Private equity and ESG: it’s time for evolution not complacency
In recent years we’ve witnessed the rise of ESG from a niche consideration to a fundamental aspect of investment strategy. Many private equity (PE) firms in particular have made significant progress in this area. They’ve created relevant policies and in some cases hired dedicated ESG teams. Plenty of evidence points to the work that’s been done to embed ESG principles into operations.
At Sancroft we have worked on many of these ESG integrations. However, we’re now seeing a period of consolidation. Could it be that many PE firms now believe they’ve done enough? That they’ve created the policies, ticked the right boxes, so they’re fine?
This would be a dangerous mindset to adopt.
PE firms should now be asking how much their portfolio companies integrate ESG principles into their day-to-day operations. Are they addressing issues in a way that not only satisfies the policy requirements, but also genuinely contributes to profitable and sustainable business models?
They should also be looking ahead, not with a sense of completion, but with a focus on evolution as the risks and expectations related to sustainability continue to develop and emerge.
In particular, there are three pressing areas PE firms need to focus on to ensure they remain ahead of the curve:
Human Rights Risks
The conversation around ESG is constantly evolving, and in our experience is now shifting to also incorporate the management of human rights risks beyond just Modern Slavery. Regulations such as the EU’s Corporate Sustainability Due Diligence Directive and similar efforts worldwide are making it clear that companies and their investors must actively address human rights risks within their supply chains and operations. Granted, many portfolio companies won’t be caught directly because of the size thresholds set by regulations like CSDDD. But if these companies have large suppliers or customers, then the emerging requirement to understand environmental and human rights risks in upstream and downstream supply chains means they will still likely face questions about their practices. With this in mind, PE firms need to move beyond general policy statements on ethical conduct and assess the real risks their portfolio companies and their commercial ecosystem might face in relation to labour practices, worker safety and human exploitation.
Biodiversity
Biodiversity destruction is a looming risk that many businesses are not prepared for. Yes, some businesses are having the conversation, but it’s currently not going much further than that. This won’t be the case for long. The increasing degradation of ecosystems and loss of biodiversity presents both environmental and financial risks. Businesses that depend on natural resources, directly or indirectly, are especially vulnerable. The private equity industry, with its exposure over a wide range of sectors from agriculture to manufacturing will in the not-too-distant future need to prioritise biodiversity within its ESG frameworks. This includes understanding supply chain dependencies on natural ecosystems, measuring impact and actively managing risks related to biodiversity loss.
Action beyond disclosure
Investors are already aligning with the Task Force on Climate-related Financial Disclosures to enhance their understanding of climate-related risks and opportunities. However, it’s not enough to simply disclose. Now is the time to act. Investors must take their findings and transform them into actionable strategies across their portfolios. They need to engage directly with each portfolio company to ensure risks are fully understood and mitigation efforts are in place.
The commercial risks of complacency
Private equity firms are, at their core, value creators with a fiduciary duty to protect their investors’ capital and deliver returns. Consideration of a comprehensive range of ESG factors is an increasingly crucial part of that duty.
They are also risk managers, and they must recognise that the risks of inaction are substantial. Portfolio companies that don’t integrate increasingly advanced ESG considerations into their business models will struggle to meet emerging regulations and lose favour with socially aware consumers.
When a PE firm is ready to sell a company, prospective buyers will scrutinise these factors closely. If all evolving ESG risks aren’t thoroughly addressed, this may directly lower a company’s valuation and could significantly reduce returns on investment.
Equally, PE firms should be mindful that competitors who take a proactive, forward-looking approach to ESG will gain an edge, positioning themselves as leaders in sustainability. Likely with better returns, and better ability to attract new capital.
What PE firms should do next
In summary, over the coming months and years private equity firms will need to ask themselves how they can drive new action and evolve. This will involve consideration of three key areas:
1. Strengthening your ESG implementation – Ensure that your ESG policies are genuinely being enacted across portfolio companies. Set measurable targets, track progress and hold companies accountable for their performance.
2. Identifying emerging risks – Assess how human rights, biodiversity and other advanced sustainability risks might affect portfolio companies. Integrate these considerations into risk management frameworks.
3. Evolve your ESG Strategy – Move beyond a compliance and disclosure based approach to a more dynamic, future-oriented ESG strategy. This means not only responding to regulations but also anticipating future challenges and opportunities.
Private equity’s ESG journey is far from over. In fact, it’s only just beginning. Firms that rest on their laurels now will be the ones left behind. But those that continue to innovate and drive sustainability forward will stand a far better chance of thriving in an increasingly complex world.