Top private equity firms must incorporate ESG practices to improve financial returns, exit opportunities, and deal-making processes, making it a vital tool.
According to an E&Y analysis, top private equity (PE) firms must incorporate ESG practices to improve financial returns, exit opportunities, and deal-making processes, making it a vital tool.
The PE funds that implement advanced ESG practices can achieve an internal rate of return (IRR) that is up to eight percentage points higher than that of their rivals.
ESG should be completely incorporated into all operations, changing from a compliance tool to a cross-functional value creation enabler, in order to optimize returns, according to E&Y.
Societal impact drives stronger financial results, accumulating value throughout the investment cycle. Treating societal and shareholder value effectively positions private equity for optimal outcomes, the market analysis firm said.
Private equity value creation services:
A recent EY-Parthenon study indicates that funds with strong ESG positioning can outperform their rivals by up to eight percentage points in terms of IRR.
Most funds now incorporate environmental, social, and governance (ESG) principles into their value creation and deal-making processes due to their significant impact on financial performance.
Businesses often treat ESG as a reporting exercise, but integrating principles throughout the company is the true opportunity for increased returns. A recent EY PE Pulse survey found that less than one in three general partners are holistically examining ESG to drive deal metrics and ROI, instead of focusing on recent regulations.
ESG remains crucial in investee companies’ value creation strategies, and funds should maximize ESG’s potential to profit from operational improvements. ESG should be integrated into all business operations, from exit planning to LP fundraising, to optimize financial returns,
EY said.
Advantages of an integrated ESG practice:
Improved deal-making processes: ESG teams can be undervalued as deal accelerators if they are seen as separate entities. Integrating ESG teams with deal teams can help detect investment opportunities that meet the fund’s ESG principles and yield high returns, expedite sourcing, reduce execution time, and lead to better investment decisions and favorable lending terms.
Optimized value creation strategies: Businesses with robust ESG policies can boost profits by cutting wasteful product lines, increasing customer base, and negotiating better financing terms. Sponsors must maximize these tactics to yield the highest return on investment. An integrated ESG strategy ensures deal teams, operating partners, and portfolio management focus on initiatives positively impacting sales, profits, and financing.
ESG as a route to superior exits: ESG-focused businesses are valued by acquirers as lower-risk investments. PE firms can position portfolio companies as sustainability leaders, attracting a wider range of bidders and making auction procedures more competitive.
How to unlock the financial potential of ESG?
Three steps can help PE firms create a return-maximizing ESG strategy that integrates all operations and optimizes financial returns.
- Strategic fund structure: The client needs to evolve, with separately managed accounts enabling funds to create fundraising plans aligned with investor objectives and ESG preferences, ensuring stakeholder buy-in. Investor relations teams collaborate with ESG teams to create transparent fundraising documentation, ensuring accountability, investor confidence, and alignment between GP and limited partners. This includes creating private placement memoranda, dynamic fund structures, specialized committees, and reliable reporting systems.
- Incorporate ESG into assurance work: Integrating ESG into all assurance processes helps businesses meet regulatory requirements and take advantage of incentives, reducing expenses and increasing EBITDA by balancing sustainability and financial objectives.
- Full investment cycle integration: Integrating ESG into deal origination and due diligence helps firms identify post-acquisition value creation opportunities, evaluate risks, and understand the market landscape. Funds prioritize ESG strategy as managers focus on capital allocation and returns. Consistent improvement and refining of ESG equity stories optimize upside potential, especially with ESG-interested buyers.
Summing-up:
To optimize financial performance in PE funds, it’s crucial to integrate ESG into origination and diligence, create a 100-day plan for ESG strategy, develop a robust ESG equity narrative, and engage with ESG-focused buyers early. Leading firms should integrate a holistic ESG strategy across the entire fund operation and investment lifecycle.
