Unlocking sustainability value in private equity

IN PARTNERSHIP WITH:2024UNLOCKING SUSTAINABILITY VALUE IN PRIVATE EQUITY A new tool to move beyond identifying red flags Private equity (PE) is leaving billions of dollars in sustainability value on the table. While some practitioners focus on the value proposition of sustainability, the current status leaves much to be desired. Gaps in current approaches include cumbersome frameworks focused on risk compliance rather than value creation, difficulty capturing the financial benefits of a sustainability strategy, lack of clarity around which KPIs to track, and significant communication issues between general partners (GPs) and limited partners (LPs). This Viewpoint introduces a powerful tool to better identify value creation and risk-mitigating opportunities at the due diligence and early holding phases.AUTHORSFlorent NanseJulien MarcheseAlan MartinovichSean McDevittTensie Whelan, NYU Stern School of BusinessVIEWPOINT UNLOCKING SUSTAINABILITY VALUE IN PRIVATE EQUITY -Deal-sourcing/pre-due diligence phase. Current practice focuses on ESG data requests, checking against general exclusions, and often applying a gating methodology based on specific criteria (e.g., an impact investor might use criteria focused on quality jobs). This type of approach may be adequate for the pre-phase, although knowing how much depth to aim for can still be difficult. -Due diligence phase. This typically involves reviewing material issues, including ESG KPIs if available and an ESG scorecard. ESG sensitivities may be applied to valuation analyses to reflect possible impacts. The main shortcomings are an emphasis on red flag downside risks, superficiality in understanding the full extent of ESG issues, lack of data (especially for small and medium-sized enterprises), and limited or no focus on upside opportunities from sustainability (e.g., the financial upside of mitigating risks that may drive improved performance or how sustainability investments could build competitive advantage).Between 2010 and 2022, assets under management of PE more than quadrupled. As the PE industry continues to expand, there is a growing opportunity to generate financial and societal value through sustainability initiatives. Increasing the availability of finance is also a key lever to move the industry toward net zero goals; for example, according to BloombergNEF, only about 16% of climate finance needs are currently being met. Because PE firms often hold majority control over their portfolio companies, they wield considerable power to implement sustainability initiatives across a wide swath of industries at the portfolio company level. However, many PE firms are currently poorly identifying and capturing sustainability value. Based on new research by the New York University Stern Center for Sustainable Business (NYU Stern CSB) in collaboration with Arthur D. Little (ADL), we know that most GPs tend to focus on identifying red flags during due diligence (with a few leading exceptions, especially in Europe) but rarely look into sustainability value creation. After purchase, GPs may track a few environmental, social, and governance (ESG) reporting metrics but often do not implement sustainability value creation plans. This Viewpoint outlines a new tool (open source and available free of charge) developed jointly by NYU Stern CSB and ADL to help GPs better identify and capture sustainability value, both at the due diligence phase and during the first few months of the holding period.OPPORTUNITIES FOR IMPROVEMENTThe research identified several clear opportunities for improvement in how GPs approach sustainability during the investment lifecycle. Underlying these opportunities is the basic premise that GPs still tend to approach sustainability as primarily a reporting issue rather than a potential driver of value during each stage: About the researchNYU Stern CSB, in collaboration with ADL, conducted a research program aimed at facilitating the PE industry’s transition toward sustainable investing practices. The scope included the identification of the issues and barriers as well as the development of a new framework tool and guide to embedding sustainability within portfolio companies. The research included 40+ interviews with GPs, LPs, and other stakeholders, alongside several webinars with hundreds of practitioners. A working group of five GPs applied firsthand experience to help develop the tool, ensuring its practicality and effectiveness. An additional 10 GPs tested the tool to provide feedback before finalization.VIEWPOINTARTHUR D. LITTLE2 UNLOCKING SUSTAINABILITY VALUE IN PRIVATE EQUITY This enables better monetization of sustainability benefits and the development of a stronger sustainability narrative over time, grounded in real data. Striking a balance between short-term efficiency gains and sustained revenue growth is crucial. GPs must ensure the long-term viability of assets rather than short-term value extraction. Targeted sustainability stra