Private Equity: Can Responsible Investment Deliver Enhanced EBITDA?
The evolution of the sustainability agenda
Corporate response to sustainability issues has evolved as companies recognize the financial impacts. Sustainable development - the notion of being able to continue current operations indefinitely - requires the concurrent management of economic, environmental and social issues. Corporate action aimed at achieving this was historically compliance driven and concentrated on risk management. Companies were protecting their licence to operate as regulations became stricter and were guarding against negative public relations caused by environmental or social impacts.
This risk focus shifted as companies began viewing business through a sustainability lens, achieving cost savings through energy and fuel efficiencies and through waste reduction. Using sustainability to obtain new EBITDA enhancement opportunities is now being expanded beyond cost cutting to revenue growth. Companies are finding ways to use the sustainability agenda to create new products and services or to modify existing ones in order to attract and retain customers who are increasingly demanding “responsible products”. Effective management of sustainability issues has become a strategic issue for large corporations, not least because these factors are increasingly linked to corporate profitability and value.
How this trend affects Private Equity firms
Private equity (PE) firms generally invest in portfolios of companies, where specific opportunities have been identified (before investing) to generate value for investors over the four-to-six years of their typical ownership period. This often highly-leveraged business model, with its focus on business efficiency and value creation, has not generally been seen to be naturally aligned with the need to take account of seemingly long-term sustainability megatrends, such as population growth or resource depletion. Furthermore, the ‘private’ aspect of the sector, with its perceived lack of transparency and accountability, led to concern among stakeholders that investments were not being made and managed responsibly.
However, the picture is changing. Over the past few years, an increasing number of private equity houses have begun to factor environmental, social and governance (or ESG) considerations into their investment strategies. These private equity managers are not only concerned to ensure that their investors are protected from the ESG-related regulatory, financial and reputational risks which their portfolio companies might face, but are increasingly aware that they can use ESG levers to maximize value creation. Indeed, PwC’s recent survey of 17 international PE Houses on ESG issues, showed that 93% of respondents believe that ESG issues can be a source of value, with 80% indicating that their attention to managing these issues will rise over the next 5 years. An increasing number of influential investors - particularly those who are signatories to the UN Principles of Responsible Investment - are asking for demonstration that their private equity managers are taking ESG issues into account in their investment analysis, ownership practices and long-term strategic thinking. In short, that they are “responsible investors”.
How can PE firms monetize the value of responsible investment?
Leading PE firms are taking ESG considerations into account and realizing incremental value throughout the investment life cycle. This process needs to start at the pre-investment stage if sustainable development considerations are to be truly integrated into the 100 day or 180 day plans for portfolio company performance improvement that are typically initiated on acquisition. Traditionally, the focus of pre-investment ESG due diligence has been on commissioning site-specific, environmental due diligence as part of risk management. For companies operating in environmentally sensitive sectors in particular, there is still a place for this – the quantum of environmental risk or contingent liability should certainly be ascertained in advance. However, today the scope of ESG due diligence has been extended to embrace both ESG opportunities and risks, and to cover the portfolio company’s entire value chain.
Having identified ESG opportunities for value creation at the pre-acquisition stage, leading PE firms ensure that they are realized during the PE house’s period of ownership. Indeed, freed of the short-term spotlight of analysts in public equity markets, PE houses have a real opportunity to think and act on a slightly longer timeline – and gain a competitive advantage in the ‘green race’.
Several PE houses have recognized the influence they can wield through having control – particularly in buyout situations – and are engaging in ESG issue management not only via representation on the board, but increasingly through a deeper level of engagement with operational management teams. Indeed, several houses are starting to work in active partnership with their portfolio company management teams to identify incremental ESG value. An example is KKR’s Green Portfolio Program which applies the firm’s approach of assessing, measuring, and optimizing performance to help their portfolio companies manage their environmental impacts while also improving their businesses. KKR has reported some impressive results: “Through energy efficiency, waste handling, process improvements and other initiatives, participating private equity portfolio companies cumulatively have avoided approximately $365 million in operating costs, over 810,000 metric tons of greenhouse gas emissions, 2.2 million tons of waste, and 300 million liters of water since 2008”. KKR is now understood to be rolling the program out to cover approximately 30 percent of companies in its global private equity portfolio.
Success in delivering value from ESG initiatives is not confined to those PE houses adopting a holistic ‘cradle to grave’ philosophy. Many are taking a ‘retro-fit’ approach. That is, they are reviewing their existing portfolios to identify opportunities to protect or enhance value which may well have been missed at a time when pre-acquisition ESG due diligence had a narrower scope. Examples include not only the “eco-efficiencies” mentioned above, but also the development of new products or services with strong ethical or environmental credentials. Such houses then have a great value story to tell at the point of exit which resonates with investors and other increasingly interested stakeholders.
Not all PE houses are yet embracing the notion of integrating sustainability considerations into the investment cycle. Nevertheless, there is evidence that consideration of environmental, social and governance issues is moving to centre stage. Those firms who are able to develop a reputation as responsible investors are likely to see tangible results through enhanced EBITDA.
Malcolm Preston is Global Head of Sustainability Services at PwC, and leads a global team of some 700 sustainability and climate change experts, with over 100 based in the UK. Malcolm's role is to drive the understanding of sustainability and climate change throughout the firm to ensure the risks and opportunities associated with these issues are considered in the advice PwC gives to its clients.
Malcolm has been a partner since 1996. Prior to joining the sustainability team he worked in the mid-market, advising fast-growing, entrepreneurial companies, and working on numerous transactions, mainly backed by PE Houses.
Malcolm has a BSc (hons) in Oceanography. He can be contacted on +44 (0) 20 721 32502 or by email at firstname.lastname@example.org
Lauren is a Director in the Sustainable Business Solutions team in New York who leads work on sustainability strategy for financial institutions. She has 14 years of experience working to monetize environmental assets for corporations and financial institutions.
She works with private equity firms to integrate sustainability into investment decisions and throughout the existing portfolio. Projects have included pilots at specific portfolio companies to unlock new value drivers and work across a portfolio of companies to leverage the benefits of sustainability initiatives.
Lauren has a Masters of Environmental Engineering, an MBA and a BA in Public Policy. Lauren can be contacted on +1 646 471 5328 or by email at email@example.com
Phil is a Director of PwC’s Sustainability and Climate Change team in the UK, specialising in, and leading our sustainability work in, the private equity sector.
Phil has had extensive experience of working with private equity houses in conducting sustainability assessments of potential acquisitions, and in developing strategy, policy and procedures for implementing a sustainability programme. He has also worked with PE Houses to develop “tools” to facilitate policy implementation, and in designing and running training events for investment professionals.
Phil is currently a member of the BVCA’s Responsible Investment Advisory Board, and has co-written Guidelines for BVCA members on sustainability risk management, published in 2011. Phil can be contacted on +44 (0)20 7212 4166 or by email at firstname.lastname@example.org.