Private equity firms, to an ever-greater degree, are looking for companies that have strong environmental, social and governance (ESG) credentials. As Sophia Walwyn-James, ESG and sustainability director within 3i’s private equity business, says: “ESG is no longer just a risk management issue for private equity firms. It is now a core part of their investment strategy.”

One school of thought is that businesses with better gradings against ESG metrics are better managed, more resilient to shocks and more likely to generate higher returns for investors. James Hilburn, who leads the sustainability and climate practice in Deloitte’s financial advisory business, agrees: “Certainly, as expectations for corporate ESG practices evolve, the bar for companies’ performance rises.”

He also recognises that while CFOs may acknowledge the long-term benefits of ESG, they will also point to the immediate costs of implementing these new measures once the private equity funding comes in. “This is something companies didn’t need to address yesterday, but will be mandatory tomorrow, and the costs of compliance are significant.”

He does, however, highlight the cost benefit: “There are also potential rewards for being at the forefront of ESG practices. Companies that excel in this area are better positioned for faster growth, and enhanced market reputation and customer attraction. Conversely, those that fail to meet even the minimum ESG standards risk becoming industry laggards. The gap between ESG winners and losers is essentially the premium paid for responsible business practices.”

When ESG pays off

While larger private equity funds can afford dedicated ESG teams to meet sustainability disclosure requirements, small to mid-market private equity firms are finding ways to integrate ESG into their investments.

WestBridge says it is proven to them that ESG helps generate better returns. When the firm invested in AJM Healthcare – a business that provides wheelchair and other mobility solutions for NHS trusts – in 2018, it went on a “comprehensive ESG journey”, recalls James MacLeay, WestBridge investment director and lead on ESG.

“Before we invested, the tracking system for the inventory required upgrading,” he says. “So they would often lose track of items, meaning they were hard to get back – perhaps the patient was deceased or had moved house. That is why we supported the business to build a system to track and monitor stock more closely. Then, when we did get the stock back into the warehouse we could recycle, refurbish and use it again. This, combined with stock-sharing agreements between NHS trusts, resulted in cost savings and a significant reduction in stock and materials usage.”

In the last 12 months before WestBridge exited in May 2021, the amount of mobility stock recycled or refurbished by AJM had more than doubled and the firm was also on its way to having a fully electric fleet of vehicles. 

Societal benefits were also attractive. As a certified “Disability Confident” employer, AJM’s workforce included roughly one-sixth disabled employees, well above the national average.

AJM’s sustainability initiatives had a significant impact on profitability. Its EBITDA grew by 60% over the two-and-a-half years that WestBridge held the company. And the multiple WestBridge achieved at exit through a secondary leveraged buy-out to mid-market fund Livingbridge increased by 50%. AJM’s ESG initiatives helped to reduce the company’s carbon footprint, improve the lives of NHS patients, and save costs within the NHS.

MacLeay says WestBridge does not cherry-pick businesses that already have outstanding ESG credentials, but rather chooses management teams that have the potential to make “measurable improvements” on their ESG footprint. Backers of secondary buy-outs are more likely to look for strong ESG credentials.

Deloitte’s Hilburn suggests that when an investment is set for realisation, the internal ESG due diligence process should start 12-18 months before the sale process starts. Doing so means the company can smooth over any ESG concerns before bidders start their own due diligence.

Where to start

Fiona Moore, head of ESG at private equity firm ECI Partners, says that when it comes to implementing ESG strategies into 100-day plans, you need to help management teams prioritise: “There are a million things you can do on ESG, but often that means teams are thinly spread and can’t see the wood for the trees. Our role is to help them understand what initiatives are impactful for their business, and help them to deliver these.” 

For example, companies must be prepared for the upcoming EU Corporate Sustainability Reporting Directive (CSRD), which will require them to disclose a wide range of ESG information, including their greenhouse gas emissions, water usage and gender pay gap.

In addition to disclosure requirements, there are a number of frameworks companies can use to measure and improve their ESG performance. Some of the most popular include B Corp, EcoVadis and the Science Based Targets initiative.

WestBridge has tasked each of its portfolio companies to be net zero by between 2035 and 2045, ahead of the UK government’s target year of 2050. This is likely to streamline costs, minimise regulatory hurdles and optimise capital expenditures. It will also attract and retain talent aligned to environmental preservation.

The firm has implemented a stringent set of measurements and now collects key ESG metrics from more than 150 data points for each of its portfolio companies. That is a lot of data, which brings us to the topic of materiality. Portfolio companies should understand what metrics they need to focus on, and which are less relevant to their sector and business objectives. 

Hiring an ESG consultancy is often a good way to help solve this bottleneck, despite the additional cost. Those costs are repaid when it comes to tender and bid eligibility, supply chain risk, attracting or retaining talent, operational efficiencies and meeting ESG requirements, not only of regulators but also of strategic or financial buyers.

“We’re finding that companies facing the most pressure from their customers are often the ones who are making the most progress on ESG,” says Walwyn-James. That said, she adds: “While a well-crafted report can be impressive, that alone won’t substantially impact valuation. True value lies in demonstrating how sustainability practices directly enhance their business operations and align with their strategic goals.”

