Private Equity Exits Increasingly Hinge on ESG

Eighty percent of fund managers now see ESG questions integrated into the due diligence questionnaires for portfolio company exits, according to a new survey.

(Illustration by II)

(Illustration by II)

Environmental, social, and governance issues are increasingly impacting exit opportunities for private equity firms. But keeping up with ESG standards remains an ongoing challenge, especially for mid-market managers.

According to a new survey by U.K.-based KEY ESG slated to be released this week, firms can take as long as up to 12 weeks to collect the proper ESG data, which often results in missing reporting deadlines — something that can stall exits or even cause deals to fail.

KEY ESG, a company that helps measure, manage, and report ESG performance, based its results on a survey of 43 firms from the U.K., 43 from Europe, and 14 from the U.S.

“When it comes to your exit process, for instance, more and more buyers will be doing ESG due diligence when they are acquiring a business,” said Heleen van Poecke, chief executive at the firm. “That means if you have any ESG risks in that portfolio company, if there are any environmental damage that you’ve caused by your activities, or you have problems within your workforce, or a lack of diversity, it means that you don’t have the right governance, policies and procedures in place. That is something that will come up as a red flag in diligence now.”

Focusing on ESG during the due diligence process is especially important for U.S. managers with European limited partners, who would need to abide by E.U. regulations when it comes to disclosures. An important part of that process should include breaking down the E, S, and G components through different functions within a company, according to van Poecke.

“It is about knowing who owns what data in the company so that you can quickly assess the situation. A lot of the environmental data will sit with operations; a lot of the S data will sit with human resources; the governance data, with legal; and some the required information will sit with finance,” she said. “So what you see private equity managers do when they tackle this is they make sure they bring together the relevant group of people who own the data in those different categories, right. So that they can get to work on this pretty efficiently.”

According to the survey, 80 percent of fund managers now see ESG questions integrated into the due diligence questionnaires for portfolio company exits. “This means that being able to showcase strong ESG performance at exit, backed up with credible data, helps speed up exit processes and can indeed help investors realize a premium at exit,” KEY ESG said.

Some 90 percent of portfolio companies, however, said they were unsure of how to report on ESG data — including what kind of data to collect in order to gauge certain metrics or not having the right systems or resources in place to track the data over time.

That’s partly due to the extensive questionnaires that are now being posed by institutional investors — many of whom are based in Europe. Eighty percent of the 100 managers surveyed said it took a considerable amount of time to respond to the requests, which ate up vital resources for the firms. Seventy percent said they preferred to report on material factors, versus an all-encompassing analysis.

“Private equity funds, their limited partners, portfolio companies. and regulators will need to work together to overcome the challenges of knowing what to measure and how to report it,” the paper stated.

ESG is, by definition, a broad and mega effort — and according to the van Poecke, part of the success for managers boils down to the capability to quickly identify and narrow in on the core competences of their firm.

“When you see the best-in-class managers, they will go do their ESG due diligence as they do their financial, their tax, and all the other diligence work. They will very quickly identify the low hanging fruit, what kind of the things they can improve on in five years, where the real red flags are that need to be addressed immediately,” she said. “They will be able to set priorities together with the management team and start phasing the implementation and the improvement of those ESG metrics over time. And that, of course, for a public investor, you wouldn’t engage at the operational level in the same way. So that’s why we’re saying, look, there’s a real opportunity here to drive a lot of positive change.”