Value Creation Through ESG Vendor Due Diligence
15th October 2024
Insights
This article was originally published in the ICAEW Corporate Financier Magazine in October 2024.
As private equity looks for returns from exit, one helping hand could be the value creation offered by ESG vendor due diligence. Zara de Belder and Matt Smith of Anthesis Group explain this relatively new offering.
Many factors have led to private equity hold periods being lengthened. The fact of the matter is that the longer an asset is held by a fund, the greater the pressure to find an exit route. Research from Bain & Co published earlier this year revealed that buyout funds are sitting on 28,000 unsold companies worth more than $3tn. And more than 40% of the companies have been in firms’ portfolios for at least four years. With typical holding periods ranging from three to five years, private equity managers will, at the very least, be starting to feel the heat. They may be at the stage of the private equity cycle where they are looking to raise their next fund and will be under increasing pressure from limited partnerships to develop exit strategies.
The benefits and reasons for improving environmental, social and governance (ESG) performance are well documented and broadly understood. But the reasons for undertaking an ESG vendor due diligence (VDD) exercise are perhaps less so. VDD can be a crucial part of an exit strategy and, increasingly, specialist ESG vendor due diligence has started to gain traction. Private equity sponsors are starting to recognise the value of proactively reporting the ESG credentials of portfolio companies ahead of a sale. They are beginning also to see the benefits of transparently addressing any concerns or reputational matters.
Different to an information memorandum, an ESG vendor due diligence report provides a more in-depth review of the activities and achievements of a portfolio company’s ESG programme over the course of the private equity backer’s ownership period. Undertaking such an exercise offers a unique opportunity to demonstrate to buyers and their advisers how a portfolio company has evolved its ESG strategy and narrative. And, crucially, it should explain the positive impact its ESG strategy has had on its operations, personnel and performance. It will highlight the company’s positioning relative to its peers and any future challenges and opportunities – be they regulatory, commercial or reputational.
Furthermore, where data allows, it can also show how ESG-related activities and initiatives have created value through margin improvement, as well as top-line and bottom-line growth. This will help demonstrate how the business has improved its future potential quality of earnings.
Value Adding
There are multiple benefits to be gained from undertaking ESG VDD. First, VDD offers a third-party review of the portfolio company’s strategic priorities, targets and progress to date. At the same time it can spot any previously unidentified issues. This will allow the private equity sponsor, working with the portfolio management team, to take remedial action in advance of a sale process – akin to vendor assist.
Second, ESG VDD proactively addresses questions a buyer may have about a target’s ESG performance, risk exposure and overall alignment to their investment strategy. Evolving regulation, such as the UK’s Sustainable Disclosure Requirements and the EU’s Sustainable Finance Disclosure Requirements, Corporate Sustainability Reporting Directive and Corporate Sustainability Due Diligence Directive, has helped increase awareness of the risks associated with regulatory non-compliance.
Improved awareness of climate risk, from both a physical and a transition perspective, has raised questions about stranded assets and the upfront capital expenditure required to support a business as it transitions to net zero. An ESG VDD report will identify these potential risks, but should also acknowledge the policies, systems and compliance processes that have been developed as part of the portfolio company’s risk management.
Proactive communication lessens the likelihood of a buyer drawing incorrect conclusions and reduces the demand on the seller, at a time when they will be handling multiple requests from many parties.
Finally, a private equity firm can use VDD more widely with investors. The document will allow the firm to demonstrate how ESG is embedded in its portfolio engagement strategies and, more broadly, across its investment lifecycle. While the primary focus is to present the credentials of a portfolio company, the robustness and consistency of its owner’s responsible investment strategy and approach to portfolio engagement is also displayed.
Start Early
The execution of an effective ESG VDD, like any VDD report, requires early engagement and preparation. Buy-in from ESG leads and investment deal teams, who are key to proactively engaging with portfolio management teams and appointing external advisors as part of their ESG onboarding and exit preparations, is critical to success.
Appointing external consultants three to six months prior to exit provides sufficient time to undertake a comprehensive process, and should verify and authenticate the narrative and information presented as well as helping to alleviate potential concerns about greenwashing.
Early consideration of the likely bidder, and its approach to ESG, is also critical. By understanding a potential buyer’s ESG commitments, sellers can tailor the information presented in their VDD report to demonstrate alignment, potential ESG synergies and new value-creation opportunities – all within a consolidated, buyer-friendly document. It also allows time for remedial actions to be taken.
With pre-investment ESG due diligence firmly embedded within private equity’s approach to responsible investment, the rise of ESG VDD presents an often previously untapped opportunity. It gives firms the chance to proactively present the ESG credentials of a business and its potential long-term value as a sustainable investment, and is an opportunity for realising an ESG-related premium at exit.
The Private Equity View
Aga Siemiginowska, Head of Sustainability, Oakley Capital:
“As a potential purchaser of a business, we find having access to an ESG or sustainability VDD hugely beneficial. It provides us with a basis to start our own due diligence process from. It demonstrates that the company has thought about sustainability and identifies which individuals or teams we need to be speaking with. If done well, a VDD discusses the priorities for the company, how it will achieve them and progress with performance metrics and targets to date. This helps us understand the maturity of the company and how much interaction and input will be required from our team to meet our fund’s sustainability priorities during the hold period.
On the flip side, as we exit a business, a VDD helps us and the company articulate what the sustainability focus of the business has been. It helps to demonstrate the vision and ambition of the business for the future.”
Explore Our Sustainable Finance & Transactions Solutions
We are the world’s leading purpose driven, digitally enabled, science-based activator. And always welcome inquiries and partnerships to drive positive change together.