Center for Sustainable Business | Responsible Private Equity: Insights and Tools to Generate Financial Value From Embedding Sustainability

Private equity has a unique opportunity to create value for investors, portfolio companies and society through helping portfolio companies to embed sustainability strategies and practices that will drive improved financial performance.  Numerous studies have illustrated that ESG-focused firms have higher multiples and lower cost of capital. They note an “ESG Premium.”  A Deloitte report indicates, “Using regression analysis, we find that a 10-point higher ESG score is associated with an approximate 1.2x higher EV/EBITDA multiple. Furthermore, we also find that a company that increases its ESG score by 10 points experiences an increase of approximately 1.8x in its EV/EBITDA multiple.”  

Private equity has long prided itself on its ability to bring strategic insights and operational excellence to portfolio companies.  In today’s world of material environmental and social challenges, PE’s skills in improving management, strategy and operations can be applied to sustainability practices that will drive operational efficiencies, innovation and growth, risk mitigation, employee engagement and productivity, supplier resiliency, and so on.

NYU Stern Center for Sustainable Business research on the return on sustainability investment (ROSI), as reported in Harvard Business Review, has demonstrated that embedding sustainability core to business strategy can create a competitive moat for business leaders by driving operational efficiency, innovation, employee engagement, supply-chain resilience, risk mitigation, improved sales, and other strategic business benefits.”

We are developing an understanding of the value drivers underlying sustainability practices employed to tackle material ESG issues across industries and have turned that lens to private equity for a two-phase effort.  In the first phase we reviewed the academic literature about private equity’s performance in a series of impact categories and summarized our findings through a framework that defines best practice for both PE firm leadership and portfolio companies.  In the second phase, we developed tools for GPs, portfolio companies and LPs that will help them unlock value from sustainability strategies. Findings are summarized in an ImpactAlpha article titled "Private equity is leaving billions of dollars in sustainability value on the table."

CSB has developed a Responsible Investing Framework that provides insights into the state of private equity in terms of its contribution to creating or extracting value. The framework delineates the main categories of impact for the PE firms and their portfolio companies, including:

• management & human capital management
• financial engineering
• fund management
• strategy & innovation
• reporting transparency
• societal impact

The framework is explored further with examples and case studies in a whitepaper by NYU Stern CSB titled The Road to Responsible Private Equity.

Based on extensive interviews with General Partners (GPs) and Limited Partners (LPs), NYU Stern CSB has developed tools to help GPs and LPs to better embed sustainability strategy that drives better financial performance with PE investment processes. These tools aim to improve several gaps identified in our research, including:

1. Lack of sustainability expertise amongst GPs, LPs, and portfolio companies
2. Primary focus is on risk, compliance and reporting, rather than value creation
3. An inability to assess and capture the financial benefits of sustainability strategies despite a growing desire across the ecosystem to build and track the “sustainability stories” of portfolio companies
   •   Some research anecdotally indicates a valuation premium given to sustainable companies, yet many companies track their sustainability investments poorly, not capturing the “avoided costs” or “operational efficiencies”
4. Lack of clarity around what type of sustainability KPIs should be tracked, and how these can be tied to the underlying financial case of specific sustainability strategies
   •   Many sustainability KPIs are output-based, rather than performance and outcome-oriented (e.g., just because an ESG policy is in place, does that indicate anything about the performance of the company?)
5. Communication issues and lack of decision-useful data between GPs and LPs
   •   GPs fill out 500-question questionnaires for LPs, LPs often modifying questions slightly, leading to significant time and focus on complying to requests, yet LPs may not even look at these questionnaires once they’ve been received.  The same challenge exists regarding ESG reporting metrics for the fund – LPs rarely ask questions

Embedding Sustainability for Improved Portfolio Company Performance 

Based on our interviews and work with private equity, we find that most portfolio firms do not have sustainability expertise on staff, which limits their ability to design and execute on sustainability strategies that will unlock better financial performance.  We built this free, open source asynchronous course for portfolio companies (and PE firm  employees) based on our expertise in teaching practitioners.  It can be executed on your own timeframe (should take a few hours to be complete and can be done in stages) and covers everything from developing ESG materiality and sustainability strategies to defining and tracking sustainability related financial returns to governance and culture topics. It includes brief quizzes to check your understanding of the concepts. Register for the class here.

Sustainability Strategy Prioritization and Value Driver Tool for Due Diligence and the Holding Period

This two-part assessment and strategy tool aims to help GPs and PE practitioners analyze portfolio company performance on material ESG issues and provides guidance on which sustainability strategies and practices can drive financial value. 
The tool is intended to be used first during the due diligence phase to gain a high-level assessment of ESG-related risks and opportunities that can drive improved financial performance, then in the early holding period for material issue prioritization and strategy and KPI development, culminating in strategic inputs and ESG and ROSI (aligned financial metrics) KPIs that can be used to monitor and improve performance during the life of the investment.
During the due diligence stage, the objective is to provide an assessment of the current performance of the target on material sustainability issues, together with related value drivers.   After selecting the sector, the model automatically populates the relevant material issues specific to the sector (using the SASB standard) as well as NYU CSB-defined strategies, practices, and value drivers. The tool then guides the assessment of the target portco across several criteria. 
This assessment establishes a pulse check on the target company's performance across the spectrum of material issues and identifies red flags and upside opportunities.  A heat map (Figure 1) is generated to help make a decision on whether to move ahead with an investment.

