We’re entering a new era in the PE industry. One where ESG (Environmental, Social and Governance) integration is no longer just for stewardship funds or environmental groups. It’s becoming an integral part of companies that want to manage more effectively, as well as find growth opportunities that bring them closer to realizing their organizational goals.
Early ESG adoptees had the opportunity to gain a competitive advantage, reaping the financial and reputational benefits of integrating impact across their business. But that window is quickly shrinking as time goes on.
The reality is that ESG data collection and disclosure is rapidly becoming a baseline expectation for the financial industry. Regulators are pushing for mandatory standardized ESG disclosures. Investors are heightening their expectations for funds and their portfolios. The rapid maturation of the field means that firms that don’t achieve the minimum expectation threshold for ESG measurement will soon be left in the dust.
The good news?
There’s still time to get a head start on crafting a compelling ESG strategy and narrative.
Not all firms understand how it works yet.
But those that invest in a powerful ESG strategy that is integrated throughout their process can expect to see a dramatic shift in their fund’s ability to deliver stronger returns with lower risk. More importantly, they can confidently demonstrate their compliance with a science-backed ESG narrative when it inevitably comes time to report.
This article will cover the different ways in which a strong ESG strategy can help boost returns, what good ESG management means for LPs, and how this evolution in corporate strategy can be an opportunity for funds to showcase their leadership at this critical point in time.
Many funds have found that engaging with their companies on ESG issues helps drive improved financial performance. Not just because it makes them look better to investors or disrupts the status quo for existing management, but because it often enables fresh thinking (and faster decision-making) around key business challenges like:
With stronger teams and more efficient processes in place, you can expect to see improved operational efficiency (fewer supply chain surprises or quality issues), higher margins (due to better pricing power), greater liquidity (less working capital required for longer tenors), and better risk management (reduced cost of capital).
The great thing about looking beyond traditional ESG measures is that it opens the door to partnering with companies that might have otherwise been out of scope.
Expanding your investment universe through a clean technology lens or social innovation focus, for example, could help you generate fresh ideas while also diversifying your fund’s exposure. Both are key components of a successful PE strategy. And one that can’t be fully realized without looking beyond the traditional categories of ESG.
Impact-driven investors (and their limited partners) are starting to see companies bid differently for deals that align with their strategy. Even if it ends up being slightly more expensive on an absolute basis, the reduced risk profile means there’s less pressure to pay a premium multiple.
Capital efficiency is also improved since you’re not able to extract full value until the company reaches scale anyway… so you may as well support growth early on by taking a smaller piece of something bigger.
That said, it’s not always easy to tell if a company is truly impact-driven or simply paying lip service to ESG issues. You may need an outside perspective—one that takes the time to understand your strategy and what you’re trying to accomplish as a firm—before jumping into a transaction.
If your fund isn't managing its impact, you can expect your returns to be lower, risk higher, and growth more difficult to achieve over time.
In some cases, those impacts will only become clear in hindsight—when it's too late for investors who didn't know better. In others, however, they could spell doom for PE funds as we know them today:
If you look at the S&P 500, just about every major PE player is already present. That means there are fewer companies available to invest in. It’s also harder to find the ones with the highest growth rates and best returns potential (which makes them more expensive).
When it comes to the private sector, often the biggest challenge is the lack of consistent and high quality data. Until clear standards and regulations are established, investors will have to rely on piecemeal data and ESG ratings across different frameworks to evaluate the companies they’re investing in.
With an increasing number of investors looking for ESG integration across all parts of their portfolios, firms will need to offer clear evidence of impact inside their funds if they want to continue attracting capital.
But for many GPs, that poses a challenge: They may not have the internal capacity or expertise required to measure and manage it effectively. Or, they may not have the data to even know whether their investments are adding value beyond traditional measures.
If your fund can't or won't follow its money—and you're forced to rethink where you place your capital—a whole range of alternative investment strategies become possible. Impact-driven funds will get an early look at interesting targets while the rest of the market chases after them, limiting supply and driving up prices across PE as a whole.
If you want to stay competitive you’ll need to go back to basics: Identify opportunities for profitable growth before everyone else does, plugging away until one sticks. But this time, don't forget about the impact. A key way to differentiate yourself in the market these days is to make sure your fund has a compelling ESG narrative backed up by credible data and clear evidence of impact.
To sum it all up:
One of the best ways to get a head start on your ESG and impact strategy is to partner with a trusted third-party expert like Tablecloth. Doing so will provide you with the right combination of data analysis and visualization tools, subject matter expertise in impact strategy and framework development, and ESG storytelling insights to communicate with your LPs. No matter which route you choose, the most important thing is to take the first step.