Why Private Equity firms must integrate ESG into the valuation process

ESG valuation

Top asset managers and hedge funds are integrating ESG factors into investment decisions to reduce long-term risks and enhance returns. The PwC Private Equity Responsible Investment 2019 survey highlighted that over 88% of GPs and LPs report at least annually on the ESG performance of their portfolio companies.

Against this backdrop, a white paper released by the International Valuation Standards Council (IVSC) stated that, given the ever-increasing adoption of ESG by the majority of market participants, including PE firms, ESG considerations must be considered into business valuations.

Growing pressure from investors and regulators

A survey of 23 top private equity players in July 2019, conducted by the Professor of Corporate Strategy at the Universita Cattolica del Sacro Cuore and published by MDPI, revealed that private equity firms feel the need to integrate ESG factors primarily because of investor pressure. LP pressure has been a key factor for ESG integration in recent years, a trend we’ve witnessed increasingly in the French market, most notably over the last two years.

Indeed, the French market is seeing the entry of more and more international LPs and it is clear – like in other leading fund jurisdictions – that ESG and substance consideration are the hot topics for private equity funds during the fund-raising process. In the past this pressure was more concerned with the quality of reporting, whereas now it is more about the positive impact of ESG on people, the environment, society and the necessity to assess any risk of non-compliance on the valuation of the portfolio companies.

Meanwhile, regulatory pressures are also on the rise. In 2020, over 700 pieces of legislation were published around increased levels of ESG disclosure in financial markets. MDPI’s survey indicated that the second most important reason for private equity firms to integrate ESG into investment decisions is pressure from regulators and public institutions.

In this context, a significant piece of legislation affecting private equity firms in European markets is the Sustainable Finance Disclosure Regulation (SFDR), which will be fully implemented by the end of 2022. The SFDR currently requires disclosures about whether and how ESG factors are integrated into investment decisions. By the end of 2022, it will also require disclosure on whether and how adverse impacts are being considered.

Challenges in incorporating ESG into the valuation process

Despite the rising focus on ESG factors by investors and regulators, private equity firms still face barriers that prevent their effective integration into the valuation process. The survey published by MDPI pinpointed a lack of information related to people, environmental and social issues and of comprehensive ways to measure them as the most significant barrier. It also noted a lack of internal skills and the time-consuming nature of such activity in the absence of clear processes and automation as another important key barrier.

Meanwhile, the PwC survey indicated that monitoring ESG performance through the use of KPIs relies on frequently collecting accurate data from portfolio companies. Whilst bespoke software solutions for automating the collection of ESG data are preferred, some consider them too sophisticated and adopt tailor-made or manual solutions covering just a few material issues instead. Finally, the PwC survey points to the lack of a robust methodology as another key reason for failure to estimate the value of ESG performance and the positive or negative impact of valuations.

How can ESG be integrated into the valuation process?

The white paper by the IVSC suggests that, to account for ESG factors, a Valuer will be required to:

1)  Identify and assess the relevant ESG criteria for the comparable companies and industry

2)  Assess the performance of the subject company for such criteria; and

3)  Calibrate the market inputs (e.g., EBITDA multiple, etc.) to the subject entity to take into account the relevant performance as compared to the benchmarked companies

Thus, the ESG framework presents a new set of factors not only for Valuers to consider, but also for management consideration. It is important for Valuers to bear in mind that management will be best equipped to identify, consider, and quantify many of the considerations noted in the framework. As such, the incorporation of an ESG framework into business and fair market valuation will require the active participation of both management and independent Valuers such as IQ-EQ.

Potential impact on the future financial landscape

McKinsey notes that there have been more than 2,000 academic studies on the value added by ESG, and around 70% of them find a positive relationship between ESG scores on the one hand and financial returns on the other, whether measured by equity returns, profitability, or valuation multiples.

Based on large volumes of information available to date it seems clear that private equity firms that successfully incorporate ESG risks and opportunities into their investment strategy and value creation approach are well poised to not only improve their returns but also reduce their vulnerability to risk.

To find out more about our ESG and valuation service offerings, please do reach out to your IQ-EQ contact for more information.