For private equity firms, sustainability initiatives can represent not merely a response to regulatory and investor pressures or societal expectations, but a strategic move to enhance long-term value creation. When implemented effectively, they can drive operational efficiency, spur innovation and growth, mitigate risks, and ultimately improve financial performance.

• 77% of dealmakers in a BCG and Gibson Dunn survey indicated that a higher environmental, social, and governance (ESG) maturity results in a higher valuation for targets – in other words, investors are pricing in an ESG premium leading to higher multiples.
• In an MSCI ESG Research study, 6.8% was the average financing rate for companies with the highest ESG ratings, compared to 7.9% for the lowest-rated.

The key to unlocking these benefits lies in rigorous due diligence across the investment lifecycle: thorough, ongoing assessment of ESG factors to identify potential risks and opportunities and link sustainable practices to financial performance. A deeper understanding of ESG data enables tracking performance-based versus process-based metrics.

Main challenges in sustainability due diligence

Despite its importance, we are still in the nascency of performing ESG due diligence – and extracting value – in the context of sustainability, which means there are still challenges along the way for both private equity firms and limited partners (LPs). 

1. Lack of maturity in sustainability practices: LPs are increasingly requiring private equity firms to have processes and policies in place for their portfolio companies to report sustainability metrics. However, many LPs are still in the early stages of integrating sustainability into their processes, and often focus on risk and compliance rather than value creation.
2. Inconsistent data and lack of standardization: In the absence of standardized metrics and reporting frameworks, LPs report receiving varying metrics across portfolio companies and fiscal years, while private equity firms struggle with inconsistent due diligence questionnaires (DDQs) from LPs. This inconsistency makes it difficult to report and compare sustainability performance across companies and time, and can hinder the ability to make informed investment decisions or identify value creation opportunities.
3. Unclear use of sustainability data: Even when sustainability data is collected, it is often underutilized. Many firms review this data only during the initial due diligence phase, failing to leverage it for ongoing performance monitoring and improvement.

Better analysis for more sustainability value

To overcome these challenges and effectively implement sustainability initiatives, PE firms should focus on the following strategies during the due diligence phase and beyond:

• Assess material sustainability issues: Identify and evaluate the sustainability issues that are most materially relevant to the target company and its industry and stakeholders. This involves looking beyond surface-level metrics to understand the underlying drivers of sustainability performance.
• Define and track measurable, outcome-based metrics: Move away from output-based metrics and “sustainability stories,” and focus instead on outcome- and performance-based data points, such as “avoided costs” and “operational efficiencies,” that help quantify the financial benefits of sustainability practices.
• Establish consistent reporting standards and timelines: Develop and implement consistent metrics to allow for better aggregation of data and more meaningful comparison across portfolio companies. Track key sustainability and related financial KPIs systematically from the start of the holding period to build a record of improvement and help illustrate a sustainable growth narrative at exit.
• Leverage proven frameworks: Utilize established methodologies, such as the Return on Sustainability Investment (ROSI™) framework developed by the NYU Stern Center for Sustainable Business, to quantify the benefits of identified sustainability practices.

Conclusion

With rigorous due diligence, PE firms can unlock significant financial value from sustainability initiatives. This approach holds the potential to not only enhance the operational performance of portfolio companies and generate a higher exit multiple, but also contribute to broader societal and environmental goals – and position PE firms as leaders in responsible investment.