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Initiative in Sustainable Finance: Research Highlight
Proactive ESG management is becoming increasingly important in the Private Equity (PE) sector. However, there is still often a lack of know-how about how to most successfully implement ESG strategies in portfolios.
This comprehensive study by the Initiative in Sustainable Finance co-head Falko Paetzold, Noah-Bani Harouni and Ulrich Hommel explores which measures allow PE firms to successfully execute ESG transformations in their portfolio companies.
The private equity (PE) industry is undergoing a significant transformation. Traditionally, investment managers focused primarily on financial strategies, such as optimizing capital structures and improving operational efficiency. However, Environmental, Social, and Governance (ESG) considerations have now become a central part of investment decisions and portfolio management.
What's particularly interesting is the shift in motivation behind ESG adoption. In the past, PE firms approached ESG primarily as a risk management tool—essentially trying to avoid potential disasters. Now, most PE investors are embracing ESG with a more proactive mindset. They see ESG as an opportunity for creating value, not just avoiding problems.
To understand this emerging trend, these researchers conducted an in-depth study analyzing 210 funds managed by 102 Private Equity (PE) firms, and revealed that the strategic implementation of specific ESG measures not only improves environmental and social outcomes but also drives superior financial returns.
1. Early Integration Pays Off – and size seems to matter
PE firms that incorporate ESG considerations during the due diligence process and initial screening phase achieve better ESG profiles in their portfolio companies. This effect is particularly pronounced for funds managing over €1 billion in assets.
2. Value Creation Plans Drive Results
The study finds that implementing carefully considered ESG value creation plans leads to improved ESG profiles, again especially for larger funds (>€1 billion AUM). However, smaller funds (<€1 billion AUM) struggled more with implementing their ESG strategy, and value creation plans led to comparatively worse ESG profiles.
3. Active Impact Monitoring is Critical
Funds that set specific ESG performance targets with over 50% of their portfolio companies, maintain active impact controlling systems, and implement digital Environmental-Social-Management-Systems (ESMS), consistently achieve better ESG profiles, regardless of fund size.
4. Reporting Frequency Matters – and differently so for small vs large funds
Larger funds (>€1 billion AUM) achieve optimal results with quarterly or more frequent ESG reporting. Interestingly, smaller funds perform better with annual reporting cycles, suggesting different optimal approaches based on fund size.
The research team employed a comprehensive, multi-faceted approach to ensure robust findings. At the heart of the analysis lay the UN Principles for Responsible Investment (UN PRI) annual ESG survey data, which provided detailed insights into PE firms' ESG strategies and implementations.
This was complemented by RepRisk ratings covering approximately 2,000 portfolio companies, offering an objective measure of ESG performance.
To add depth and context to the quantitative data, the researchers conducted direct discussions with PE firm representatives, gathering valuable practical insights about implementation challenges and successes.
A comprehensive regression analysis tied these various data streams together, enabling the team to identify clear patterns and correlations.
Perhaps the most compelling finding of the study is the strong link between ESG performance and financial returns. It's important to first clarify that the analysis uses RepRisk ratings, which quantify an organization’s current exposure to ESG-related incidents and reputational risks, rather than comprehensive ESG performance ratings. With this context, the data reveals an intriguing pattern: funds with lower reputational risk (indicated by their RepRisk rating) consistently show higher financial returns. Funds achieving the AAA rating (indicating the lowest expectation of ESG-related incident risk) delivered an impressive average Internal Rate of Return (IRR) of 25.4%, compared to 23.4% for AA-rated funds, 18.0% for A-rated funds, and 17.6% for BBB-rated funds.
To move beyond these reputational risk indicators, the researchers conducted a comprehensive regression analysis. Their findings suggest a more profound connection: portfolios with a genuinely robust ESG-risk profile generate higher financial returns. This correlation remains consistent across different fund sizes, geographical locations, and when examining various return metrics (including IRR, TVPI, outperformance, versus benchmark).
The findings paint a clear picture of what a successful ESG transformation looks like in practice for PE investors.
ESG strategies should cover the entire value chain, from investment selection through portfolio management to exit. In ongoing portfolio work, PE firms must develop a precise ESG value creation plan that articulate clear objectives and pathways to achieve them for each portfolio company. These plans should be anchored by concrete performance targets and supported by regular monitoring and reporting mechanisms.
However, the research also reveals an important nuance: one size does not fit all.
Smaller funds, particularly those managing less than €1 billion in assets, face distinct challenges in implementing ESG strategies. These challenges may stem from a possible professionalization gap, the authors argue, or due to specific institutional requirements unique to the fund’s size segment. This suggests that while the core principles of successful ESG transformation remain constant, the implementation approach needs to be carefully tailored to the fund's size and capabilities.
PE firms must therefore be thoughtful in designing ESG strategies that align with their operational realities while still delivering meaningful environmental and social impact alongside financial returns.
Bani-Harouni, Noah and Hommel, Ulrich and Paetzold, Falko (2023)
ESG Footprints in Private Equity Portfolios: Unpacking Management Instruments and Financial Performance
Photo Source: Sebastian Staines by Unsplash
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