In the US, there is growing pushback against ESG by private equity, but what’s going on in the UK mid-market? Jo Russell reports.
Earlier this year, asset manager BlackRock disclosed that it had supported just 20 of 493 environmental and social proposals put forward by shareholders at annual meetings – around 4%. That compares with the 47% it supported in 2021. This move seems to be part of a growing trend in the US to push back against environmental, social and governance (ESG) investing: several states have even introduced legislation preventing engagement with companies that use ESG criteria to boycott industries such as fossil fuels.
The mood music in the UK and Europe, set in part by the legislative environment, is sounding somewhat different. Around two-thirds of signatories to the UN-backed Principles for Responsible Investment (PRI) are based in Europe, while the Corporate Sustainability Reporting Directive (CSRD) and Corporate Sustainability Due Diligence Directive are heightening focus on the ESG performance of large businesses, and feeding down their value chains.
“In the UK, we are building momentum rather than losing it,” says Mark Keeley, partner and chair of the ESG committee at ECI. “A growing number of private equity firms are achieving BCorp certification, while bank lenders are introducing ESG margin ratchets, reducing the interest rate on portfolio company loans once certain KPIs are met.”
Fiona Place, acting head of ESG at BGF, agrees with him: “If we are looking to access capital ourselves, demonstrating ESG criteria is not optional. We need to demonstrate good credentials and that the capital is earmarked for organisations that understand the value associated with good ESG metrics.”
Early focus
Given the importance placed on ESG performance by investors, lenders and stakeholders, assessing the ESG credentials of a portfolio company is becoming more commonplace. The exercise frequently involves third parties and begins at the start of the investment cycle. Using a third party makes sense for a number of reasons, explains Lucie Mills, value creation and ESG partner at NorthEdge: “We use an external provider to conduct the first ESG maturity assessment, as we don’t have the bandwidth to assess all ESG regulations in every sector and sub-sector. This helps us decide what is important and material for that company, where they sit in relation to the competition, and what we should focus on. It is a practical piece of due diligence that gives us a benchmark for the full investment period.”
Ways and means
The approach at ECI is similar. “We are required to assess a company’s ESG credentials as part of due diligence when we are considering investing,” says Keeley. “We’ll see what the issues are, and whether they can be mitigated – if they can, it shouldn’t be a red flag to stop an investment.”
The Appointment Group, an ECI portfolio company providing travel services for musicians, is one example. Intrinsically, a travel company would score low on environmental metrics, but making the switch from private jets to more environmentally friendly trains and electric vehicles has a more positive effect.
External benchmarking
With a portfolio of around 350 companies, BGF has a wealth of data it can draw on in order to track and benchmark ESG performance. It has enlisted the help of a third party to take advantage of the opportunity. Through survey evidence, gathered as part of the new investment process, the platform assesses ESG performance at individual company level.
There is a quantitative component to the assessment and benchmarking, but supplementary material – such as employee engagement surveys – are uploaded to provide a more rounded, evidence-based picture. Those findings are benchmarked against a wider database of SMEs alongside BGF’s internal portfolio. The exercise, run annually, provides BGF with an overall ESG score for each company in the portfolio, which can then be broken down into separate environmental, social, and governance metrics.
“We have awareness of where companies are and where they should be on the ESG journey,” says Fiona Place, acting head of ESG at BGF’s. Of most value to management teams, she believes, “is the ability to contextualise their results, by benchmarking with other similar-sized businesses at similar growth stages in their sector. On the last assessment we saw an uptick of 17% in social scores and an increase of 15% on governance scores. We have had a lot of conversations on environmental topics, and have subsequently seen a 26% improvement on environment scores.”
Within the first 90 days ECI will instruct an external consultancy to conduct a formal assessment of the portfolio company and provide a rating with tangible actions for improvement for the management team. The ratings will then be revisited every six months, and Keeley receives a full briefing on those actions through a board report at the monthly board meetings.
In order to provide a comprehensive picture on ESG performance, both quantitative and qualitative metrics are taken. Alex Bexon, ESG director at LDC, explains: “On the qualitative side, we assess every portfolio company’s ESG maturity annually, using a framework we have created. The framework asks questions about processes, controls, governance and policies, to see how ESG is being integrated into the business model. Each question has a range of answers that we can aggregate to produce a numeric score using our methodology. Quantitatively, we supplement that assessment with a range of metrics, grounded in the ESG Data Convergence Initiative (EDCI), that we request on at least an annual basis.”
