Sustainable private equity and the new drivers of value creation

Sustainability is reshaping the world, and private equity sponsors are responding by implementing new and creative investment practices, often favoring prospective portfolio companies poised for changes in societal norms, regulatory regimes, consumer preferences, and investors’ expectations. Businesses that are inattentive to growing calls for responsible stewardship of environmental and social capital are likely to lose competitive advantages and find themselves spurned by consumers and investors alike.

Private equity investors recognize the importance of ESG factors

Whether coming from customers, employees, suppliers, or communities more broadly, the call for sustainable practices has only increased since the start of the pandemic. Consumers across the Americas, Asia, Europe, and elsewhere say their spending is migrating toward companies conducting operations sustainably.¹ Brands such as Bombas, Patagonia, Reebok, and Tom’s of Maine have publicly aligned commercial priorities with environmentally and socially conscious ones, helping foster stronger connections to customers with shared values²—and investors have been taking notice.

The consumer’s call for sustainability is growing louder

Share of consumers supporting socially responsible brands, 1999–2020 (%)

The global pandemic has helped underscore the importance of the sustainable investing imperative. Exogenous risks seemed abstract to many investors until they experienced one that hadn’t surfaced in a century. More than eight out of ten private equity investors agree or strongly agree that “the COVID-19 crisis will raise meaningfully the profile of ESG.”³ A transformational black swan—the shared experience of a global pandemic—opened imaginations to a wider range of factors that can influence corporate performance, and, by extension, portfolio returns.

Private equity sponsors and LPs look to sustainability for value creation

Sustainability has become a commercial imperative since so many investors now demand it. While they still require strong investment returns, service, and transparency, sustainability has risen to a commensurate level for many investors. The reasons aren’t purely altruistic. In fact, 66% of limited partners (LPs) say that value creation is a leading driver of their ESG initiatives.⁴ Three-quarters expect sustainability to influence their investment decisions over the next five years⁵; additionally, 86% expect ESG investment opportunities to increase, and 93% agree that focusing on ESG themes will generate attractive investment opportunities.⁶ Investors limiting themselves to yesterday’s return sources may also limit portfolio performance potential as sustainability reshapes tomorrow’s economy. Private equity sponsors who fail to adapt may soon find their funding sources at risk. Whether it’s a matter of investor demand for ESG considerations or not, sponsors with a record of past success can’t count on repeat business without demonstrating a vision of and commitment to what may lie ahead.

Private equity LPs see sustainability as a driver of value creation

What are the key drivers of your ESG activity? Proportion of respondents who ranked each answer among their top three

Risk management is playing a role in the shift of capital commitments. Private equity LPs are fiduciaries who must answer to diverse constituencies of their own, including:

• Students, faculty, and alumni affiliated with university endowments
• Employees, patrons, and trustees of charitable foundations
• Unions and beneficiaries of retirement pension plans
• Citizens and government officials with sovereign wealth funds

Stakeholders are urging their fiduciaries to avoid or divest of holdings that don’t align with their values. Quickly changing attitudes toward fossil fuel exposure, for example, illustrate a case in point. During the first half of 2020, just two North American oil and gas funds closed, raising only $2.8 billion combined; during the first half of the prior year, 16 such funds closed, raising an aggregate $17.1 billion.⁷

LPs are getting more explicit about what sustainable investing in private equity means to them. The largest public pension fund in the United States, CalPERS, holds $25 billion in private equity.⁸ Its sustainable investment guidelines for the asset class call for “monitoring of ESG issues across the portfolio” in order to “focus on long-term value creation.”⁹

Long-term value creation opportunities may reside in any number of specific sustainability themes, including:

• Clean technology, renewable energy, and carbon reduction
• Community economic development, education, and housing
• Cybersecurity and data privacy
• Diversity, equity, and inclusion
• Food and sustainable agriculture
• Health, wellness, water, sanitation, and hygiene

Private equity-backed Kersia, for example, is a France-based company that focuses on farm biosecurity and food safety all along the value chain, “from farm to fork.” Its operations include dairy farming, pig and poultry farming, food service, and water treatment.¹⁰ In addition to tying its key performance indicators to its recycling of packaging, share of green products, and percentage of employees who are given the opportunity to become shareholders, the company is also funded by France’s first corporate social responsibility (CSR)-linked syndicated leveraged loan. The CSR-linked margin affects the pricing of the loan, up to 7½ basis points (bps) margin reduction if CSR targets are met and 7½ bps margin increase if targets are not met.¹¹

While it’s tempting to assign value judgments to entire lines of business, sustainable investing isn’t a binary endeavor. Sustainability spans a broad spectrum, and almost any company—no matter what its industry—can demonstrate sustainable behavior. ESG integration can be applied to a virtually limitless universe of portfolio companies and assets for consideration; even those firms whose goods or services aren’t explicitly tied to a sustainability objective can pass the test if they’re operating their businesses sustainably. On the surface, the flexible packaging market might not seem like a fertile area for sustainability, but private equity-backed ProAmpac, one of the top players in North America, has made a commitment to recyclable manufacturing and over one-third of its products are sustainable.¹² Rather than relying on assumptions about the sustainability of a particular sector or industry, investors need to do company-level due diligence to discern sustainable business practices from unsustainable ones.

