Private Equity: ESG Due Diligence and Impact Investment Funds

ESG due diligence is becoming a market standard in private equity. Meanwhile, impact investing is reshuffling the cards for a growing number of players. Here are a few pointers to help you address these developments.

Last month, the AFITE (Organization for the Financing and Transfer of Companies) interviewed our Managing Director as part of a guide on impact investing and ESG due diligence it is producing. With upwards of 20 years of experience in investment and asset management, Raphaël Hara shared expert insights into sustainable finance and impact investment.

The AFITE convenes various professionals involved in advising on mergers & business transfers and acquisitions. This includes M&A boutique consultancies, investment banks, audit and accounting firms, independent consultants and advisors, etc. The AFITE plans to publish this guide by the end of 2021.

The present article delves into new market standards and how ESG due diligence offer a prime tool for a better assessment of non-financial risks. It also stresses on the evolution brought by the development of impact investment strategies…

About Ksapa

Ksapa is a mission-driven company firm with a dual of Sustainable Development and Finance expertise. We support investors and companies to combine value creation and impact on environmental and social issues.

Ksapa works with companies, investment funds and financial institutions. Together, we address ESG, CSR and positive impact issues with regards to strategy development and implementation.

What Is ESG Due Diligence? How Does It Work?

ESG due diligence consists in analyzing the target company’s performance against ESG (environmental, social and governance) criteria. This is generally done in the context of a company acquisition.

ESG due diligence may include regulatory aspects related to environmental law or to the respect of social and Human Rights standards. This either within the company or across its supply chain. The evolution of European regulations will in particular support much-needed progress on the harmonization of currently misaligned expectations and standards. This notably includes the new EU Green Taxonomy as part of its Sustainable Finance Plan, the overhaul of non-financial reporting obligations with the Corporate Sustainability Reporting Directive and the highly anticipated mandatory Human Rights due diligence directive, etc.

ESG due diligence must also integrate an analysis specific to the target company’s sector of activity. This means adopting ESG performance lens, based on the identification of the most important ESG risks related to that very sector. It also involves comparing corporate practices against international sectoral standards. In short, it is a form of maturity analysis for companies. ESG due diligence effectively helps them position themselves against the sustainability practices of the sector in which they operate. The target company’s policies and trajectory may also be taken into account. This, provided it has identified its key risks and consequently organized to address them.

This assessment must be based on a double materiality approach. What are the environmental and social risks my activities generate for the environment and/or society at large? Consider for example the river pollution risk tied to a given factory. Conversely, what are the main risks that environmental and social changes may cause for my activities? This could for example refer to exposition to biodiversity loss in relations to an agricultural or agro-industrial activity.

Is it Systematic? Why Should Investors Take Note?

ESG due diligence is not a systematic requirement to date, but it is generally headed in that direction. This because of the now well-established link between the non-financial performance and the control of business-related risks, including in the long run. Non-financial performance is also an essential driver of asset value preservation. This is particularly true in a context where market rate levels are currently far from hitting their historical benchmarks.

Key Trends in ESG Due Diligence

One of Ksapa’s previous articles in fact stressed the importance of integrating non-financial performance at all stages of company development. In 2020, 88% of LPs (private equity management companies) integrated ESG criteria in their investment decisions. More than 500 of these management companies also joined the United Nations’ Principles for Responsible Investment initiative.

On the impact side, in 2020, one third of European private equity firms launched an impact fund or wish to set one up within the next two years. As a result, the potential for value creation and acceptability linked to the positive social or environmental impact of a company’s activities is increasingly sought-after. In Ksapa’s webinar on sustainable finance, we invited the French Banking Federation and BNP Paribas to share expert perspectives. We notably addressed the fact the impact investment market has grown tenfold in the past 5 years! By the end of 2020, it exceeded $700 billion. According the GIIN, a leading organization in the field, it is expected to reach $12,000 billion by 2030.

