There are two main reasons behind ESG’s growing influence in deals. First is the value attributed to the business which is increasingly being assessed not only according to financial metrics capital, but increasingly by what is fast being coined as “natural, social and human capital”. Businesses that can develop or demonstrate these forms of non-financial capital will reap the rewards. A recent NYU/Stern study, for example, found that leading your competitors and peers in the market correlates to a 12 percent uptick in market capitalisation, whereas being a stand-out leader on ESG is worth 15 percent.
The second key piece here is about the operating model; the way businesses produce their products or deliver their services has to be cleaner, greener and fairer than it ever has before, otherwise this will negatively impact value. This creates two kinds of opportunity for PE buyers: a) businesses that already have strong ESG credentials that can be further enhanced or b) businesses that have weak ESG credentials, that can therefore be bought for a lower price, ‘cleaned up’ from an ESG perspective, and sold at a premium. The real prize for PE is to look at how their portfolio company may well be valued at a significantly higher multiple of EBITDA at exit than the price at which they went in at through business and operating model shift that drives a ESG “high score”. The evidence shows that a business performing well across E, S and G will attract more interest (more bidders) and also higher multiples.
Added to these factors is the increasing pressure that PE houses are coming under from stakeholders, particularly their LPs and (for those with listed entities) institutional investors, to account for and report on their investment decisions from an ESG perspective. Plus, there is a growing set of regulations that require in-depth ESG reporting and disclosure including TCFD (Task Force on Climate-related Financial Disclosures), TFND (Task Force on Nature-related Financial Disclosures), ISSB (International Sustainability Standards Board) and the UK’s own public plans on the transition to a low-carbon future. Going forward, our view is that PE funds will struggle to raise funds if they can’t demonstrate not just compliance with ESG driven regulations but also an activists shareholder approach to changing their investee companies for the better during their period of ownership.