Integrating ESG into investment decisions can be challenging for private equity firms, primarily due to the lack of data pre-investment and the need for a tailored approach for each portfolio company. Walwyn-James says 3i has recognised these challenges and has implemented measures to address them: “Historically, 3i’s portfolio companies compiled and shared ESG data in Excel, a straightforward method that worked well when ESG demands were lower. However, as ESG data became more strategically important, this approach became increasingly inefficient. To tackle this challenge, we have adopted a software tool to streamline ESG data collection and reporting.” 

A number of other off-the-shelf and bespoke portals where investee companies can upload relevant ESG data and supporting evidence have been developed.

3i is also fostering knowledge sharing through portfolio company events, and leveraging its unique position as a trusted partner to its portfolio companies for ESG insights.

Lucie Mills, a partner in value creation and ESG at NorthEdge Capital, says the firm has been taking a proactive rather than reactive approach to integrating ESG into its investment process. Her advice? “Keep it simple. Don’t overload your portfolio companies with complex ESG reporting requirements. Focus on a few key metrics that are relevant to their business. Link ESG to business outcomes,” she says, adding that portfolio companies should be proactive: “Don’t wait for regulations to force you to focus on ESG. Start now and get ahead of the curve.”

She says actions and proper reporting of those actions will become a natural process in the company’s weekly, monthly or annual sustainability efforts. She also praises transparent reporting, even when targets are not met. Sometimes, even with the best intentions and efforts, certain KPIs cannot be met, whether that is due to market conditions, unforeseen events or the supply chain. A transparent approach can help companies and their investors avoid litigation and accusations of greenwashing – overpromising on ESG targets and underdelivering.

Mills says that, to achieve best practice, NorthEdge will suggest ESG or specialist sector advisers to their portfolio companies. Often, she says, portfolio companies generate relevant ESG data in an Excel format so NorthEdge will aggregate and analyse this on its portfolio companies’ behalf in order to help them reach ESG milestones and facilitate data-led ESG reporting. This will also satisfy limited partners that sustainability goals are being met.

Something for everyone?

The initiatives and systems discussed above reflect a broader trend of private equity firms and their portfolio companies embracing software tools and, for some, being publicly committed by pursuing B Corp status.

NorthEdge’s semi-realised portfolio company Cloud Technology Solutions Group (CTS), a Google Cloud-managed services company, became B Corp certified in February 2023. Mills says NorthEdge supported the company through the daunting two-year process. Just a month before, NorthEdge sold its majority stake to Marlin Equity Partners, but retained a minority stake.

Mills says businesses don’t have to become a B Corp company to reap the benefits. “We’ve thoroughly reviewed our policies, procedures and processes to identify areas for improvement. We haven’t yet pursued B Corp certification, but we’ve already demonstrated our commitment to responsible investing and ESG principles. We believe that our most significant impact lies in helping our portfolio companies enhance their ESG performance.

“Our small ESG team focuses on actively engaging with portfolio companies, ensuring that ESG considerations are integrated into company boards, and aligning ESG performance with employee remuneration. We’re confident that our proactive approach to ESG will drive positive change and create value across our portfolio.”

Teamwork and timing

ECI is B Corp certified. Fiona Moore says the most challenging aspects of the assessment are team engagement and timing. “It takes a whole team across the business to be able to provide and assess answers to the B Lab questionnaire as it covers such a broad scope across your business, and it needs buy-in from everyone in order to commit to the certification, from your leadership team down. 

“The other point is timing – the demand for B Corp certification is increasing, which means even once you are ready, you are joining a long queue for them to follow up, evidence your responses and interview the team. My advice would be that if you are considering B Corp, start early.”

Moore says the great benefit of the B Corp assessment is that it provides you with a roadmap of goals: “ECI now has a prioritised list of actions, covering everything from DEI [diversity, equity and inclusion] to decarbonisation.” 

She says the importance of ESG to limited partners (LPs) is certainly increasing over time, and something ECI witnessed in its recent £1bn ECI 12 fund closing: “LPs want to understand how rigorous you will be when it comes to ESG assessment ahead of a deal, but also how you can help portfolio companies progress on key initiatives during the investment.

“Being able to evidence the approach we’ve taken, for example by demonstrating our ESG assessments and scores over the past decade, really brings that to life.” 

For some, though, becoming a B corp is not a panacea and it can even prove a distraction because of the increasing demands of mandatory regulation. Many organisations choose to focus on ensuring quality reporting and identification of key ESG risks and opportunities. A careful cost-benefit analysis can help with the decision on whether to pursue the B Corp certification route. 

Moore recalls when portfolio company Tasker, a salary sacrifice vehicle lease company, pivoted to electric vehicles as a percentage of its total fleet, going from less than 10% to more than 70%. “That had a direct impact on exit, with LBG acquiring the business in 2023, to support the group’s ambitions and to achieve the UK government’s net zero emissions targets by 2050 or sooner, resulting in a multiple of 6.2x on exit for ECI.”

Despite the challenges, private equity firms are optimistic about the future of ESG-based investment strategies. As more data becomes available and as more companies start to measure their ESG performance, it will become easier for private equity firms to integrate ESG into their investment decisions. The growing demand from investors for ESG-focused investments will drive further innovation and returns. Key to that, in the long term, is demonstrating that it is more than greenwashing and that the investment of resource does deliver improved returns.