ESG Investing Creates a Better Bottom Line for PE Firms

ESG investing is a method of investing that seeks out companies that meet defined criteria in the ESG categories—Environmental, Social, and Governance. This approach considers both financial and non-financial performance and practices. One shift that this approach introduces for firms is that non-financial criteria haven’t been considered in traditional financial analysis. But, it has been shown that if a company or investor integrates the non-financial data into analysis, it results in more secure investments. 

Given today’s realities, ignoring non-financial data and making business and investing decisions solely on the merit of financial performance—seeking profit at any cost—puts shareholders at risk of reputational, financial, and criminal damages.  

In light of the move to more responsible investing, many PE firms are looking at ESG investment strategies as a core way to future-proof their portfolio. It has only been a few years since ESG first appeared on the scene. In the years since it was introduced, we have seen firms treat ESG investments as a side project, not necessarily incorporating the practice into the fund’s standard investments. 

Yet, as the concept of ESG and our world evolves, firms need to react by incorporating ESG investment more holistically into the overall fund and investment strategies. European firms are moving quickly to make ESG a core focus. Some US firms are following suit but at a slower rate. 

The Market is Demanding Change

The value of ESG strategies for PE firms is illustrated through the increased market, consumer, and investor demands for change. It’s not enough to be “well-intentioned.” Investors and their constituents are looking for proof of change beyond stated policies and “green-washing.” Qualitative change is valued just as much, if not more than quantitative change. 

A good example of this shift to ESG consumerism is a company called Sustainable that ranks businesses across the ESG criteria. Using aggregate data, consumers can make informed decisions about the businesses they support, based on their environmental, social, and governance data.

Future-thinking firms recognize that consumers, regulators, and employees believe that investors have a responsibility to leverage their economic power to address the big problems the world faces. And, as illustrated by Sustainable and companies like it, the data is becoming more readily available to empower consumers to make more informed choices. In fact, a recent report published by Bain shows that stakeholders in several areas of the market are demanding change.

ESG investing

The data above is from a 2020 Capgemini survey of 7,500 consumers and 750 executives globally. What’s interesting is to observe the disconnect between buyers’ preferences and organizations’ expectations of buyers. Businesses clearly have some catching up to do. The data shows the increasing importance of ESG-minded business practices and investment decisions. 

The Elements of a Strong ESG Investing Strategy

Given the survey results, it’s in a firm’s best interest to start to develop a thoughtful ESG strategy. An effective strategy must be multi-faceted. It needs to consider policies, practices, and reporting. Firms often account for policies and reporting, but don’t address practices. All three pieces are core elements of a successful ESG strategy. 

To put an ESG strategy into practice the policies have to be fully integrated. Getting the full value from ESG requires embedding its values throughout the entire PE value chain—all the way from deal sourcing, due diligence, performance improvement, to the exit. If your firm takes the perspective that ESG is a core competency of your firm, it will become an inherent element of value creation. 

A firm’s strategy must also have a focus to be successful. Selecting a few areas that your firm cares about and doubling down on those areas will make a bigger impact than a scatter-shot approach. Identify the areas of ESG that your firm cares about and commit and execute on those. 

The Competitive Benefits of ESG Investing

Firms are moving to an ESG-focused approach and it isn’t just out of the goodness of their hearts. There are tangible financial and business benefits. Both companies and investors are developing frameworks, standards, tools, operating procedures, and data collection to enable ESG strategies to differentiate their businesses. 

In the same article mentioned above, Bain featured a great example of the impact of ESG incorporation into the value-creation cycle. 

In 2016, EQT bought AutoStore, a Norwegian maker of warehousing robots that is headquartered on a remote fjord, a six-hour drive from Oslo. The warehouse industry had limited focus on environmental or workplace issues at the time. But the firm and management saw an opportunity to change the conversation with AutoStore’s flagship robot, which automates retail warehouses by wandering through a compact shelving system, picking and packing.

EQT anticipated two ways it could create value at AutoStore. First, the firm would encourage the company to address its own footprint with a series of cost-saving initiatives aimed at decreasing consumption and reducing carbon emissions. Second, it would focus the company’s marketing on sustainability and workplace quality. AutoStore’s robot already used less energy and was significantly quieter than any other product on the market. But the management team and salesforce weren’t hitting those value arguments in their sales pitch.

EQT’s perspective came from the top of the firm―one of its primary investment themes is that sustainability attributes are increasingly becoming key purchasing criteria in any industry, and the AutoStore deal team was convinced warehousing was no different. To bring the company’s leadership on board, it launched a set of value-creation initiatives linked to sustainability and put a regular reporting function on the board agenda, tying environmental concerns to governance. The company also launched a project to determine if the robot’s sustainability features were a point of differentiation among customers. The answer was yes.

Leadership directed the company’s R&D lab to make its robot even more sustainable and worker friendly. By switching from a lead-acid to lithium-ion battery and increasing the share of recyclable components, engineers significantly reduced the carbon footprint of the product while maintaining its remarkable energy efficiency. (The robot uses one-tenth the energy of a vacuum cleaner.) By running in the dark, it also reduces energy usage within the warehouse.

Armed with a much improved next-generation product, the company then retooled its communication strategy to focus on sustainability and savings alongside the robot’s impressive technical abilities. The new message resonated loudly with customers globally. During EQT’s ownership, its global installations grew by 2.5 times, the number of installed robots tripled, revenues quadrupled and EBITDA increased by 4.5 times. And the social impact was significant: During ownership, global employment doubled, including in the small village where the company has its headquarters and is an important contributor to the local economy.

As you can see in this example, incorporating an ESG perspective into your investing approach helps to incorporate ESG throughout the entire value chain and can result in great returns.

There’s still more to learn about ESG approaches. There’s more data to collect, and best practices to be defined, but it’s important that firms start thinking about their ESG strategy now. The market is changing rapidly, consumer expectations shift quickly, and companies are actively changing their policies and procedures to meet those demands. Investors need to evolve with the market to stay competitive and more fully incorporate responsible investing into their portfolios.

Want to learn more about how our clients are incorporating ESG into their funds? Listen to the Preferred Return episode, “Waiting on the World to Change”.

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