Figure 1: Due Diligence Heat Map

The second stage of the tool is designed for initial implementation during the 100 days of managing a newly acquired portfolio company. This period allows GPs to conduct in-depth research on material issues and strategies, as well as develop specific KPIs for the sustainability strategies they intend to prioritize. Conducting this analysis at the beginning of the holding period allows GPs to: 1) Identify and prioritize the sustainability strategies that will drive the most impact and financial value (see Figure 2) and 2) Begin tracking robust sustainability and related financial KPIs from the start of the holding period to establish a record of sustainability improvement throughout the investment's lifetime (see Figure 3).

Figure 2: Scatterplot Defining Sustainability Strategy Priorities Based on Material ESG Assessment

Figure 3: Database of Sustainability and Related Value Creation (ROSI) KPIs

Additional insights into using the tool can be found in an article in ImpactAlpha titled "Equipping private equity managers to unlock value through sustainability."

Sustainability/ESG Due Diligence and Monitoring Impact

According to Private Equity International’s LP Perspectives 2023 Study, “88% of LPs take evidence and consideration of ESG into account during manager due diligence” and “69%  of LPs  believe adopting a strong ESG policy will lead to better long-term returns in their private markets portfolio.”  In a Bain report, 50% of LPs surveyed cited better investment performance as a key reason to incorporate ESG. 

However, Limited Partners typically do not have much hands-on involvement in their investments and tracking the GP commitment to sustainability can be difficult. In addition, the LPS have differing sustainability objectives – a foundation endowment, for example, might be more focused on ensuring positive social impact, while a pension fund may be looking to avoid risk due to climate change or other ESG factors.

According to interviews conducted by NYU Stern CSB, many LPs report that they struggle with creating robust engagement with GPs on their ESG approach or the sustainability performance of their portfolio companies.  There are two phases of engagement:  the first focused on due diligence related to the PE firm itself, the second on the ESG performance of the fund/portfolio companies.  The LPs use tools such as the ILPA Due Diligence Questionnaire as informed by the UN Principles for Responsible Investment DDQ, SASB standards, and side letters to track sustainability investments, but they struggle with a common approach to request and assess ESG disclosures and impacts.

Our interviews asked LPs for best practice recommendations.  Some LPs have taken current frameworks, such as the ILPA UNPRI and SASB, and adapted them to build their own custom ESG DDQ for their GP selection process.  Others are developing their own quantitative metrics to track and ask of their GPs and portfolio companies.  In addition, some have developed their own sustainability policies that require their teams to score the GP before considering any investment.
In response to the challenges, we have developed a two-phased tool for LPs to simplify due diligence and sustainability reporting, enhance transparency and facilitate ongoing assessment, ultimately aiding LPs to make informed investment decisions without compromising returns.  

Phase 1 aims to assist LPs with their due diligence of GPs regarding responsible investing criteria. Most LPs are using the ILPA/UNPRI DDQ to assess GPs. However, because the DDQ has 500 questions, we find that LPs are not able to extract the most material ESG topics related to GP performance.  Accordingly, we have extracted 80 material questions from that DDQ, adding a handful from the ESG Data Convergence Product.  LPs who use that DDQ will have already had the questions filled out and can export them.  Those that don’t use the ILPA DDQ can ask the GPs to fill out the 80 questions directly.  The responses are then graded and mapped into a few key areas (e.g. management and human capital, fund management, societal impact, strategy and innovation) so that a heatmap can demonstrate areas of strength and weakness.  The tool also points to critical non-conformities so the LP can ensure ongoing monitoring of problematic areas (should they decide to proceed with the investment.

The second part of the tool includes CSB-recommended performance-based metrics (aligned with EDCI) aimed at improving data collection and ongoing monitoring for fund and portfolio company performance.  The LP can encourage the GP to track real performance metrics which will provide more decision-useful information.

Figure 4: Overview of LP DD and Monitoring Tool for PE and Sustainability

The ratings of the material questions autopopulate a heat map that assesses performance based on the categories of impact identified in CSB’s first phase of PE research, thereby identifying areas of weakness and strength.  An additional tool highlights major non-conformities that the LP may want to discuss further with the GP.

Figure 5: Rated Assessment and Heat Map of the GP Questionnaire

Figure 6: Database of Sustainability KPIs to Improve Fund/Portco Reporting on Performance

Following are the links to the open source LP tools, as well as additional reporting tools used to track ESG investments.