Evan Greenfield, Managing Director for ESG at British Columbia Investment Management Private Equity, argues for a more evidence-based approach, centred on value creation.
When British Columbia Investment Management (BCI) surveyed 20 of its private equity managers on what they meant by ESG, it received 20 different answers. While this might be expected in a dynamic and competitive market with diverse investment philosophies and business models, the intense scrutiny the term has faced in recent years may also have played a role.
Committed through experience to a belief that ESG factors can be powerful value drivers across its portfolio, BCI sought to define ESG more clearly and narrowly, the better to demystify and depolarise the term.
Rather than referring to the acronym’s underlying terms – environmental, social, or governance – BCI took a holistic approach, defining ESG as “a set of societal issues that, due to their growing relevance, have become material to business performance. These factors influence core drivers of enterprise value such as profitability, risk exposure, capital allocation and readiness for exit.”
Evan Greenfield, Managing Director for ESG in BCI’s private equity team, points out that ESG is still very much in its infancy as a capital markets concept, and one only adopted and integrated in the private equity markets at scale in the last five. This entails a need for asset owners and managers to learn from mistakes, including a tendency to focus overly on reporting, often with insufficient regard for materiality, rather than leveraging ESG for economic return.
“The next stage is taking back the narrative around ESG. We need to continue to demonstrate that this can be leveraged for one of the last domains of wide-open space in value creation in private equity. We can set the standards today, as opposed to allowing others to define and set the standards for us,” he says.
Power of three
Greenfield recently co-authored an academic paper with Stanford University’s Long-term Investing Initiative, focused on ESG value creation in private equity.
Last year, the UN Principles of Responsible Investment launched guidance – with the backing of firms including Apollo Global Management, CVC Capital, EQT, Permira and KKR – on using sustainability to drive financial outcomes. The papers share a laser focus on using ESG factors to increase the financial value of portfolio companies.
One of Canada’s largest institutional investors, BCI provides pensions to many of its home province’s 5.68 million residents. It oversees approximately US$220 billion across 32 public sector and institutional clients, of which US$25 billion is invested in private equity globally.
Around half of those assets are invested in underlying private equity managers or general partners (GPs) as a limited partner (LP), with the other half allocated to direct investments and co-investments, typically alongside GPs. BCI focuses on five main sub-verticals: business consumer services, financial services, industrials, TMT (technology, media and telecoms), and healthcare.
“We’re steadfastly focused on ensuring that we leverage ESG and sustainability for economic return, as our ultimate fiduciary obligation is to achieve risk-adjusted returns,” says Greenfield.
Greenfield draws parallels between BCI’s returns-focused approach to a central theme of ‘Jerry Maguire’, the mid-90s Tom Cruise movie about a sports agent’s struggles to meet the financial and emotional needs of his clients. “A key component of how we leverage ESG is to ‘show the money’,” he says.
BCI has developed a framework that centres on the three main stages of the private equity investment process: due diligence; value creation and operational improvement; and exit.
At the investment diligence stage, BCI focuses on understanding the material financial risk associated with a potential investment from an ESG perspective, specific to both the company and the industry. But it is looking at those also material ESG factors from both an operational and transactional standpoint.
“Should we look at reducing purchase price because of the ESG risk that we have identified? Are there post-close operational enhancements that we will look to deploy given the identified ESG risk? Or could we potentially step away from the transaction? At this first stage, we’re spending a fair amount of time with the management of a potential investment target to discuss opportunities emanating from ESG to set the culture and the tone early,” explains Greenfield.
Importantly, however, BCI seeks to fully understand the underlying firm before engaging from an ESG perspective, by talking to management about its overall challenges and opportunities, for example by digging into strategic advantages and barriers to entry.
“From that information, we try to assess how we can leverage some of the macro tailwinds behind sustainability and climate to develop products or solutions for their underlying clients or figure out operational enhancement and improvement that we would ascribe to sustainability,” he adds.
Tangible opportunities
During the key second phase, the focus intensifies on turning ESG-related value drivers into tangible opportunities for long-term revenue growth. Having gained a deep understanding of
the portfolio company, post-diligence attention turns to ongoing risk assessment and reduction from an operational perspective, Greenfield explains.
“We’re also spending significant resources and attention on ascertaining the value creation drivers emanating from sustainability. How can we leverage the macro winds behind sustainability and the climate transition to ensure that the portfolio company is pursuing product innovation, supply chain diversification, and operational improvement and enhancement?
“Most importantly, we’re tying those elements to dollars and cents, financial outputs and linkages. We’re looking at how we could leverage these factors for EBITDA growth, margin expansion, capital efficiency, and ultimately enhancement value at exit,” he adds.
During this second stage, it’s critical to cultivate strong relationships with management, asserts Greenfield.
“We need to ensure that management buys in and understands the vision, the implications and the opportunities emanating from ESG and sustainability and are able to deploy them. We are not members of management. We can provide guidance, but the day-to-day operation of the business is down to members of management.”
The recent white paper highlights an example in which BCI worked with management to resolve shortcomings in environmental, health and safety (EHS) governance across multiple manufacturing sites after these caused operational downtime and financial losses.
The establishment of centralised governance, unified reporting systems, clear accountability mechanisms, and leadership incentives tied to measurable EHS outcomes boosted operational resilience, reduced costs and became a source of competitive advantage. It also paved the way for a new business line in the alternative energy sector.
