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Sustainability Boosts Returns for Private Equity Funds, Part II

Maximizing Earnings through Environmental Management

In the first installment of this series, we provided a brief overview of why sustainability matters to private equity fund managers and how environmental, social, and governance (ESG) management can be leveraged to unlock value.  This article will focus on how private equity general partners (GPs) can maximize portfolio EBITDA (earnings before interest, taxes, depreciation, and amortization) by utilizing sustainability as a lens to identify cost saving opportunities. Leading funds are already leveraging sustainability to create strategic advantage for their portfolio companies and global trends will only make this issue more crucial during the coming years.

While business success in the last century was based upon maximizing returns from labor and capital investments, earnings in this century will grow increasingly dependent on efficient management of resources. A recent study by the McKinsey Global Institute found that, in real dollar terms, commodity prices have increased 160 percent during the past decade. This trend is accelerating; during the coming years, energy, steel, water, and other commodities will become increasingly expensive with more volatile pricing.  In fact, McKinsey has calculated that the commodity uplift of the past decade has completely erased the gains of the preceding century.  As a result, businesses and societies are focusing on how to produce more economic value with fewer resource inputs.

Smart companies are already integrating this thinking into their business planning.  For example, Paul Polman – CEO of the consumer product giant Unilever – has famously pledged to double his company’s revenue while halving its environmental footprint (more information here).  I had the chance to speak with Polman about these issues last year; to him, reducing the impact of Unilever products is about the long term success of his business as those products depend on an increasingly taxed agricultural system.  Managing footprint is managing exposure.

Private equity fund managers are in a unique position to help their portfolio companies benefit from improved resource and environmental management.  As Toby Mitchenall of Private Equity International noted in the publication’s first Responsible Investing Compendium, “Management teams at private equity-backed businesses are incentivized to grow the value of the business over the medium-term, not to hit targets on a short-term basis, as is often the case with public company executives. The private equity shareholder is not a disparate group of nameless individuals represented by a group of non-executive directors. It is a narrow, focused group of shareholders with their own capital at stake.”  With an appropriate investment horizon and a significant level of influence over the companies they own, fund managers are ideally positioned to promote sustainability – and to create additional value for themselves and their investors from doing so.

So what actions can private equity GPs take to enhance the environmental performance of portfolio companies?  Fund managers should consider the following approaches:

  • Incorporate Sustainability Services into Operational Teams – Many private equity funds have operational teams dedicated to assisting portfolio companies with everything from sourcing to sales.  By focusing on resource efficiency, these teams can help their companies cut costs.  By wielding this approach, KKR helped portfolio company US Foods to avoid $30.6 million in energy and fuel costs between 2008 and 2010 while saving the same GHG emissions as almost 6 million propane cylinders for home barbeques.
  • Engage External Experts – As keen spotters of growth opportunities, GPs know when to engage experts who can assist portfolio companies in integrating business process improvements.  Specialist consultancies assist funds with a range of such services from lean manufacturing to enterprise resource planning.  Recognizing that resource efficiency is becoming a material element of optimizing business performance, funds like the Carlyle Group engage experts to help with sustainability initiatives.  For example, at Allison Transmission, Carlyle identified $1.2 million in annual savings while saving the GHG equivalent of taking 2,800 cars off the road.  They did so by organizing an ecomagination Treasure Hunt supported by external experts who helped to propose 20 separate process improvements to cut resource use and costs.
  • Integrate Sustainability Initiatives into a Broader Strategy It is tempting to focus only on the low hanging fruit; i.e. executing one-off initiatives such as lighting retrofits without considering a broader strategy.  Doing so risks leaving many other benefits on the table.  Taking a big picture view of sustainability, which often means setting targets to reduce impacts in a company’s key impact areas, forecasting sensitivity to volatility in resource availability, and focusing on ongoing improvements in environmental management, among other initiatives better positions both businesses and funds to identify the next generation of opportunities and secure long term value.  That’s why Paul Polman embedded this strategy into Unilever’s corporate mission and set long-term, sweeping targets for Unilever.

These actions, and others, can help fund managers create value for their portfolio companies through sustainability.  The green lens helps to cut costs and reduce risks, which in turn translates into increased value for them and their investors when funds exit holdings at a multiple of earnings.

Beyond engaging portfolio companies on resource efficiency, private equity GPs can manage exposure to environmental issues by integrating ESG considerations into the investment decision process.  Our next installment in this series will examine this issue by considering how ESG can be integrated into the due diligence process.

Zach Goldman is a Partner with Malk Sustainability Partners (MSP), a specialty management consultancy, which guides businesses in developing profitable corporate environmental sustainability programs.  MSP has particular expertise in engaging private equity funds to unlock value through shifts in thinking about sustainability.  This article was written in collaboration with MSP Managing Partner Andrew Malk. If you have enjoyed this series so far, we invite you to also download Malk Sustainability Partners paper outlining how private equity funds can unlock value through sustainability online here.

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