Tjarda Molenaar: ESG in Private Equity in three steps

September 19, 2023

By Tjarda Molenaar, Director of the Dutch Association of Participation Companies (NVP)

The term ESG has now become commonplace for entrepreneurs, investors and an increasingly large audience. Private Equity started developing and implementing ESG policy relatively late, but the learning curve from ESG 1.0 to 3.0 is now increasing steeply.

Taking Environmental, Social and Governance factors into account became fashionable from the early 2000s. The term ESG was first used in the UN Global Compact report Who Cares Wins: Connecting Financial Markets to a Changing World (2004). Two years later, the UN Principles for Responsible Investment were a fact. A lot has changed since then and ESG is now also playing an increasingly important role within Private Equity.

The conversations I had with fund managers as part of my PhD research showed that during their ESG journey, the meaning, possibilities and limitations of ESG integration have become increasingly concrete. In my view, it is imperative that these long-term investors integrate ESG into the value creation plans for their portfolio companies. As a result, they use the power of the Private Equity model to also achieve non-financial results. Not everyone has gotten this far, but the investors who are at the forefront came to this insight in the following three steps.

ESG 1.0: Ad hoc action, driven by individuals

Between 2016 and 2018, individual investment managers started asking themselves what else they could do to contribute to a better world, in addition to good returns for investors and a positive impact on growth and innovation in their portfolio companies. Some investors cite their passion or personal values ​​as an initial incentive, others ask the strategic question of how to stay relevant in a rapidly changing world.

A striking number of fund managers first examined their own organization and tried to adjust purchasing, waste flows and travel behavior. This is under the motto: before you ask others to become more sustainable, you must first experience what is involved. The realization grew that a major positive impact can be achieved by getting the portfolio companies on board.

ESG 2.0: Policy, but little real change

From 2019 onwards, institutional investors started seriously discussing ESG with Private Equity managers who come to raise funds. Written ESG policy appears to have quickly become a hygiene factor. The great emphasis on reporting is striking. The conversation about actual change is rarely had. A gap is growing between the expectations of investors and regulators, who are pushing for broad E, S and G targets and measurements for all funds and their portfolio companies, on the one hand, and the pragmatism of the investment manager, who is trying to implement concrete changes, on the other. in SMEs.

In this phase, many fund managers allowed their portfolio companies to choose two environmental or social goals on which they wanted to make progress and monitored the actions and results in periodic consultations with the management teams. Certainly not perfect, because over time the companies appeared to choose less and less ambitious goals or to focus management attention on other priorities. This approach also did not help the ESG standard bearers in the investment teams to get their colleagues on board for the long term.

ESG 2.0 leads to more solar panels, LED lighting and other measures to reduce the CO₂ footprint, but is often separate from strategic and long-term plans.

ESG 3.0: Integration in long-term value creation

In recent years, Private Equity has thought intensively about how ESG factors can become a permanent part of long-term value creation and can therefore be managed, measured and reported, like all other topics of strategic importance.

The result is that the forerunners are now mainly looking at opportunities for improvement in the core activities of companies and at factors that are relevant to the future sustainability of the company and that can actually be improved within the term of the investment. That also means something for the approach: establishing focus, setting measurable goals and KPIs and agreeing on a timeline. This appears to be a way to get the investment teams on board and achieve challenging goals.

Many fund managers indicate that this does not always mean that the financial results of the companies immediately improve. It is assumed that demonstrable improvements will give companies a stronger competitive position and a more modern appearance, which will ultimately result in a higher price/earnings ratio upon sale.

The limits to ESG policy are becoming clearer: a positive impact on short-term results is not necessary, but a contribution to long-term value creation is an absolute must. That is also possible, because there is a lot to choose from: fund managers invest on average in two out of a hundred investment propositions. Investors can expect to choose two, with financial and social returns going hand in hand.

This article contains a personal opinion from Tjarda Molenaar