The realm of private market investing is witnessing a transformative wave: the rising prominence of sustainability. Despite recent backlash and politicization of ESG, sustainable investing remains a strong priority for many firms—and a business imperative. A recent study by McKinsey & Company reveals a striking fact: companies with high ratings for Environmental, Social, and Governance (ESG) factors have a 10% lower cost of capital compared to their lower-rated counterparts. There’s a pivotal shift in investment paradigms, highlighting the increasing relevance of ESG in private equity (PE). So, where should firms begin? In this guide, we’ll walk you through everything you need to know to start considering ESG investments as a PE firm.
Fundamentals of Sustainable Investing
ESG stands for Environmental, Social, and Governance( ESG) in PE means evaluating potential investments not just on financial returns, but also for risk mitigation specific to their environmental impact, social responsibility, and governance practices.
Historically, ESG considerations were secondary if at all present in the investment decision-making process of PE firms. However, this trend has shifted dramatically in recent years — in part because of the regulatory landscape favoring sustainability, and the business value associated. A report from the Principles for Responsible Investment (PRI) indicates that over 80% of private equity investors now consider ESG factors central to their investment decisions. This evolution reflects a deeper understanding of how ESG factors can impact long-term investment performance.
Growing Importance of ESG in PE
While the tide has not unilaterally turned, sustainability is no longer a fringe concern, and has emerged as a common and central theme driving investment decisions. With the Principles for Responsible Investment (PRI) as a guiding framework, institutional investors are increasingly demanding ESG integration throughout their portfolios, and private equity (PE) firms are rising to the challenge.
The urgency of decarbonization, particularly in traditionally high-impact industries like energy and manufacturing, is shaping the investment landscape. Gone are the days of overlooking environmental footprints; today, PE firms managing large portfolios are actively engaging in strategies to reduce their carbon footprint. A staggering 72% of institutional investors, according to a Preqin survey, factor ESG considerations, including decarbonization, into their investment choices. This shift in priorities is clear: a demonstrated commitment to decarbonization becomes a key differentiator in attracting capital.
Leading PE firms are paving the way with innovative approaches. One such example: KKR's $2.8 billion Global Impact Fund II, invests in companies that deliver scalable, commercial solutions to global problems across key investment themes of climate action, sustainable living, lifelong learning, and inclusive growth. As summarized in the firm’s press release by Ken Mehlman, KKR Partner and Co-Head of KKR Global Impact, “Globally, there is increased urgency to solve some of the world’s greatest challenges, such as the energy transition, supply chain resiliency, digitization and a shortage of skilled workers.” By focusing investment strategies on companies that create business opportunities to address these widespread global challenges, leading firms are taking advantage of these macro tailwinds.
This strategic imperative of ESG integration is further underscored by research from the Global Impact Investing Network (GIIN). Their findings reveal that impact investments, heavily focused on ESG criteria, not only deliver compelling returns but often outperform traditional investments. Decarbonization, as a crucial component of this strategy, offers PE firms a multitude of benefits:
- Risk Mitigation: By proactively reducing their carbon footprint, PE firms mitigate the risk of their investments becoming stranded assets in a rapidly decarbonizing world.
- Regulatory Compliance: Stringent environmental regulations are becoming the norm across geographies. Firms leading the decarbonization charge are better positioned to navigate these evolving regulatory landscapes.
- Operational Efficiency: Implementing energy-efficient practices can translate into significant cost savings, bolstering the bottom line.
- Reputational Advantage: Companies with strong ESG credentials, particularly in decarbonization, enjoy enhanced brand reputation and customer loyalty, leading to a competitive edge.
By embracing the principles of sustainable investing and prioritizing decarbonization strategies, PE firms not only accelerate solutions addressing widespread global issues, but also unlock new avenues for long-term value creation. The journey towards a sustainable future requires collective action, and PE firms have a crucial role to play alongside institutional investors in building a more resilient investment landscape.
Decarbonizing Investment Portfolios
In the realm of private equity (PE), sustainability is no longer an afterthought but a vital component of investment strategies. At Sustain.Life, we emphasize the importance of integrating Environmental, Social, and Governance (ESG) considerations into the very fabric of investment processes. Here’s how PE firms can effectively enhance sustainability:
1. ESG Due Diligence: Understanding the Scope and Importance
- Conducting Comprehensive ESG Assessments: The process begins with an in-depth ESG assessment during the due diligence phase, and will vary by sector and material risks.
