How to Incorporate ESG into Investor Due Diligence

Private equity investors are increasingly recognizing—and responding to—the importance of ESG (Environmental, Social, and Governance) factors in their investment decision-making processes. To achieve strong outcomes that unlock value drivers and contribute to long-term sustainable returns, firms must set the precedent for good ESG practices from the very outset of their investment cycle. Which means starting with rigorous due diligence. This guide outlines how to effectively integrate ESG factors into the due diligence process for private equity investors.

5 Steps to successfully implementing ESG due diligence

Step 1: Leverage an ESG Framework

Define ESG priorities. Identify the key ESG factors that are relevant to your investment strategy. Consider sector-specific ESG issues and align them with your fund's investment goals.

Choose Corresponding ESG metrics. Establish specific ESG metrics and targets to track the performance and impact of potential investments. Consider using widely recognized frameworks such as the EDCI or SASB for a more standardized and consistent reporting structure. 

Step 2: Establish a Screening Procedure for Potential Investments

Integrate ESG into the screening process. Review potential investments against your established ESG priorities and metrics. Exclude companies that don't align with your fund's ESG objectives. This helps screen out negative risk and will narrow down the investment universe. Do the companies you are targeting have areas where ESG could help them significantly? Would reducing GHGs make them more profitable, for example? How about turnover – would implementing a plan to reduce turnover give them a turnaround value? Work with your provider to create a set of surveys that quickly gets you the information you need to know if your target investment has good ESG potential. Remember, it’s not about being good now. It’s about finding the right places where your investment itself can help change the company for the better. 

Use Third Party ESG data providers to help identify criteria. Partner with a trusted data expert for step-by-step guidance on how to collect, wrangle, and track the information required for meaningful ESG analysis specific to your fund. Meanwhile you can use Public Markets ESG data providers such as MSCI ESG Research, Sustainalytics, or Bloomberg ESG for broader trends to potentially guide you. These entities may offer ESG ratings, reports, and analyses based on industry-specific criteria.

Step 3: Conduct ESG Due Diligence

Inform and educate deal teams. Inform and educate deal teams. Private equity deal teams play a critical role in conducting ESG due diligence since they’re the ones assessing investment opportunities. It’s a smart move to provide deal teams with the necessary education and resources around ESG factors. One way to do this is to develop rubrics and tools specifically tailored for ESG due diligence. These should outline key considerations for deal teams to evaluate, such as standard ESG metrics, regulatory compliance laws, best practices around labor and supply chain management, and stakeholder engagement efforts. By establishing a structured framework, deal teams can consistently incorporate ESG factors into their analysis for more informed investment decisions that align with sustainability objectives. Regular training and knowledge-sharing sessions can further improve the capabilities of deal teams in integrating ESG due diligence into their investment process.

Balance risks and opportunities. During due diligence, assess the target company's ESG performance, potential risks, and value drivers. Engage with management to gather relevant ESG-related information. Get their opinions on how they can see ESG playing into reduction of risk and increase of value. This will open up new ideas potentially, or if not, then it also serves as a way of identifying who on the leadership team can be your ESG champion. 

Assess ESG governance practices. Evaluate the company's governance structure, board composition, executive compensation, and policies related to risk management, ethics, and compliance. Benchmark not only against industry metrics where you can find them, but also against regional demographics. The US Census and BLS datasets can be helpful in both of these efforts. Your data provider should have these metrics handy. 

Evaluate environmental factors. Examine the company's environmental impact, including energy efficiency, carbon emissions, waste management, and resource consumption. Consider sector-specific regulations. Again, public datasets can help you with identifying the proper benchmarks which are not just segmented by industry but also by location. For regulations, obviously be present to the need for consulting with counsel on issues related to the environment. A baseline Scope 1, 2 should be estimated at this point as well. For their supply chain you will also want to discuss the feasibility of a Scope 3 analysis.

Assess social factors. Evaluate the company's treatment of employees, labor practices, diversity and inclusion policies, community relations, and product safety. Consider relevant social standards and industry-specific expectations. Look toward HR specialists who can act as advisors on compliance and regulatory issues. Here we are looking less for Corporate Social Responsibility efforts and instead are trying to mitigate the risks of employment/discrimination suits and increasing the potential for profitability through high employee engagement and low turnover, for example.

Review ESG-related legal and regulatory compliance. Assess the company's compliance with relevant ESG-related laws, regulations, and international conventions. Include areas such as data privacy, anti-corruption, and human rights. It’s not enough to have indemnification. You want to understand what areas of potential risk there are to resale here. Get your hands on cybersecurity questionnaires. Look at AP to identify where payments are going and place particular scrutiny on contractors and misc vendors. For human rights, you will need to examine their supply chain and whether their suppliers are filling their own proper disclosures. 

Engage external experts. Consider engaging independent experts with specialized knowledge on specific ESG issues (e.g., climate change, human rights, regulation, employment) to provide deeper insights during due diligence.

Step 4: Quantify ESG-related Risks and Opportunities

Assign risk scores. Use the gathered ESG data and analysis to assign quantitative ESG scores to potential investments. This enables comparison and benchmarking of ESG performance across the investment portfolio. Use a 5x5 risk matrix as a quick and easy tool to assess your scores. Consider having more than one person fill it out so your scores suffer less from personal bias and have multiple perspectives built in. 

Assess financial implications of these risks. Identify potential financial impacts associated with ESG risks and opportunities. Quantify factors such as cost savings, revenue growth, regulatory risks, and reputational risks to determine the financial implications. Sometimes the ick-factor of risk can translate into good opportunities for value creation. Remember, a bad score or even high risk does not automatically rule out an investment opportunity.

Integrate financial and ESG analysis. Establish reliable, repeatable and scalable processes to merge financial and ESG analyses. This is critical in understanding how ESG factors may affect the target company's long-term financial performance and value creation potential. Ultimately, the deal time should be well versed in the tradeoffs that get exposed during this discovery process. 

Step 5: Incorporate Findings into Post-Investment Terms

Develop an ESG action plan. Based on the due diligence findings, develop an ESG action plan that outlines specific measures and targets to enhance ESG performance after the investment is made. This plan can help guide value creation and ongoing monitoring. And hey, guess what? Your due diligence questions make for great continuing evaluation questions. After all the baseline for that portco will be what you found before you invested. Keep that alignment going forward.

Communicate ESG findings. Proactively share the ESG due diligence findings to the investment team, stakeholders, and portfolio companies management teams and internal helpers. The key here is fostering transparency and alignment. Make use of different mediums such as reports, training sessions and discussion groups to engage stakeholders in building a sustainability-minded company culture. And also make sure to reinforce that ESG is a process not a goal. You’re not striving for an A grade or to just be better than your peers. Great if you can do that. But also great if you are able to move the needle every quarter on issues that matter to us all AND drive excellent resale value for the investment.

Contact us

We hope this article serves you well. But remember, you don’t have to do this alone. Nor should you. It’s a best practice to hire a third party so that you can keep an objective eye on your ESG progress and help you with making change a way of doing business. So give us a call and we can talk it through. 

For more valuable tips on how to translate your ESG strategy into a competitive advantage, check out the other articles in our series:

• ESG Isn’t About Compliance. It’s a Competitive Advantage.
• ESG Integration in Private Equity: From Due Diligence to Exit