The keynote interview below was published on Private Equity International (see here for the original) and is reproduced here with their kind permission.

In recent years, private equity’s approach to ESG has evolved from a focus on downside risk mitigation into a key value-creation driver. Andrew Radcliff, global lead for M&A services, and Claudia Solaini, a partner in the M&A
services team at sustainability consultancy ERM, explain what’s behind this
shift and discuss how technology and data are playing a crucial role in assessing both ESG risks and opportunities.

Q. When did ESG first seriously come into the frame for PE firms and why? 

Andrew Radcliff: The term ESG may have only entered the mainstream private equity conversation around a decade ago, but the industry has been engaged with these topics for more than two decades. Private equity’s approach to ESG has, however, evolved significantly through that period. Historically it was a tactical risk mitigation or risk identification topic, and it was often driven by lenders focused on identifying risks and liabilities. The focus was narrow and heavily weighted to the ‘E’ side of things, mainly focusing on direct industrial operation impacts.

Over the years the scope gradually broadened. Managers began to look at risks and opportunities through an environmental and social lens, which represented a natural progression from ‘E’ risk. They also began to look along the value chain, considering impacts generated by suppliers and throughout a product’s life cycle.

ESG’s reach has continued to broaden, and we now see it embedded in everything that PE firms do. That push started in Europe, but during the last five or six years ESG has become established in the US too and is now increasingly important in Latin America and Asia Pacific. It has also been interesting to observe how ESG has moved into the mid-market in a strong way.

Claudia Solaini: The shift in regulation of ESG-linked topics from voluntary to mandatory compliance has been a big driver of ESG uptake in PE. We are also observing that a sound ESG strategy represents a key element for capital raising and is perceived as a must-have by the investor community.

There have been voluntary ESG frameworks in place since the early 2000s, but the real game changers have been the Task Force on Climate-Related Financial Disclosures and the EU Sustainable Finance Disclosure Regulation. Both of these reporting frameworks are now mandatory and that has had a big impact on investors, which have had to comply and handle their manager relationships accordingly.

In addition to the regulatory piece, there was an acceleration in the focus on ESG topics and corporate social responsibility through the covid-19 lockdown periods. Companies were challenged by consumers, investors and the general public to speak up, take a stand and look internally at their own policies and workforce, with diversity and inclusion – and more recently biodiversity – in particular moving up the agenda in a way we had not seen previously.

Q. As the importance of ESG has deepened, how have PE firms adapted due diligence and investment processes?

AR: ESG assessment has become very sector specific. In the past, when managers were just looking at environmental factors, there was a standard scope, but the exercise has become increasingly detailed and bespoke. When we work with a manager on a deal, we still make use of general tools, such as the Sustainability Accounting Standards Board framework, but we have also developed a suite of internal tools that drill down into the material sector and geographical factors that are going to impact a specific asset.

It has been interesting to see how managers have become more sophisticated on ESG. In the past it was just consultants like us and the deal teams that would be assessing ESG, and while the deal teams did hold some general ESG knowledge, they were by no means experts. Now, many of our clients have their own in-house ESG teams, and that means the scoping becomes a much more informed process that involves us, the deal team and the firm’s ESG expert(s). Investment committees are also much more informed on ESG issues and better equipped to ask challenging questions of the deal teams.

With more ESG expertise around the table, due diligence has become a more granular, iterative process. As the process becomes more detailed, a robust materiality assessment becomes pivotal. It takes experience and judgement to stay focused on what matters. This is something we have become good at doing, and that matters from a budgetary, time and consumption of data perspective. Defining priorities during due diligence is key to designing a sustainable roadmap that can be implemented through the ownership period to create long-term value.

Finally, we now also include some level of benchmarking on every due diligence project. When ESG becomes a decisive factor in pursuing a deal, one of the most important things for a dealmaker is how the target compares to its direct and aspirational peers and public market comparators.

CS: ESG due diligence has evolved from addressing a narrow environment, health and safety scope into a much wider exercise that includes exploring upside ESG potential. As that scope has widened, ESG due diligence timetables have expanded. Projects used to have a quick turnaround and we were there primarily to identify any red flags or deal stoppers.