Continual assessment
The aim at LDC is for each portfolio company to have an ESG improvement plan, ideally with a board-level sponsor, approved at board level within the first year of acquisition. ESG progress performance remains a board agenda item, which means that for many companies it is discussed monthly or quarterly. Within each company ownership of the ESG agenda will vary, depending on maturity. Some may have chief sustainability officers, others a committee or working group-based approach. All may benefit from LDC’s network of consultants, who are on hand to provide support as and when needed.
As with LDC, the approach at NorthEdge is to gather both qualitative and quantitative metrics using a proprietary system. An annual survey asks each company questions ranging from carbon emissions to more qualitative questions relating to approaches to supply chain sustainability. “These can feed into the social values of our ESG report, giving a sense of how embedded each company’s thinking is on this,” explains Mills. The latest report shows the improvements that are being made (see box, Maximising Opportunities).
All NorthEdge portfolio companies have an ESG section within their board pack that is tailored to their company, product and market. “From a board sponsorship perspective, we are trying to put the onus on the CEO rather than the CFO. There should be an understanding that ESG is material to the business, and therefore it should form part of the strategy, owned by the CEO,” says Mills.
Seeking validation
If there is growing acceptance of the importance of demonstrating value created through ESG performance, there is equal understanding of the need for consistency across those demonstrable metrics. The value of a data point, after all, lies in its comparability with a similar data point. In this regard, the EDCI is helpful.
“It’s important to have consistent, comparable benchmark data so companies can understand where their performance sits within their sector or market. Data is easier to come by from listed businesses, whereas it can be quite difficult for private market participants. The EDCI is a very rich data set, giving us access to around 6,000 portfolio companies submitted by more than 450 general and limited partnerships,” says LDC’s Bexon.
Looking ahead, demonstrating and validating ESG performance metrics is set to become increasingly important. Companies are starting to be asked to verify credentials on exit, and while many mid-market firms don’t fall under the umbrella of the Corporate Sustainability Reporting Directive or Sustainable Finance Disclosure Regulation requirements, they may be asked to provide comparable data in the future.
However, advises Place, companies should be mindful of over-use of validating metrics. “One of the challenges of validation is that the ESG function is already stretched with respect to reporting obligations. There is a risk that spending too much time on reporting and metrics distracts from the real work of creating value. We need to strike a balance in terms of what we ask of a company,” she says.
As Mills points out, there is also a need to talk in a language that is relatable to management teams, rather than in pure compliance terms. “I don’t talk to portfolio companies about regulation. Instead, I ask, ‘How do you hold pricing power in a difficult market? How do you attract and retain customers and talent? How do you make yourself as attractive as possible for capital?’ If you focus on what is material, and measure it as you would every other part of your strategy, you will see the benefits from a customer and a stakeholder perspective.”
Even in a perfect world, where metrics and performance measurement are equal and effortless, there will always be an element of subjectivity when it comes to value. It is better to set realistic expectations as to what ultimately can be validated through measurement.
“The holy grail,” says Keeley, “would be to take a business with average ESG credentials, improve it to a significant extent and then prove that we got a higher value on exit as a result. But it’s a challenge as you can never be sure how people attach value.
“In initial marketing documents we increasingly see big sections on ESG, people and culture. That tells me the market does care. If you’re strong in those areas, theoretically you drive more interest, and therefore a better price. That is logical, even if quantifying it is more challenging.”
Maximising opportunities
Given that the majority of its companies are UK-headquartered services businesses, the primary focus at NorthEdge – and where it feels it can make the biggest difference – is on the social and governance aspects of ESG.
The core ESG team has assessed 21 topics and, in a newly published materiality matrix, highlights the areas that are prioritised, giving consideration to risk, opportunity and stakeholder requirements. Corporate governance and cyber and information security rate highly. Water supply and waste management are a low priority. Sitting mid-table are social topics such as human rights and corporate citizenship.
The firm also commissioned a business economist to undertake an independent review of its social and economic impact. It showed that in 2023, the activities of NorthEdge and its portfolio generated £844m of gross value added in the UK. Ninety per cent of its capital has been deployed in the UK regions outside of London and the South East, which is where the majority of employees are based. Of those, 28% live in the 30% most deprived areas in the UK. Wages were 13% higher than the national average and, adjusting for NorthEdge’s regional mix of employment, men were paid 17% more than their peers and women 15% more. All portfolio companies have female representation and 33% have minority representation in the senior leadership team.
