15 September 2021
We are seeing a fundamental shift in the thought processes of a number of private equity players regarding "impact", argues Martin Calderbank
When thinking of private equity, people often have in mind caricatures of financial engineers, buccaneering dealmakers, and profit-focused cost cutters. It is perhaps unlikely that the first image that would come to mind is an investor attempting to have a positive impact on the world.
However, this may change in time because the private equity industry is witnessing a sustainability revolution.
We are seeing a fundamental shift in the thought processes of a number of private equity players regarding "impact".
What started as a desire to avoid doing harm, has become a recognition that using the energy of private equity to do good is not just necessary and satisfying, but can also be a powerful risk management tool and a lever for value creation.
Indeed, there is mounting evidence that harnessing the transformational power of private capital to create environmental and societal value also contributes to remarkable risk-adjusted financial returns.
This is partly because the value created by investing sustainably tends to be more enduring. In an environment where the probity of businesses is scrutinised heavily, those that have a positive impact on the environment and society are less likely than "bad" corporate citizens to have value eroded by regulatory or consumer forces.
Similarly, businesses that focus on improving their positive impact are less likely to be rocked by regrettable incidents or controversy.
Furthermore, businesses that contribute to human and planetary flourishing are usually mission-critical, meaning they tend to be less cyclical and enjoy high defensibility.
A focus on sustainability in investment decisions therefore reduces risk for investors.
Key drivers of this evolution are those investors, including some pension funds and endowments, who have put ESG factors on the agenda as key criteria before committing to funds, and have called for ESG-related targets and data.
These investors have dramatically influenced behaviour and are increasingly causing private equity firms to reflect and to invest in their own businesses, not only to improve sustainability but also to change how they back, track, and grow portfolio companies.
Likewise, regulators have also implemented sustainability-related disclosure requirements for the financial services sector. These are pushing more private equity firms to change their system and control processes, and to allocate resources to ensure transparent provision of information.
Fund investors and regulators have thereby been key influencers in encouraging private equity firms to treat sustainability with the seriousness it deserves.
The Covid-19 pandemic may also play a role in accelerating the sustainability revolution within the private equity industry. It has made painfully apparent that humanity and the planet face significant challenges.
More positively, it also shown how businesses can bring ingenuity and energy to help address these challenges.
Businesses of all types – including private equity firms – are now more likely to recognise that they have a responsibility to become part of the solution and generate positive change.
The pandemic has also amplified how positive purpose, as well as financial rewards, can help private equity firms attract and retain talented individuals.
Whilst the private equity industry is seeing a sustainability revolution, there are various approaches, and individual firms are at different stages of the journey. Some managers are still paying little attention to ESG, even being comfortable acting as "lovable rogues". Others see ESG factors mainly as a compliance and reporting issue, with their behaviour driven by regulatory requirements.
Some firms position sustainability at the heart of their investment strategy, but in such a way that there is a trade-off between shareholder returns and positive impact.
Such a trade-off is often unavoidable for these strategies, because in large parts of the economy, being more sustainable is not always rewarded with revenue growth.
Each of these approaches ultimately sees sustainability as a drag on, not an accelerator of, investor returns.
However, in some cases, remarkable shareholder returns and equally remarkable impact can be created with no trade-off. One way this is possible is by only backing businesses where there is a strong alignment between the company's fundamental purpose – which is addressing a societal or environmental need – and its financial performance.
Dramatic growth of such a business results in an increased contribution to human or planetary flourishing, and therefore generates strong financial returns while also creating significant environmental and societal value.
"In some cases, remarkable shareholder returns and equally remarkable impact can be created with no trade-off"
Given the trends set out above, the alignment of shareholder value with fundamental purpose, as well as reducing risk for investors, can establish a powerful virtuous circle through which positive fundamental impact and investor returns are mutually reinforcing and thus offer the possibility of exponential performance.
An example of this approach in action is Reconor Group, an environmental services provider in Denmark. Reconor treats and remediates soil, and handles waste, the majority of which is recycled for reuse.
The company's fundamental purpose is to develop efficient environmental solutions that reduce waste generation and therefore contribute to a cleaner, more sustainable environment. It is highly defensible, with unique capabilities and facilities that provide mission-critical services in a growing market, which is driven by increasingly stringent regulation, higher recycling rates, and a strong pipeline of publicly funded infrastructure construction projects.
With Agilitas's backing, the company has gained market share, added capabilities and services, and expanded across Denmark. It is now a leading provider of sustainable environmental logistics and resources solutions with national coverage across the waste management value chain.
In the process of transforming the business, strong financial performance and the creation of sustainable environmental value have gone hand in hand.
It is often challenging for investment firms to shift to a focused and purposefully restrictive approach to portfolio construction, but there are many ways of harnessing the incredible power that private capital can have in driving positive change.
Regardless of the approach that is pursued, it is becoming increasingly clear that investing sustainably is now a fast-growing feature of private equity investment.
Over time, I hope positive progress on sustainability will lead private equity to be increasingly associated with responsible investors, who grow businesses in ways that benefit society and the planet.
Martin Calderbank is the managing partner of Agilitas Private Equity.