Despite market turbulence, private equity is reaching new heights, with dry powder reaching an all-time high of $3.7 trillion in 2022. Driving this growth is the fact that even median private equity returns of 19% net IRR are more than triple the forecasted S&P 500 performance for the next decade.
But as the industry matures, investors increasingly focus on finding private equity firms that generate strong returns while adhering to environmental, social, and governance (ESG) principles.
The Rise of ESG in Private Equity
ESG has become a significant focus for the private equity industry in recent years. In fact, a 2022 survey of LPs found that 70% consider ESG when making investment decisions, and 85% of those LPs have an ESG investment policy fully (52%) or partially (33%) implemented in private equity portfolios.
This focus on ESG is not surprising, as firms that embrace sustainable practices tend to be more profitable and have better risk management processes in place. In addition, investors are becoming increasingly aware of the societal impact of their investment decisions and want to support companies that are making a positive difference in the world.
However, LPs are under-committed versus their targets for sustainable and impact investing. Another study found a nine-point gap between the target allocation to PE and the actual allocation, with a 21% target for private equity and only 12% actual exposure.
This means there is still significant room for growth in ESG-focused private equity investing. And as more LPs commit to sustainable investing, the pressure will be on PE firms to step up their ESG game.
Why ESG Drives Outperformance
ESG isn’t just a feel-good social responsibility initiative – it makes good business sense. An Accenture study reveals that 81% of sustainable indices outperformed their peer benchmarks in 2020. Why? Because increasingly, society is demanding that businesses take into account the environmental and social impact of their actions.
Several factors, including regulatory intervention, input costs, supply chain reliability, and competitive positioning are driving this societal shift.
Reducing Regulatory Risk
A Bank of America analysis reveals that ESG controversies have wiped $500 billion off the market value of companies in the last five years. This includes significant regulatory fines, including over $243 billion in fines paid by banks since the financial crisis.
Similarly, anti-competitive practices and privacy violations have led to billions of dollars in regulatory fines for companies like Google and Facebook. As society becomes more aware of the risks posed by climate change, we can expect more significant regulatory intervention in the coming years.
This means that companies who fail to consider their actions’ environmental and social impact will be at a competitive disadvantage. Those who adapt their business models to address these issues will be better positioned to thrive in the new regulatory environment.
Lowering Input Costs
Inflation remaining well above historical averages means that the cost of inputs is still high. This puts pressure on companies’ margins and raises the risk of inflationary spirals.
However, companies incorporating sustainability into their business models are less exposed to these cost pressures. As McKinsey explores, managing supply chain efficiency can help companies reduce their input costs.
Increasing Supply Chain Reliability
The war in Ukraine and the pandemic before it exposed the fragility of global supply chains. As businesses scrambled to source alternative suppliers, many faced the risks of relying on a single supplier.
Incorporating ESG considerations into supplier selection can help mitigate this risk. For example, they can work with suppliers based in countries with a stable political environment.
This approach can help companies avoid disruptions to their supply chains and ensure they have access to the inputs needed to maintain or increase production levels.
Investors Increasingly Expect ESG
As ESG becomes more mainstream, investors increasingly expect private equity firms to have a robust ESG strategy in place. In fact, Gartner research reveals that 85% of investors considered ESG factors in their investments in 2020.
To meet this growing demand, private equity firms must prioritize ESG. This means integrating ESG into all aspects of the business, from investment decision-making to portfolio company management.
Firms that fail to do so will miss out on potential investment opportunities and risk losing favor with LPs. This is a recipe for disaster in the competitive world of private equity.
How Private Equity Can Lead the Charge on ESG
Private equity firms are uniquely positioned to drive real change as the world increasingly awakens to the importance of environmental, social, and governance considerations.
First and foremost, private equity firms exist to create value. And while there is some debate over how best to measure that value, there is no doubt that high-performing PE firms seek to increase growth sustainably. As such, they are uniquely positioned to reap the benefits of ESG initiatives in terms of reputation and value creation.
Second, private equity firms have a close relationship with their portfolio companies. This gives them a great deal of influence when it comes to setting the strategy and driving operational excellence. And while some might argue that this puts them at odds with ESG goals, the reality is that PE firms are well-positioned to help their portfolio companies strike the right balance between financial performance and societal impact.
Finally, private equity firms are often lauded for their ability to think long-term. This is another key advantage when it comes to driving ESG initiatives, as many of the most impactful changes take time to implement and require a long-term commitment.