The process is now more collaborative and there is more time to engage with the PE firm and the target company in a more comprehensive way. As the final goal for managers has shifted away from pure risk identification and mitigation, we are now asked to help identify ESG value-creation opportunities. There has also been growing demand for decarbonisation expertise during due diligence, whether that be developing new decarbonisation plans for target companies or diligencing existing plans.

The focus on ESG as a value-creation lever is something we have seen expanding beyond due diligence into other parts of the deal life cycle. It is now a core aspect of portfolio management and will also go to value on exit.

Q. What areas are PE firms focusing on when using ESG to drive value through a hold period, and how are they implementing ESG post-deal?

AR: It is crucial that ESG stands on its own two feet. It must earn its place at the table. What we see many managers do within the first week of the deal closing is bring all their advisers in one by one to meet with the management team and present what they think should be included in the 100-day plan. What we have learned from those sessions is that you need to give management a compelling reason to consider ESG and show how ESG will drive value creation.

Once there is that buy-in it comes down to putting sustainability into action at a tactical level every day. That can range from building a decarbonisation strategy to addressing biodiversity issues to programmatic work on diversity and inclusion.

CS: We work with stakeholders across private markets, and particularly with PE firms post-deal, helping them to operationalise sustainability at the portfolio company level and deliver on the ESG themes in their investment theses. That includes helping fund managers to build their own ESG frameworks and toolkits that they can then deploy across their portfolios, as well as working with portfolio companies to bring their ESG performance up to the levels the fund has committed to.

To put that into practice, a ‘boots to boardroom’ approach is key. That involves developing an ESG strategy, setting out operational actions to deliver on that strategy, and putting all the associated reporting frameworks in place. Again, the materiality assessment plays a key role here; only by understanding priority items for the business’s value chain and stakeholders is it possible to design an effective ESG action plan and generate value through tangible impacts.

AR: While we provide that support, ultimately, the management team must be the ones driving it. If the management team isn’t taking that ownership, then ESG obviously isn’t a high enough priority. Portfolio company performance is critical to GPs achieving their ESG targets, so if the ‘softly, softly’ approach doesn’t work then a mature conversation with management is required. That said, management teams are increasingly seeing the commercial value of ESG and are more likely to embrace ESG value-creation plans than they were in the past.

Q. How will technology’s role in ESG evolve?

CS: Technology and data are already adding value to the ESG due diligence process, and they will only become more and more influential throughout the investment life cycle. Deal processes move fast, and time management is a critical aspect of any due diligence mandate. With the help of technology, we have beenable to materially shorten the time required for ESG due diligence. Using the pre-screening capability of our ESG Fusion tool, for example, we can deliver a report for a manager within 48 hours. That demonstrates the power of technology in a tangible way.

Technology may be where the future of ESG assessment lies, but technology is not that useful if it is not combined with people who are experienced in the field. Without that experience you end up with a digital tool and data that has no context or meaning. This is why we combine our strategy advisory expertise with an in-house bench of technical experts that spend every day putting sustainability into action at the ground level.

Q. Where does technology and data come into due diligence and ESG implementation post-deal?

AR: Technology and data are critical. Across the market there is an arms race for ESG data, and we have invested significantly in our ESG data and technology capability. Our ESG Fusion platform is an example of this. It’s focused on drawing data available in the public domain on private companies and small-cap listed companies, and then providing a risk and opportunity signal on the ESG performance of that company.

ESG Fusion is a tool that we use in all our diligence projects, often – but not always – as an early-stage indicator of a target’s ESG performance. It is powered by artificial intelligence and enables us and our clients to assess a target’s ESG performance from the outside in. While technology plays a critical role in ESG Fusion, which has natural language processing and data analytics capabilities, we believe it is crucial to have ESG specialists operating it and reviewing outputs.

We also have a tool that helps clients understand the risks around changing climatic conditions associated with particular locations, and we are preparing to launch a climate transition risk tool that will look at the risks and opportunities that will emerge as the global energy system transitions to net zero.

It is important to highlight that partnerships are essential for bringing data tools like these to market. No organisation can do this alone. We have built partnerships with many other data providers to develop these tools. We don’t hold all the data and technology expertise ourselves. It will take a village – maybe even a city – involving multiple market participants to get to a point where we have reliable ESG data for private markets.

Copyright: Private Equity International