Sponsors are building sustainability from a foundation of good governance

Alignment of incentives between owners and managers, along with strong systematic risk management, has been a key feature of private equity for decades. Relative to public companies, the link between the private firm’s ownership and the true direction of its business is much stronger. Smaller and more agile boards populated by professionals with the right specialized expertise can offer private equity-backed companies a competitive edge.

While good governance has been a hallmark of private equity investing, historically systematic considerations of environmental and social factors have been less prevalent in the asset class. However, the stronger ownership-management link puts private equity firms in a strong position to promote sustainability. Nimble and responsive private equity sponsors have the influence, incentives, and expertise to exercise leadership in sustainable investing. And investment decisions incorporating environmental and social considerations may help private equity firms better identify hidden ESG risks and opportunities.

As recently as 2018, there were only about 400 private equity fund managers who had signed the UN’s Principles for Responsible Investment (PRI), “agreeing to comply with, and report on compliance with, its principles.”¹³ That number has grown quickly. Including 6 of the world’s top 10 private equity firms, PRI now has 807 private equity signatories, 79 of which joined just in the past year.¹⁴ Manulife Investment Management became a signatory to PRI back in 2015, publicly affirming its commitment to sustainable investing and specific ESG initiatives across its investment teams.

Demand for climate-friendly assets may grow for decades

In the near and intermediate term, cumulative investment in the clean energy transition—renewables, electric vehicle infrastructure, and power networks—may represent a $16 trillion opportunity through 2030.¹⁵ Increasingly, institutional investors are stepping forward with public commitments to achieve portfoliowide net zero emissions by 2050, which suggests the outlook for climate-friendly assets is likely to remain favorable for decades.

Private equity investment in climate solutions is expected to increase

Likely modifications in LP investment strategies in response to climate change

Stimulus measures by governments in North America, Europe, and Asia may also increase demand. Bigger government budgets for climate-friendly assets, including renewable energy private equity, may bid up prices for sustainable investments. OECD countries have allocated $336 billion to environmental measures as part of their pandemic recovery packages.¹⁶

Private equity offers an edge as sustainability reshapes our world

One of the most underappreciated investment risk factors might be the pace of change. Investors in private equity have access to two differentiated traits that make the asset class well positioned to navigate accelerating rates of change—more control and a greater sense of urgency.

1 Control—Unlike a typical public equity shareholder who has little influence on how a corporation is run, private equity investors often take controlling positions in portfolio companies and become actively involved in setting the strategic direction of their businesses. Well-run private equity-backed companies tend to benefit from an incentive structure that aligns owners and managers and encourages the executive team to focus its best thinking and efforts on the two or three most meaningful objectives likely to drive value creation. That gives private equity investors a clear opportunity to put ESG goals at the top of a portfolio company’s priority list.

2 Urgency—Private equity investors don’t hold portfolio companies in perpetuity; the typical holding period is only about three to five years. Well-run private equity-backed companies tend to benefit from a timeline that encourages managers to promptly marshal the right resources to achieve their ESG goals. Seven in ten (72%) private equity executives “expect to capture an ESG premium in businesses they are considering exiting” and “57% say social impact policy, including diversity and equality commitments, is a critical area of ESG focus in their exits.”¹⁷

While sustainability is a goal, it’s also a journey. When it comes to creating a more sustainable world, private equity firms can have a meaningful impact by aligning the wants and needs of a portfolio company’s diverse range of constituents to focus on sustainability and create lasting value for all.

Note: All information noted about other companies has been drawn from publicly-available sources.

1 globescan.com, 2020. 2 newswhip.com, July 16, 2018. 3 cdn.ihsmarkit.com, 2020. 4 pwc.com, 2021. 5 collercapital.com, summer 2021. 6 ceres.org, June 3, 2021. 7 Preqin, June 30, 2020. 8 calpers.ca.gov, June, 2017. 9 calpers.ca.gov, March 16, 2015. 10 Manulife Investment Management manages portfolios with exposure to Kersia as of June 30, 2021. 11 IK Investment Partners, December 10, 2020. 12 Manulife Investment Management manages portfolios with exposure to ProAmpac as of June 30, 2021. 13 Corporate Governance and Responsible Investment in Private Equity, Simon Witney, 2021. 14 ifre.com, April 15, 2021. 15 brookfield.com, February 2021. 16 oecd.org, 2021. 17 ey.com, May 19, 2021.