Using ESG to boost portfolio company value in private equity

In brief

• The private equity (PE) industry has embraced ESG. And companies with strong sustainability DNA outperform others on EBITDA margin by up to 21%.
  
  
• Yet sustainability still isn’t mainstream. PE investors recognize sustainability as a strong value driver but struggle with operationalization.
  
  
• Firms can accelerate sustainability by leveraging a strong digital core to unlock portfolio company (PortCo) value and maximize employee engagement.

Accelerating change

The evidence is compelling: companies with deeply ingrained sustainable management practices outperform their counterparts on EBITDA margin by up to 21%. Despite the enthusiastic adoption of ESG by PE firms over the last couple of years, we have yet to see the embedding of sustainability within value creation plans become mainstream.

Two-thirds of PE signatories to the principles for responsible investments (UN PRI) indicate they recognize sustainability as a source of PortCo value creation. Still, activities tend to focus on static pre-deal due diligence.

Teams struggle to systematically embed sustainability across the deal lifecycle. While four out of five PE investors reporting to UN PRI support their PortCos in formulating ESG strategies, around half struggle with operationalization.

Europe scores the highest globally. Still, just one out of three investment managers can prove the integration of ESG in their fund’s practices and policies. In North America, only one out of five can do the same.

Clearly, there’s massive room for improvement. And without proper ESG integration and PortCo prioritization, significant sustainability-led profits are being left on the table.

Figure 1: Global transparency of investment managers’ ESG practices

As UN Secretary-General António Guterres said, we’re past the era of global warming and “the era of global boiling has arrived.” While three out of four executives consider operating more sustainably to be a business imperative, only 15% have defined it as their top business priority.

Figure 2: A strategy-implementation gap of ESG measures leads to unrealized value (illustrative)

So, how can PE firms close this strategy-implementation gap? Here are four ways to accelerate from “what” to “how” at a time of great urgency.

1. Speak the lingua franca: Financial materiality

To gain buy-in from deal teams, operating partners and PortCo executives, sustainability must be framed in terms all stakeholders understand.

Leveraging frameworks like Sustainability Accounting Standards Board (SASB) can credibly defend certain immediate interventions and demonstrate sustainability’s criticality to the business.

Despite the importance of moving toward double-materiality — financial impact and the impact on society and the environment — we find that leaders and GPs gain broader buy-in by anchoring their messaging to single materiality (financial value only) at the earlier stages of their sustainability journey.

It’s crucial to articulate each sustainability program in terms of its financial contribution, associated risks and strategic implication to growth by presenting a quantifiable business case aligned with long-term value creation.

One example: Carlyle partnered with Included Health, one of its PortCos, to bring expert medical opinion services to other PortCos free of charge. This is helping employees and their family members navigate a difficult or complex diagnosis. A great example of the “social” aspect of ESG, Carlyle estimates that this initiative has helped participating employees and PortCos save over $200 million in healthcare related costs annually.

2. Land and expand: Prioritize margin expansion

There are valuable opportunities where sustainability drives revenue growth. Sustainable consumer products yield up to 2x sales compared to their non-sustainable counterparts when aligned with consumer preferences. Likewise, for products that are truly purposeful and deliver a superior sustainable customer experience, a 5% price premium can generally be justified with sustainable consumers, which can further boost revenue.

Given limited holding periods, however, we recommend general partners (GPs) initially focus on quicker wins that prioritize margin expansion. This helps ensure speed to value, supports broad-based buy-in and expands the license to take on more ambitious efforts. It also tactically aligns with the more traditional and recognized value levers, often already stood up as a cross-portfolio GP function. For instance:

• Embedding ESG within supply chain procurement programs to maximize scope 3 decarbonization.
  
  
• Cloud has a lower total cost of ownership than on-premise software and unlocks significant new capabilities while also reducing carbon. In helping clients integrate sustainability into their cloud migration, we have seen a data center carbon footprint reduction of more than 90%.

When considering immediate cost and productivity levers, it’s important not to erode long-term organizational health in the pursuit of short-term financial profits: “value creation” plans that undermine future competitiveness, profitability and talent. A thoughtful buyer will internalize organizational health into exit value.

Figure 3: Effects of margin and revenue expansion using ESG measures on EBITDA (illustrative)

3. Share the value: Employee incentive plans

Employees of purpose-driven organizations are 25–40% more productive. Strategic workforce management can help mobilize the right ESG measures for HR, performance management and incentive plans.

Equity programs like those piloted by KKR and Partners Group allow all PortCo employees to participate in the upside of the buyout. Employees have an attractive mechanism for continuous engagement from their active ownership that aligns well with the “governance” aspect of ESG.

According to KKR, exits of companies where these programs were implemented are among their best and returned multiples of 3–10x.

4. The Trojan horse: A strong digital core

While sustainability is often considered a vertical function, it’s a horizontal capability that should be embedded into a total enterprise reinvention strategy — with organizations continually investing to improve financial and non-financial metrics alike.

A strong digital core is a critical enabler, from end-to-end carbon intelligence to PortCo-specific interventions like artificial intelligence for logistics, which reduces cost-to-serve and emissions through route optimization. It’s an already recognized cross-PortCo value lever, like procurement, and is embedded into most 100-day value creation plans.

One could say that a digital core is what truly unlocks the enterprise value of sustainable innovation, and sets up the business for net-zero to avoid ending up as a stranded business model. This is a key driver for valuation. A net-zero business has more value than a potential end of life business.

Along with the strategic role it plays, a strong digital core can also act as a tactical Trojan horse for teams looking to embed sustainability in better business decision-making.

For instance, 87% of total global commerce ($46 trillion), and a similarly high share of global emissions, currently run on SAP. Embedding sustainability modules into S/4HANA refreshes is a smart way to help ensure it becomes standardized, turning sustainability data into business intelligence from the boiler room to board room.

From deal-breaker to deal-maker

While every GP has its own investment philosophy and investment process, embedding sustainability across the investment lifecycle should now be universally accepted. Anything that can affect what should be paid for an asset, the value added during the holding period and the value achieved at exit should be considered essential for leading firms.

Material ESG risks lower the valuation in 80% of cases and can even turn into a deal-breaker. Vice versa, companies with solid ESG fundamentals tend to have less systemic risk exposure, lowering the firm’s cost of capital and translating into a valuation premium.

"One of EQT’s flagship climate initiatives is its commitment to the Science-Based Targets initiative, the global gold standard for carbon emission reductions for companies aligned with the Paris Agreement.” said Sophie Walker, EQT’s Head of Sustainability for Private Capital. “EQT is supporting its portfolio in setting targets, in ensuring high quality climate governance and sustainability literacy at Board and Management level, and in ensuring there is appropriate investment and a suitable execution plan in place to drive reductions.”

“We believe that companies with science-based targets are future-proofed companies,” Sophie added, “and will ultimately achieve higher multiples at exit. This example speaks to the scalability of the PE model — what we learn in partnership with one portfolio company on their net-zero journey can be leveraged across the hundreds of businesses in our portfolio, and is now starting to inform our approach to underwriting for new deals as well. That’s how we make an impact at scale."

The author would like to thank Jay Barrymore, Marty Glenn, Viktor Winkler and Lionel Olliver for their contributions to this article.