How ESG Works in Private Equity

February 8, 2012
  • Virginia Terry

    Former Director, Advisory Services, BSR

At a recent New York event that BSR co-hosted with Morrison & Foerster and Private Equity International, speakers from BSR, KKR, The Carlyle Group, Morrison & Foerster, and Generation Investment Management discussed how to integrate ESG considerations into the private equity lifecycle. With its long-term investment horizons and its ability to work directly with portfolio companies to improve performance, private equity is ideally suited for ESG investing. Ultimately, thoughtful management of ESG issues is critical to the success of long-term private equity investment.

Today, more than 900 organizations have signed the United Nations Principles for Responsible Investment, including at least 100 private equity firms. As firms enhance their ability to analyze and manage ESG issues, many have hired in-house experts or established partnerships with external ESG experts.

These companies are moving beyond the “why” to the “how” of integrating ESG into their practice. According to Generational Investment Management’s research, a growing number of private equity firms are integrating analysis of environmental, labor, health and safety, and ethical practices into all phases of the investment cycle. For example, The Carlyle Group is building ESG into the firm’s due diligence assessments with tools such as its EcoValueScreen that help improve acquisition decisions and uncover potential risks. During the active ownership phase, private equity firms are beginning to integrate ESG issues into company-improvement plans by investing in energy efficiency, adopting responsible sourcing policies, or improving the ability of company managers to oversee sustainability issues. During the exit phase of the investment cycle, private equity firms are increasingly assessing how new ownership will affect the company’s ESG mission—and ensure that ESG improvements are not diluted under the new ownership model.

Panelists at the event pointed out that private equity investors can prioritize ESG at three levels during the ownership phase:

Consider which issues to manage portfolio-wide: KKR’s Green Portfolio Program and Responsible Sourcing Initiative are great examples of how the firm has established energy efficiency and good working conditions as priorities for its entire portfolio and has developed resources to help improve performance.

Identify the relevant issues for each industry: Many private equity firms represent multiple companies in the same sector and can prioritize ESG issues that are common for that industry. For health care investments, for instance, a firm’s analysis may indicate that access to health care and hazardous waste are priority issues.

Integrate priority ESG issues for company-specific improvement plans: Private equity should identify priority ESG issues that may be specific to an individual company due to its business model, regional presence, past performance, or governance practices, and integrate those priorities into company-specific improvement plans.

In spite of these developments, challenges remain for private equity to integrate ESG into its practices, including defining meaningful ESG metrics, integrating ESG into the exit phase, and aligning compensation with ESG performance. Additionally, although both panelists and audience members noted an increasing interest in ESG investing from limited partners, they agreed that industry needs to better demonstrate ESG value to this critical stakeholder group.

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