Using ESG to Assess Risks and Value Creation in Private Markets

In private markets, environmental, social, and governance (ESG) considerations are increasingly influential in how limited partners (LPs) assess and evaluate investment decisions. For instance, in a survey from INSEAD’s Global Private Equity Initiative, 89% of limited partners said that ESG criteria play a role in investment decisions. And 77% consider it as a criterion when screening fund managers. 

Sofia Dolores Martos, Partner at Kirkland & Ellis, has seen a growing number of private equity firms seek ESG advice during the due diligence process. She recently spoke at a Novata webinar on the need for private equity firms to develop an ESG strategy. Hosted by Lorraine Wilson, Chief Impact Officer and Head of ESG at Novata, the webinar also featured Allison Spector, Head of ESG at One Rock Capital, and Paul Yett, Director of ESG and Sustainability at Hamilton Lane.

Although ESG disclosures are still largely voluntary for private companies in the U.S., the demand for data points to a need to integrate these considerations into business operations and strategy. ESG data enables investors to identify potential risks with a company and understand how its ESG-related activities and programs perform. This, in turn, helps them better assess the risks, strengths, and value of the business. 

As the landscape continues to change, here are three areas where an ESG framework can help investors understand the value of potential and existing assets.

1. Determining long-term growth potential

According to Paul Yett, ESG considerations are an important part of risk management. When used as a risk framework, it helps demonstrate if and how a company is accounting for risks material to their business. For instance, with climate change and environmental concerns becoming more urgent, companies must be prepared for the impact of a warming planet on their business activities. 

Similarly, from a social impact perspective, the potential for changing public sentiment means that asset owners must take a long-term view to understand the potential longevity of a business. By using an ESG framework to assess and monitor the performance of investment companies, LPs gain a better understanding of the company’s long-term viability.

2. Enhancing value through ESG

Beyond risk management, ESG can also be used as a value creation framework to ultimately impact business growth. At One Rock Capital, Allison Spector notes that the firm identifies opportunities for portfolio companies to leverage ESG to drive top-line growth, reduce costs, and enhance the overall company value. ESG metrics can directly inform how companies grow the business, connect with consumers, and resonate with investors. Tying these metrics to business performance facilitates the collection and reporting on ESG data and the potential for continuous improvement.

3. Mitigating reputational risks

The increasing demand for progress on ESG issues such as climate change underlies a need for companies to have an actionable strategy and share results. But companies rushing to keep up run the risk of greenwashing when they misrepresent their actions or performance. Sofia Martos highlighted a rise in litigation and enforcement actions taken against public and private companies around sustainability and greenwashing claims. These reputational risks are an important consideration for private equity firms that may be affected by a portfolio company’s actions. When assessing new and existing opportunities, evaluating ESG data and using metrics to benchmark companies can help firms ensure claims can be tracked and verified. 

ESG has evolved into a key consideration for investors in assessing the viability of an investment. Conducting an assessment of portfolio companies’ ESG practices is becoming a necessary tool to assess risk and long-term profitability. Novata can help you understand the metrics relevant to your firm, support your portfolio companies’ data collection , and provide benchmarking and analytical tools to help guide your journey.