The Best PE Investors Don’t Just Measure ESG Performance – They Manage It. Here’s Why.

ESG is no longer an option. 

It’s the new norm, and not even close to the end of its evolutionary journey. As the theme of corporate responsibility continues to grow in prominence across all industries, you will see ESG (Environmental, Social, and Governance) elements increasingly influence decision-making at every level of your organization—from operations to finance, from procurement to marketing.

Many businesses are making their first foray into the ESG space from a compliance or risk-management standpoint. But it isn’t just about the risks associated with poor ESG performance. It’s also about the opportunities that businesses can create by proactively managing material issues in the supply chain, retiring toxic assets early, and prioritizing responsible investment options.

Private equity (PE) investors are the first to admit that they’ve lagged behind on ESG performance. Funds are working to play catch up on ESG reporting and transparency requirements with varying degrees of success. But many of them are now starting to realize that it isn’t enough just to measure ESG; you actually have to manage it.

It wasn’t always this way. 

At one point, PE firms had little incentive or interest in measuring an investment candidate’s ESG performance—if anything, they were more focused on growth than on sustainable development. 

But by 2008–2012, with the financial crisis fresh in their memories and growing concerns about climate change spurring widespread activism on college campuses and beyond, even conservative PE firms had begun thinking about how best to evaluate an investment candidate’s ESG risks.

In this article, we’ll explore how ESG performance has evolved and what it now means for private equity firms looking to invest in companies with responsible practices. 

ESG Management Is More Than Just a Box-Ticking Exercise

The first-generation approach to measuring ESG performance involved ticking a box in diligence on an investment. Filling in a social assessment questionnaire and hiring independent, third-party research firms to verify your answers. 

We can understand why some PE investors see this more as a time-wasting formality than anything else. They would verify once, but it had little impact on the way they actually made decisions about investments.

That’s beginning to change.

More sophisticated reviews of company policies and practices have led to harder questions about how best to integrate ESG risks into business strategy during due diligence and beyond. 

And it’s also leading funds toward actively embedding ESG issues into their portfolios, leveraging the environmental aspects of their investments as a competitive advantage, and driving internal alignment on corporate social responsibility (CSR).

Managing Your ESG Performance Is Your Passport to Growth

The fact is, extensive ESG due diligence is becoming de rigueur for PE investors looking to deploy capital into companies that want to grow by creating sustainable brands, products, or services. More interesting though is what can be done once the investment is made.

And it’s not just about zeroing in on the risks of poor performance; it’s also about leveraging opportunities like using renewable energy sources, maintaining strong supplier relationships, and establishing workplace practices that reduce turnover—all of which make your company more attractive to customers and LPs.

The keyword here is “brand”: every business decision you make should be through the prism of communicating your brand values and differentiating your business from the competition.

You’ll also see PE firms paying more attention to how their investment thesis intersects with DEI policy, driving alignment between portfolio companies and senior management teams on objectives for environmental performance targets, which can become crucial factors in success or failure. 

And you should expect to see an uptick in reports about co-investment opportunities, as well as exits that include shared value trade sales or “green IPOs”—which often involve purchasing shares back from investors during the first few years after IPO, much like a share buyback.

ESG Performance Beyond CSR

For many PE funds, ESG integration begins by assessing compliance with existing public company standards—so it feels like less of a stretch to extend those standards to employees and customers as well. 

Yet there’s also a growing awareness around how ESG can fuel future growth, and we’re already seeing PE funds leverage opportunities like:

• Incorporating environmental factors into company planning processes (e.g., understanding whether your key markets or priority suppliers are vulnerable)
• Aligning executive compensation with social impact goals (e.g., giving management discretion over the use of financial milestones tied to sustainability gains)
• Identifying best practices for brand building in emerging markets where consumers are increasingly paying attention to whether or not companies embrace ESG and CSR policies.

The outcome is often twofold: 1) building out an ESG strategy that’s not only good for the environment and stakeholders but also boosts the bottom line, and 2) creating a framework for your organization to embed ESG concerns into day-to-day business decisions.

Proving Impact

One of the biggest challenges PE funds face is measuring the difference they’re making in quantifiable terms. The conventional wisdom in public companies has been that this is best achieved through “proxy shareholder resolutions”—asking investors to vote on changes you want to make—and getting them to do so with enough consistency and frequency to drive meaningful change. Forward-thinking investors and funds in the private sector are holding ESG commitments up to similar standards by:

• Building strong internal ESG teams (or hiring someone who does) and lining up high-quality advisors for climate risk analysis and industry-specific strategy advice
• Getting more proactive by actually creating new opportunities within portfolio companies, acting as operating partners on projects that align with the ESG strategy
• Driving sustainable change at the top by identifying senior managers who are passionate about these issues and helping them advance in their career

The challenge is finding funds with the courage to do more than just ‘check the box’ on ESG performance—AKA those who see it as a growth enabler rooted in company culture, not just an external obligation. And if you can find one, you’re likely to be rewarded well beyond conventional benchmarks.

Reality Check

Companies can take several different approaches when it comes to measuring and reporting on ESG and impact. The most basic is simply to report in dollars or percentages how much they’ve invested or generated for a given cause area, without providing granular support. 

Conversely, some have developed sophisticated systems for reporting financials in a way that helps to track and maximize downstream impact, but may not be structured in a way that investors can easily understand or analyze when evaluating potential deals. 

Others still use third-party measurement frameworks from organizations like the Global Reporting Initiative (GRI) when it comes to ESG reporting—which takes you out of play if your fund isn't certified. This means even though the rest of the market seems hell-bent on talking about impact, many aren’t yet ready to invest in it.

But impact is where the growth opportunities are. 

That will change as private markets become more sophisticated over time and GPs who can't prove their investments are creating social impact start looking for other ways to make money. 

When that day comes, investors won’t have much patience for ill-defined strategies or half-hearted efforts—and even the largest PE funds will be forced to find ways of closing performance gaps that remain stubbornly persistent today.

Managing Your ESG Performance and Impact Matters

The biggest takeaway from all of this? 

If you're a private equity investor, impact matters—and you need to manage it to win over the future. It's a choice between business as usual and a new way of thinking for firms that want to stay competitive in today's market. 

The good news is that even if your firm isn't already integrated with ESG or the data infrastructure necessary to manage it, there are ways to start building a positive impact into what you do. 

At Tablecloth, for example, our subject matter experts built a platform that houses an entire suite of digital tools designed to help PE funds easily manage their impact. We work with our clients regularly to make sure both parties can keep a pulse on fund performance across different metrics. Any adjustments to goals, targets and business strategy happen much more quickly as a result. 

Bonus: working with a trusted external data partner opens the way for third-party verification of your impact. While it may feel challenging at first for PE investors to commit to an ESG strategy (which is often outside their field of expertise), the most important thing is to take the first step. 

To conclude, this article explains that traditional private equity investors are being pressured by limited partners to demonstrate the impact of their investments. This becomes increasingly important as socially responsible investment opportunities rise in popularity with limited partners looking for sustainable returns.

Furthermore, it’s not too late if your firm is yet to integrate ESG into its business practices. There are ways of developing a positive impact framework with the help of external resources, trusted advisors, or a data partner like Tablecloth who can quickly help you launch an ESG strategy appropriate for your fund, collect the required data, and identify potential areas of risk and opportunity across your portfolio—all without missing a beat.