Regulation, LP demand and value creation make this moment the time to mature in sustainable investing
Regulatory pressures for GPs and their portfolio companies are driving newfound interest in sustainability, as larger holdings fall into the scope of the Corporate Sustainability Reporting Directive (CSRD) and GPs rush to comply with the increasingly complex landscape of frameworks and legislation (e.g., SFDR, CBAM, CSDDD, TCFD, ISSB).
At the same time, Limited Partners (LPs) are demanding greater action and transparency from their asset managers. Among PE respondents, 44% reported that more than half of their LPs require ESG reporting, while the rest noted that 25% to 50% of their LPs mandate such reporting.3
Yet, the most compelling reason for this shift is burgeoning evidence that sustainability performance can drive measurable value creation for companies, and, thus, higher returns for PE. In a survey performed by Deloitte with 500 respondents across the PE and corporate M&A marketplace, it was found that 83% of M&A leaders are willing to pay at least a 3% premium for assets with strong ESG profiles, a 21 percentage point increase since 2022.3 Additionally, 14% would consider a premium of 6% or higher. In another exercise, Deloitte Switzerland found through regression analysis that, “a 10-point higher ESG score is associated with an approximate 1.2x higher EV/EBITDA multiple.”4 As a result, “(…) a company that increases its ESG score by 10 points experiences an increase of approximately 1.8x in its EV/EBITDA multiple.”4
All of this is happening against a backdrop of global climate-related events that are affecting people and companies worldwide, driving new demands from financial institutions and the public, altogether underscoring the urgency for PE firms to better integrate sustainability into their core investment strategies and practices.
GPs can take practical steps to lead in sustainable investing
As we work with managers to help them advance in their sustainability goals, we have identified a set of actions which are critical to every firm:
Get a baseline understanding: Sustainability and sustainable investing are infinitely broad topics, and the complexity and uncertainty of the subject can lead to inaction. To avoid this, put structure to your firm’s Strategy, Investment Process, and Enablers, to allow for a more objective assessment of your current position and rapid prioritization for where to turn next.5 At Deloitte we have defined best practices for each topic within these pillars, to help firms gauge where they stand and identify areas for improvement. Below are a few examples of these best practices.
Articulate your direction: The market is saturated by firms claiming to be responsible investors. Leaders must go further and specify the topics and outcomes they aim to impact. Managers need a clear vision that aligns with the firm's overall goals and resonates with stakeholders. Ambitious, guiding targets should be set at the corporate level to inform how progress will be measured elsewhere in the firm, and leaders should hold themselves accountable to drive continuous improvement towards that vision.
- Impact ambition: Develop a statement of themes or topics in which the firm and its holdings intend to have an impact, and translate this into clear implications for relevant stakeholders (e.g., employees, investors, society). Firms should focus on finding their sweet spot between addressing high unmet needs and targeting areas in which they can have a differentiated impact.
- Investment strategy and beliefs: There should be clear alignment between investment strategy (thesis for how the firm will drive differentiated returns) and material topics (driven by the overall direction of the firm and its operating environment). Managers should be able to state the investment strategy of each portfolio and how it contributes to a broader impact ambition. Leaders should also be bold in articulating the relationship between the Firm's approach to sustainability and delivering financial returns for its clients.
Integrate sustainability throughout the investment process: 57% of respondents (up from 39% in the previous year) stated that they were using clearly defined ESG metrics when determining potential acquisitions or divestitures.3 All GPs should actively consider both positive and negative sustainability metrics throughout the origination, transactions and ownership periods, for example:
- Screening: Nearly all firms apply some level of negative screening criteria to avoid acquiring poorly performing sustainability assets. Far fewer firms use positive screening to actively prioritize opportunities which positively contribute to firm sustainability targets. Both types should be tailored to the specific needs of the GP/LP and their material topics.
- Valuation: Develop methodologies to incorporate discounts or premiums for sustainability performance when monitoring your investible universe and assessing individual transactions. Various multi-variate options are available to isolate the impact of sustainability performance on asset valuations, but all are greatly improved by direct access to the target and its non-public data.6 Work with target companies to better quantify long-term sustainability risks that could impact future cash flows but may not be fully priced into initial valuations.
- Due diligence: Use your existing due diligence processes to collect and assess data relating to critical sustainability risks and opportunities. We recommend seeking advisors who can offer Integrated Due Diligence, addressing ESG metrics in a single engagement alongside traditional Commercial Due Diligence (CDD)/ Operational Due Diligence (ODD). Recognize the challenge of finding an integrated due diligence process that can scale while effectively addressing the highly individualized risks and opportunities linked to any target.
- Active ownership: To actively improve the sustainability performance of their portfolios, GPs must navigate a difficult dilemma, demanding actions on the part of often small or mid-sized portfolio companies without impeding their primary focus of growth and development. A key first step is to set expectations with portfolio companies before acquisition. Once acquired, GPs can minimize the burden by communicating expectations clearly and only requiring actions that directly contribute to defined sustainability ambitions. Be prepared to invest time and resources to support holdings and ensure they recognize this commitment.
Develop internal capabilities: 91% of respondents stated that they have a high level of confidence in accurately evaluating potential target ESG profiles.3 However, firms often struggle the most with enabling factors, such as data, reporting, and people. Building internal capacity through targeted recruitment and training ensures that ESG considerations are deeply integrated into the firm's culture, providing a foundation for achieving its broader sustainability goals.
- Transparency and reporting: European reporting regulations are rapidly driving firms to mature in their approach to sustainability, yet they have created a cavern of ambiguity, particularly for investment managers. Firms should act fast to understand what is required for compliance and whether they are on track for upcoming deadlines. The most forward-thinking leaders will use this as an opportunity not only to meet minimum requirements but also to reaffirm their vision and strategy, and enhance their brand.
- Data and tooling: Smaller, younger portfolio companies often lack the robust data that General Partners (GPs) would like to use to measure and enhance sustainability performance.. However, a lack of complete data should not be a limitation to action, as firms can make real strides in addressing existing gaps. Regulations and respected authorities offer methodologies for data collection and analysis relevant to your firm. GPs should use their scale to support holdings in deploying these methodologies and offer simple software tools to compile and manage the data.
- Innovation through AI: For instances where data is not a constraint, players are looking to develop ways to automate and accelerate. Some firms are already using machine learning to analyze external data and source deals, and conduct document review for discrepancies during due diligence.7 GPs should go further and experiment with AI for portfolio management, using historical performance, pricing data and forward-looking macroeconomic factors to inform risk, valuation and exit strategy.
- Training and development: Given the greater demand for intricate knowledge, reporting requirements, and the vast array of available data, training and development of deal teams and management are crucial. GPs are seeking new recruits to bring ESG knowledge to the firm but make a mistake in failing to develop initiatives that embed this knowledge throughout its ranks, advancing the education and commitment of its people.