For all investors, including generalists, ESG performance is increasingly key. That said, ESG criteria can cover very different dimensions. This includes for example the carbon footprint assessment (Scope 1 and 2 or even 3), health and safety performance in the workplace, or certain elements of CSR policy in place (company code of ethics, stakeholder consultation, environmental policy, management of environmental and social litigation, data management and cybersecurity incidents, etc.).

Essential Differences Between Impact and ESG

Impact investors must in addition demonstrate that they generate positive impact, in line with their strategy. This could for instance relate to embedding socio-environmental risk mitigation “by design” in a target company’s business model or its products and services.

Crucially, ESG risk management and business impact are not the same thing. A company that conducts its business in a perfectly responsible manner does not necessarily qualify as an “impact business”. Conversely, one that has a real impact may not showcase sufficient CSR performance or ESG risk management.

Actual impact rests on a least 3 core ingredients. Namely: intentionality, demonstrated additionality (i.e. positive impacts that would not exist without the company’s action) and impact measurability. At Ksapa, we add another dimension. That is, materiality, an essential indicator for us to consider corporate activities and their business model. In other words, there is no point in having an impact if it is marginal!

In any case, addressing non-financial performance is an excellent starting point for both for investors and target companies. This because it fosters mutual understanding and in turn, ensures the compatibility of their respective philosophies and perspectives in view of the integration to come.

Preparing for ESG Due Diligence: What are the Key Inflection Points, Anomalies or Progress Spaces? Does CSR Impact Value? Can This Be Quantified, Even Approximately?

Obviously, this depends on the type of investors, their size and maturity on the subject. Yet we have noted a clear convergence between expectations on ESG performance from investors, banks (notably through the development of Sustainability Linked Loans, the interest rates of which vary based on ESG performance) and clients (notably large companies demanding access to their suppliers’ non-financial ratings by agencies such as Ecovadis).

Regulatory reporting requirements will in any case lead to better reporting on ESG performance. The CSRD is going to extend the ESG reporting scheme to some 50,000 European companies with more than 250 employees, based on indicators supported by digital data. These indicators will most likely be found in transactions the likes of Request For Proposal specifications, obtaining a bank loan… but also company acquisitions. If perhaps imperfect, this is a substantive step towards mainstreaming ESG due diligence.

To meet these expectations, key players must undertake robust efforts, based on a global analysis and integrated CSR policy. With that in mind, they must analyze their main risks and opportunities, whilst remaining attentive to the stakeholder expectations. That notably includes comparing themselves to other companies in their sector. First, as a way to take stock of what they have already carried out and then to achieve further alignment with best practices. They will only manage this by defining a clear trajectory for embedding sustainability issues at the heart of their activities.

Growing Convergence Between Reporting Obligations, Client Expectations, Banks and Investors

At Ksapa, we bear witness to this definite convergence. We indeed help companies improve their CSR strategy and ESG performance ahead of an acquisition operations or in the context of the evolution of their activities. We likewise support investors in defining ESG policies or impact strategies, complete with performing the corresponding ESG due diligence and assist the implementation of ESG and Impact management and monitoring processes.

As for valuation, sustainable investments or companies aligned with the United Nations’ Sustainable Development Goals outperform their counterparts, as demonstrated by numerous studies in the listed universe. That trend is however a little less clear-cut in the non-listed universe. With that in mind, we must necessarily start with assessing the specificities of a target company’s specific industrial sector and general operating model. This will undoubtedly highlight key ESG dimensions. Due diligence on these ESG dimensions, particularly with regards to the environment, may also impact guarantee of liabilities. This, over potentially longer periods than certain usual guarantees.

In any case, according to a recent study, more than half of asset managers thus polled had already refused investments for reasons related to ESG performance. Moreover, about two-thirds of these private equity players see ESG as a key driver of value creation. Previously, risk management was the main driver of ESG focus. Now, value creation is becoming just as important. We see a clear evolution, from mere compliance to an era of ESG maturity. The reason is this is increasingly seized as an opportunity bearing in mind the rise of the impact economy.