, ESG or ethical factors had a significant influence on their decision to invest or not invest in a portfolio company in the past year. What’s more, 48 per cent said the influence of ESG or ethical factors on investment decisions had increased over the period.
And there is good reason for this: organisations that win trust through their corporate behaviour are often in a better position to win new contracts. In a jobs market where employees are increasingly values-driven, these organisations will also hold a potential advantage. Moreover, investments in energy efficiency, for example, while motivated by environmental considerations, help to reduce cost, so there are aligned motives for action.
“ESG is not only the right thing to do, it makes good business sense — that’s why it’s a key focus area,” says Philip Edmans, partner at Inflexion Private Equity. “We have seen examples in our own portfolio where buyers have been attracted to, in part, a company because of its ESG credentials, and that ESG angle has added value at exit.”
