ESG Integration in Private Equity: From Due Diligence to Exit

Private equity firms traditionally focus on financial performance and maximizing returns for their investors. In recent years, however, the industry has increasingly come to recognize that non-financial ESG (Environmental, Social, and Governance) factors do, in fact, have a material impact on a company's long-term financial performance and risk profile. This has led to a flurry of movement as private equity firms adapt—to varying degrees of success—in response to the shift towards stakeholder capitalism. 

How does ESG integration fit into the picture? 

What we now see is a market striated along different levels of ESG maturity in private equity companies. Top-performing firms practice what’s called “ESG integration,” which the UN Principles for Responsible Investment defines as “the process of including ESG factors in investment analysis and decisions to better manage risks and improve returns.” Research by McKinsey found that an effective ESG strategy can affect operating profits by nearly 60%. 

ESG integration goes far beyond a compliance exercise. It’s intentional, comprehensive, and systematically baked into every single component of a business’s operations. That’s why we say “ESG Integration.” There is no separating ESG from operations when it’s a primary focus for the org as a whole.  Without it, you get disintegration.

Key elements of ESG integration in private equity

ESG is crucial for driving both purpose and profit. Private equity firms that understand the advantage of strong ESG performance and high quality data will bake ESG principles into every stage of the deal-making process. Let’s take a look at some of the considerations to think about when developing an ESG integration strategy:    

What this looks like across the investment lifecycle 

Investment Decision-Making: Private equity firms incorporate ESG factors into their investment analysis and due diligence processes. They evaluate the materiality and relevance of ESG issues specific to the industry, market, and investee company, alongside traditional financial analysis. ESG factors considered may include carbon footprint, energy efficiency, supply chain transparency, labor practices, diversity and inclusion, board composition, executive compensation, and ethical considerations.

Active Ownership: Private equity firms actively engage with portfolio companies on ESG issues, encouraging them to measure and improve their sustainability practices, corporate governance, and stakeholder engagement. This includes setting clear ESG objectives, tracking progress, supporting the implementation of best practices, and providing resources and expertise to level up ESG performance.

Reporting and Disclosure: Private equity firms integrate ESG reporting and disclosure as part of their transparency and accountability initiatives. This involves encouraging portfolio companies to adopt recognized ESG reporting frameworks (such as EDCI, SASB, or TCFD) and communicating ESG performance to investors and stakeholders. Transparent reporting helps assess progress, demonstrate commitment to sustainability, and increase social license.

Portfolio Company Leadership: Private equity firms should actively collaborate with and support portfolio companies in overcoming ESG-related challenges. This involves fostering a strong partnership based on shared values and goals. Private equity investors integrate ESG at the portco-level by conducting thorough ESG assessments, helping set sustainability targets, providing guidance on ESG strategy, sharing best practices and resources, driving ESG reporting, encouraging stakeholder engagement, and tracking and monitoring ESG performance.

What this looks like across the organization

ESG integration from an organizational change perspective involves incorporating ESG principles and practices throughout various departments within a company.  It’s not just about  incorporating ESG principles throughout the investment lifecycle, but also about making sure ESG efforts are deeply embedded into each and every department and aspect of a business. For instance: Investor Relations, HR, and even the Board of Directors—what are all of these departments doing to move the needle on ESG from their individual standpoint? Here are just a few examples of how ESG integration can take shape in different departments:

Board of Directors: The board of directors plays a crucial role by setting the strategic direction of the firm. They have the power to establish an ESG committee or designate responsible board members to oversee ESG initiatives. The board can also integrate ESG metrics into performance evaluations of top executives to more closely align ESG targets with the company's overall strategy.

Investor Relations: Investor relations teams can focus on actively communicating the company's ESG initiatives and performance to LPs. They may provide ESG reports, participate in sustainability-focused conferences, and engage in dialogue with LPs about ESG-related concerns and interests. This helps build trust and transparency while showcasing the company's commitment to sustainable practices.

Human Resources (HR): HR departments can (and should) incorporate ESG considerations into their policies and practices. For example, they can prioritize DEI (Diversity, Equity, and Inclusion) by implementing inclusive hiring practices, promoting equal opportunities, and fostering a respectful and inclusive work culture. HR can also provide ESG training and education to employees, ensuring they understand and align with the company's ESG vision and values.

Operations: ESG integration in operations involves implementing sustainable practices across the company's supply chain, production processes, and resource management. For instance, operations teams can reduce waste, optimize energy usage, source materials responsibly, and promote recycling and circular economy practices. They may also adopt eco-friendly technologies and invest in renewable energy sources to minimize environmental impact.

Sales & Marketing: From a sales and marketing perspective, ESG integration means highlighting the company's sustainable and socially responsible practices in its branding and messaging. Sales and marketing teams can communicate the company's ESG initiatives through marketing campaigns, social media, and other channels to raise awareness among customers and stakeholders. This can include showcasing sustainable product attributes, social impact programs, or environmental certifications.

Data Team: The data team plays a crucial role in ESG integration by collecting, analyzing, and reporting ESG-related data. They may develop metrics and indicators to measure the company's environmental impact, social performance, and governance practices. The data team can also ensure accurate ESG reporting, supporting the company's transparency and accountability in meeting its ESG goals.

ESG integration is a collective effort involving all departments. Each one plays a unique role in aligning its practices with the organization’s overarching ESG principles. Only then will meaningful change happen. 

A quick recap

ESG integration involves considering non-financial factors alongside financial metrics through the entirety of the investment process—from assessing initial opportunities, to conducting due diligence, to managing portfolio companies and all the way until exit. It goes far beyond ESG as a standalone consideration and seeks to integrate sustainable value creation throughout the private equity investment lifecycle.

Learn more about the business case for ESG measurement and management, the notable difference between ESG leaders vs. laggards, as well as practical tips to get you started on your own impact  journey by visiting these articles next: 

• ESG Is An Essential Tool for Private Equity. Here’s Why.
• ESG Isn’t About Compliance. It’s About Competitive Advantage.