Sustainability’s Valuation Equation
Amid intensifying scrutiny, private equity is recognizing ESG’s role in value creation.
By Jordan Barnett, Director, Murray Devine Valuation Advisors
In April, apparel maker Patagonia made headlines when it said it would no longer be producing co-branded vests for financial services firms and technology companies – at least not without vetting the organization’s environmental and social values. The decision reflected both the importance of sustainability to a company’s brand as well as the increased scrutiny into a firm’s societal impact. Ironically, Patagonia’s subtle rebuke comes as sustainability considerations have emerged as a priority across the wider investment landscape.
behind “conscious” capitalism certainly isn’t new, but first gained broad
awareness in the 1960s and 1970s amid the divestment movement when activists
pressured institutions to sell their investments in companies supporting the
Vietnam War or apartheid in South Africa. More recently, however,
sustainability has entered investors’ collective consciousness as mounting
research has shown a correlation between certain ESG factors and financial
performance (see here, here, and here). The
United Nations instituted its Principles for Responsible Investment back in
2006 and firms such as Goldman Sachs soon after incorporated a sustainability
framework into their equity research. Adoption of ESG standards have since gained
considerable momentum as institutional investors are increasingly attuned to the
materiality of corporate social responsibility programs and their relationship
to driving long-term value.
Up until now, the private capital landscape has largely been shielded from scrutiny. However, a growing appreciation around how these factors can influence performance and portfolio-company valuations has many in PE re-assessing their approach. This is particularly the case as purchase prices hover well above historic norms, making value creation that much more important as a driver for returns. And in the middle market, where sustainability tends to be an afterthought for many developing companies, PE has a unique opportunity to position their capabilities in this area as differentiator and value add. At this point, in 2019, sustainability considerations can no longer be ignored by either GPs or the companies they back.
In many ways, awareness around environmental, social and governance issues is being driven by transparency across the global supply chain. In just one day, Bloomberg exposed the long-ignored environmental impact of the health and beauty sector; The Washington Post ran a feature on the social impact of child labor in the global cocoa industry; and big tech confronted mounting governance concerns as shareholders voted to strip Mark Zuckerberg of his chairman title and Google began preparing for what could be a drawn out antitrust case.
While these stories certainly reflect the risk, it wasn’t until ESG metrics earned their way onto public-company disclosure filings that companies and retail investors began taking CSR more seriously. Ongoing pressure from large asset owners and activists, in the form of shareholder resolutions, forced several of the biggest energy companies over the past few years to account for the risks posed by climate change. Since then investors have turned their attention to sustainability disclosures that include non-financial metrics that can serve as a lead indicator of future performance which often cannot be inferred from traditional accounting metrics.
The specific metrics in focus often depend on their materiality to the company and its sector or industry. For instance, the Sustainability Accounting Standards Board will identify relevant topics within a given sector and then assess their materiality to companies based on revenue impacts, operating costs, impact on liabilities and other inputs. As part of its research methodology, SASB will then perform a valuation analysis or create a DCF model “to assess the probability and magnitude of a potential financial impact” for the best and worst performers in a segment (based on unique sustainability factors). This is why retailers are so focused on providing transparency around their global supply chain, whereas financial services companies may focus on inclusion initiatives.
For obvious reasons, early initiatives around sustainability have largely focused on public companies. Over the past few years, however, institutional investors have turned their attention to the private markets too. Pensions such as CalPERS have made ESG screening a fundamental part of their manager selection due diligence. The Institutional Limited Partners Association (ILPA) has even created templates for fund managers to easily incorporate ESG metrics into their portfolio-company reporting documents, a nudge for those GPs who haven’t considered doing so. Meanwhile, in other alternative categories, such as real assets, new tools have become available to benchmark fund managers based on their attention to ESG standards. It’s likely only a matter of time before similar resources become available for investors in PE.
Not to be overlooked, the broader capital markets are also scrutinizing these areas as part of their credit analysis. This was magnified when PG&E filed for bankruptcy, which was attributed to the wildfires in California and substantiated the risks of changing climate conditions on companies and their stakeholders. As a result, it’s becoming more and more common to see the ratings agencies adjust their credit ratings based on either positive or negative ESG factors, providing yet another incentive for sponsors.
Increasingly, though, a shift is occurring not because GPs are being forced to change, but because they recognize ESG is becoming essential to value creation. Preqin, through a survey of PE fund managers last year, quantified that 33% have already implemented ESG policies across their entire portfolio, and more than two out of every five expect ESG policies to be in place across 100% of their portfolios by 2023. Not to be overlooked are the impact-dedicated funds whose mandates are focused exclusively on sustainability. Andy Kuper’s Leapfrog Investors raised $700 million to target healthcare and financial services impact investments in emerging markets in May; Al Gore’s Generation Investment Management raised a $1 billion fund to invest in green technology companies a week later; and Blackstone, that same month, launched its own impact-focused platform led by Tanya Barnes. It just speaks to the institutional interest and capital available across the spectrum of sustainability.
But ultimately, as is true for all things in private equity, it will come down to how sponsors can create value in the assets they acquire. McKinsey’s Tim Koller, for instance, has often distinguished between short-term profits and value creation, noting that to confuse the two actually puts “stakeholder interests at risk.” While some may contend that the model has changed, he clarifies that at the end of the day valuations are based on cash flows.
“If the forces in the world that relate to sustainability are going to be material to a business, it’s management’s job to take the longer view and figure out what to do about them,” he observed in a 2017 McKinsey & Co. Insight. “Because eventually, these things will affect cash flows.”
And that will affect valuations. But this puts private equity, as the flag bearer of patient capital, in a unique position to really move the needle on sustainability. Even if GPs remain less certain around the premise of sustainability, the fact that a critical mass is now buying in will just make it that much harder to exit assets in the future that don’t address these issues. The upshot, is if they can show traction, maybe (fingers crossed), Patagonia will let us wear their vests again.