- Identifying Risks and Opportunities: This step is critical in identifying potential environmental liabilities, social governance issues, and the overall quality of management practices. It enables firms to pinpoint risks and opportunities related to sustainability at an early stage in the investment process.
2. Setting ESG Goals & Collecting Metrics: Creating a Blueprint for Sustainability
- Defining Clear and Measurable Objectives: Establishing explicit ESG goals is vital. These objectives typically align with the firm's overall investment strategy and may be bucketed in distinct themes such as climate or equity. It's not just about ticking a box; sustainability needs to be a fundamental aspect of the investment’s value proposition.
- Metrics and KPIs: Utilize Key Performance Indicators (KPIs) and metrics to quantify these goals. This could include carbon emissions, reductions achieved, , renewable energy, or waste diversion rates.
3. Stakeholder Engagement: Building a Culture of Sustainability
- Inclusive Approach: Engaging all stakeholders – including investors, management teams, and employees – is essential. This ensures that everyone is on board with the ESG integration process and understands their role in achieving the set goals.
- Communication and Collaboration: Regular communication and collaboration among stakeholders ensure a unified approach to sustainability. This could involve training sessions, workshops, and regular updates on progress.
4. Continuous Improvement: Evolving with Changing Standards
- Regular Review and Adaptation: Sustainability is a dynamic field, with new challenges and standards emerging regularly. PE firms must continuously review and adjust their ESG strategies to stay ahead of the curve.
- Leveraging Technology: Use advanced technology and data analytics to monitor progress, identify areas for improvement, and make data-driven decisions. Technologies like AI and blockchain can play a pivotal role in tracking carbon emissions and ensuring transparency.
5. Decarbonization: The Core of ESG Strategy
- Focus on Carbon Footprint: Central to the ESG strategy is the focus on decarbonizing investment portfolios. This involves data acquisition, reduction strategies, and peer benchmarking to assess performance.
- Investing in Green Technologies: Allocate resources towards innovative technologies that promote decarbonization. This could include renewable energy projects, sustainable agriculture practices, or green manufacturing processes.
- Carbon Offsetting and Credits: Leverage portfolio scale and explore meaningful opportunities for carbon offsetting through nature-based and technology-based solutions.
In today's market, technology and data are indispensable tools in monitoring and implementing ESG goals. Platforms like Sustain.Life are instrumental in managing portfolio ESG metrics, engaging with portfolio companies, and driving meaningful, auditable, progress. These platforms provide automated data collection, auditability, data governance, and analytics, operationalizing fund-level ESG goals across portfolio companies.
As the role of ESG continues to evolve, it becomes increasingly clear that sustainable practices are key to achieving long-term financial success. Private equity firms that embrace and integrate ESG principles are positioning themselves to lead in a future where sustainability and resilience are at the forefront of investment decision-making.
Discover how Sustain.Life can streamline ESG metrics across investment portfolios and provide practical guidance to build ESG capacity and drive decarbonization across portfolio companies.
1. McKinsey & Company, "Why ESG is here to stay." https://www.mckinsey.com/capabilities/strategy-and-corporate-finance/our-insights/why-esg-is-here-to-stay
2. Principals for Responsible Investment, "Responsible private equity: Our data reveals some emerging best practices but there is more work to do." https://www.unpri.org/pri-blog/responsible-private-equity-our-data-reveals-some-emerging-best-practices-but-there-is-more-work-to-do/11286.article
3. Principals for Responsible Investment, " TECHNICAL GUIDE FOR LIMITED PARTNERS: RESPONSIBLE INVESTMENT IN PRIVATE EQUITY." https://www.unpri.org/download?ac=10459
4. Prequin, "42% of AUM across private capital is managed by funds that have an active ESG policy." https://www.preqin.com/Portals/0/Documents/ESG%20Report%202022%20press%20release.pdf?ver=2022-06-27-100234-937
5. ESG Today, " KKR Raises $2.8 Billion for SDG-Focused Global Impact Fund." https://www.esgtoday.com/kkr-raises-2-8-billion-for-sdg-focused-global-impact-fund/
6. Global Impact Investment Network," IMPACT INVESTING DECISION-MAKING: INSIGHTS ON FINANCIAL PERFORMANCE. " https://thegiin.org/assets/Impact%20Investing%20Decision%20making_Insights%20on%20Financial%20Performance.pdf
7. ESG Dta Convergence Initiative, https://www.esgdc.org