The combined contribution of the initiative to financial value was calculated at US$36 million, with the estimated enterprise value uplift attributable to ESG reckoned at US$159 million.
At the exit stage, BCI looks to make ESG is a core part of the value proposition of the portfolio company. “We want to ensure that ESG has become such a priority – emanating from competitive advantage, product optimisation, supply chain diversification – that it’s quantified and highlighted on slide three of the CIM (confidential information memorandum) as opposed to buried in the appendix,” says Greenfield.
“Our view is that those companies that can establish their ESG and sustainability credentials will likely trade at a premium because they demonstrate the economic viability, the adaptability, the resilience of that company, putting it in a much more compelling light in the exit process.”
Regardless of whether the exit is via a trade sale, a strategic acquisition or a listing, strong ESG factors are likely to be important to a successful exit, says Greenfield.
“That next buyer will potentially hold that asset indefinitely if it’s a strategic buyer, or if it’s a financial buyer for potentially the next five to seven years. The guiding star is that sustainability needs to demonstrate financial return. And if it becomes a core part of the strategy, that becomes a core part of the exit thesis for the next potential buyer.”
BCI’s framework is designed to be flexible enough for use across BCI’s private equity portfolio. “There’s no ‘one-size-fits-all’ approach. It’s customised to understanding the company’s strategy and ensuring that there is an economic advantage in linkages emanating from sustainability,” he adds.
BCI has deployed this holistic approach across every industry, geography, scale and stage of company. A key feature is that any ESG-driven initiative must demonstrate its superior economic return over competing value creation activities to justify the opportunity cost and management time.
“If it has a higher return on investment, by all means that other area should be pursued relative to ESG. But time and again we’re finding the ESG integration initiative offers compelling ROI for each of the portfolio companies,” says Greenfield.
Different dynamics
For diversified long-term investors such as BCI, the ability to exercise influence varies widely across asset classes, from an ESG perspective or any other. While the balance of power between issuers and investors in the listed markets is subject to regulatory shifts, there is a different dynamic at play in private equity, according to Greenfield.
“Private equity has a compelling advantage in respect of significant minority or majority ownership. We generally have significant governance rights, board seats. The ability to engage with management regularly allows us to have a much more comprehensive engagement on ESG factors. The less governance you have, the less economics you have; it becomes more challenging to effectuate that change.”
But ESG should be treated no differently to any other source of value creation, such as digitisation, distribution, branding, marketing, etc. The test, says Greenfield, is the case for return.
“When you have less ability to effectuate change, you need to make that case a lot harder and you need to ensure you’re having much more active dialogue with management. We have the great fortune in this asset class that we have very effective means for dialogue,” he adds.
“We want to ensure that when they [management] engage on ESG, we move the dialogue from something that may have been perceived as an administrative exercise, or a cost centre, to an area of strong value creation.”
A critical lever is the ability of direct owners to ensure management incentives and business strategy are fully aligned.
“When you’re able to tie the economic value attributable to ESG to the management incentive programme, it quickly gets interest. Our ultimate arbitrator is the financial lens to ensure ESG is a topic that management understands, executes and deploys because it’s a core part of strategy that has significant economic benefit,” says Greenfield.
BCI’s global portfolio includes investments made as an LP via private equity firms, as well as direct investments alongside a GP partner. When investing as an LP, the asset owner does not have those same governance rights as with a direct portfolio company.
“You may be on the LPAC (limited partner advisory committee), but you want to ensure you’re using your ability to influence. We are educating our GPs on the means of attributing significant value to a portfolio from this ESG lens,” says Greenfield.
Part of the motivation for the recent white paper is to help GPs to understand BCI’s approach to leveraging sustainability themes.
“It’s not just about engaging with their ESG teams. It’s also engaging with operating partners and investment professionals such that they understand the economic value. I’ve yet to meet a GP or a management company that is not interested in enhancing risk-adjusted returns. [In the paper], we demonstrate holistically and comprehensively the advantages of ESG integration into a portfolio,” he adds.
Rooted in fiduciary duty
The approach outlined in Greenfield’s white paper is informed by the specifics of the asset class, duties to investors and BCI’s overarching strategy, which emphasises use of ESG factors to enhance long-term value, often through active ownership, but stops short of an explicit portfolio-wide net zero target.
BCI uses a proprietary framework to analyse, measure, and report on ESG opportunities and risks across portfolios, and has decreased its total portfolio carbon footprint by 56% since 2019. Much of this can be ascribed to its proactive stance on climate stewardship, which includes a commitment ensuring at least 80% of its most carbon-intensive investments have mature net zero targets by 2030.
Rooting its approach in fiduciary duty means BCI considers all potential private equity investments in the markets and sectors in which it has chosen to specialise without exclusion, prioritising the identification of ESG-related risks and opportunities due to their effectiveness in creating value, measurable in clear, tangible financial returns
“It’s an approach that has worked exceptionally well for our portfolio where we see the potential for significant enhancement of returns that are attributable to sustainability,” says Greenfield.
“We look at sustainability through the financial lens as the primary objective. Our fiduciary obligation is enhanced risk-adjusted returns for our clients, including pensioners, in British Columbia, but a wonderful outcome of that intentionality is societal and economic returns that are in concert with one another, as opposed to in conflict.”
