How ESG Factors Can Boost Private Equity Returns

Frequently measuring, reporting, and monitoring ESG work does little to improve financial results. But funds that make real changes based on environmental or other factors can increase IRRs, research shows.

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Illustration by II

Buyout funds looking to juice their internal rates of return should consider ESG. Seriously.

New research shows that managers that take certain actions based on environmental, social, and governance-related findings at portfolio companies can help private equity funds improve their net IRR by up to 12.4 percent over the life of the fund.

“By systematically integrating ESG strategies and streamlining management approaches, PE investors can effectively drive positive ESG outcomes within their portfolio companies, ultimately benefiting both financial performance and sustainability objectives,” according to a new paper from EBS Universität scholars Noah Bani-Harounia, Ulrich Hommela, and Falko Paetzold.

Their paper links ESG actions to higher private equity returns for buyout funds. It also explores what ESG strategies work — and don’t.

The researchers looked at 206 buyout funds across 103 private equity firms using PitchBook data. The majority of the investors, 74 percent, are based in the United States. The remainder are European private equity firms. They augmented the data with the RepRisk database, which measures the portfolio companies’ ESG scores, as well as the United Nations PRI database and Environmental Performance Index.

The research identifies specific ESG management strategies that move the needle — and those that do not — offering managers the information they need to make effective ESG decisions.

To start with, by improving a firm’s ESG score — as defined by their RepRisk ESG ratings — by 50 percent can improve their net IRR by up to 12.4 percent over the life of the fund. This was true for funds with more than €1 billion in assets.

The study shows evidence that ESG outcomes are far more effective when implemented by the investment management firm, rather than by the portfolio companies themselves. Putting into place dedicated ESG value enhancement plans that articulate the improvements a manager will make over the fund life is effective, they found. Researchers found that this not only improves valuations but can also increase sales growth at the portfolio company level.

However, the researchers did not find evidence that frequent ESG data reporting moved the needle on returns or actual impact. The same was true for monitoring ESG improvements. In other words, the simple act of measuring and reporting ESG work is not enough to improve outcomes for firms. Funds need to make actual changes before they see improved performance.

“By prioritizing ESG practices within their portfolio companies, PE firms can position themselves as stewards of responsible and compliant investment practices,” the paper said. “This approach not only mitigates legal risks but also aligns investments with the changing expectations of regulatory authorities and stakeholders.”

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