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Sustainability Boosts Returns for Private Equity Funds

Part III: The Fine Print of ESG Underwriting

In the second installment of this series, we highlighted how private equity fund managers can drive value creation across their portfolios by integrating efficient resource management expertise into operational teams and broader corporate strategy, as well as by bringing in experts in resource saving practices where appropriate. Major funds have found that doing so is an effective tactic to identify substantial cost savings while also producing broader strategic benefits. Today, we move upstream in the investment cycle to the acquisition phase to examine how private equity general partners (GPs) can benefit from enhanced consideration of environmental social and governance (ESG) factors during the due diligence process.

For prudent investment managers, robust due diligence is fundamental; in considering acquisition of a company or asset, due diligence is a chance to ‘test drive’ the investment and look for risks or opportunities which might affect value in the future.  GPs are accustomed to looking closely at a wide range of issues during due diligence, from company financials and quality of earnings to operational issues and corporate governance.

Private equity due diligence has traditionally incorporated basic environmental, health, and safety diligence, including compliance with local law and – where relevant – the development of environmental impact studies.  However, GPs are increasingly expanding their focus on ESG issues such as resource efficiency, mitigation of long term environmental risks, working conditions, and good corporate governance practices.

There are multiple drivers behind this increasing focus on ESG in the diligence process. Prominent among these is the expectations of important stakeholders including the large institutional investors such as pension funds, university endowments, and development finance institutions which invest in GPs. These organizations, which are expected to generate stable returns over long periods of time, see ESG issues such as resource efficiency and the social license to operate as integral to the long term success of their assets. As a result, they have begun to place higher expectations on GPs.

The British Development Finance Institution, for example, has produced an extensive toolkit covering the ESG expectations it places on its asset managers and how they can meet these expectations. In the US, major investors such as the California Public Employees Retirement System (CalPERS) are also increasing their ESG management requirements. The content of a Q3 2011 CalPERS Total Fund Process for ESG Integration is available online here.

Another major driver is direct value creation. As explored in our last installment of this series, GPs can realize attractive cost savings by focusing on resource optimization. Forward thinking fund managers will look for such optimization opportunities, such as facilities retro-commissioning or lean manufacturing, while considering an investment. As explored in our last installment, which examined the McKinsey Global Institute’s finding that core commodity prices have increased roughly 160 percent during the last decade, this trend is only increasing in this era of rising prices. As a result, a variety of tools ranging from software tools such as the IFC’s Social and Environmental Management Toolkit to expert consultancies are available to help funds identify savings opportunities during due diligence.

Finally, risk profiles are evolving.  A changing climate and strained environment means that investors need to consider the impact that climate instability and shrinking resource availability, as well as tightening environmental policies may have on investments.  In a seminal report quantifying the impact of climate change on underwriting, UNEP Finance Initiative Insurance Working Group, which is composed of companies that sell products to help investors manage environmental risks, has estimated that annual losses from climate related events may top $1 trillion by 2040. Investors focused on long term success are well advised to consider how such evolving risk may affect their portfolios in the coming years.

So what actions should funds consider to benefit from integrating ESG values into their due diligence processes?

1.  Develop ESG policies and due diligence requirements which meet or exceed the expectations of limited partners. More and more institutional investors expect GPs to have ESG management policies which include both negative screens (ie, not investing in companies that do not comply with the law or are in certain industries) and aspirational efforts such as investing in a more environmentally sustainable future. Responsible investment guidelines such as the United Nations Principles for Responsible Investment are a great starting point in building such a policy, though each GP should consider how such principles relate to their particular investment thesis.

2.  Look for value creation opportunities through resource optimization.  Where possible, funds should look for value creation opportunities around resource optimization during the due diligence process.  In doing so, it is important to match the right resource and environmental considerations with the acquisition target’s industry; environmental optimization opportunities for a steel manufacturer will be different than a chain restaurant!  Fortunately, resources and experts exist to help in matching resource optimization opportunities with different types of acquisition targets.

3.  Consider mid to long term sustainability issues.  Beyond immediate resource saving opportunities, it is worthwhile to consider long term sustainability issues which might affect an acquisition target.  For instance, when acquiring a large portion of China Fishery Group Limited, an industrial fishing company with operations across the Pacific Ocean, the Carlyle Group identified marine sustainability as an issue. Having done so, Carlyle engaged China Fishery post-acquisition to begin work toward Marine Stewardship Council certification – an effort which helps the portfolio company to grow in a more sustainable way.

Due diligence is a critical component of any transaction. By integrating thinking about environmental, social, and governance issues into due diligence, funds position themselves for sustainable success.

In our next installment, we will look at how funds can effectively engage key stakeholders on sustainability issues.

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. Please contact us to discuss sustainability for private equity.

This article was written with MSP Managing Partner Andrew Malk. If you have enjoyed this series so far, we invite you to also download Malk Sustainability Partners’ tear sheet outlining how private equity funds can unlock value through sustainability online here.

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