How Private Equity Is Driving Sustainability in Europe

As long-term owners of portfolio companies spanning numerous sectors, private equity firms are well-positioned to accelerate the transition to net zero and more equitable business models. Earth.Org takes a look at the importance of prioritizing sustainability in the Private Equity (PE) sphere and Europe’s unique role in this challenging process. 

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A 2022 article highlights the tremendous growth of Private Equity (PE) from a Wall Street niche to $6.3 trillion in assets under management globally by 2021 – with such figures projected to exceed $11 trillion by 2026. According to the article, roughly 10,000 firms now oversee over 20 million employees at 40,000 portfolio companies. With an estimated $1.96 trillion in dry powder as of late 2022, the collective financial clout of PE positions the industry as a powerful player in environmental, social and corporate governance (ESG), able to generate social value through their significant capital ready for investment.

As the article notes, the relationship between the PE sphere and society’s efforts to tackle climate change is highly symbiotic. The significant size and influence that PE firms hold over so many companies makes their participation highly necessary to achieve meaningful progress on issues like climate change. However, the sector is also reliant on addressing these societal challenges for its own long-term success. 

The Opportunity for Private Equity in Sustainability

The unique PE business model gives such firms some clear advantages over public market investors when it comes to driving sustainability progress. As owners and governors of portfolio companies, PE firms have ultimate control over ESG strategy and accountability. They also have considerably more access to financial and sustainability performance data when compared to how investors in public companies may only see the information the company chooses to report. Additionally, PE ownership allows for longer average time horizons of five years that create a broader opportunity to invest in impactful sustainability initiatives.

While profitability has traditionally been the primary focus of PE firms, the growing importance attributed to ESG is evident in the quadrupling of Principles for Responsible Investment (PRI) signatories to over 1,000 PE/Venture Capital (VC) firms in just 5 years – as per August 2022. The PRI is a United Nations-supported international network of financial institutions that works to promote the incorporation of ESG factors into investment decision-making. This rapid increase in PRI signatories demonstrates a shift toward recognizing sustainability as integral to generating long-term value through responsible private equity practices.

Moreover, recent studies have shown that ESG commitment is increasingly becoming a competitive differentiator for PE firms. As Harvard Business Review noted, General Partners (GPs) are now able to leverage their sustainability credentials in negotiations with companies facing multiple bids. Additionally, research from Arthur D. Little and Invest Europe’s European PE survey found that three-quarters of GPs believe a strong ESG approach will be critical to standing out when attracting investor capital. Whereas track record used to be the sole primary differentiator, perhaps ESG considerations have now joined other factors of high importance like investment strategy. 

This reflects a confluence of forces making sustainability commitments a new sales point for GPs competing over target companies and fundraising.

Europe Leading the Way

The US has seen pushback against ESG investing, as several states have introduced legislation restricting state governments from engaging with companies employing ESG criteria seen as “boycotting” certain industries like fossil fuels. According to law firms Morgan Lewis and Ropes and Gray, as of December 2022, over a dozen states have passed laws prohibiting investment in firms that boycott industries such as fossil fuels, forestry and agriculture, primarily targeting financial organizations contracting with state retirement funds. 

In contrast, Europe has established itself as the clear industry leader in promoting sustainability; a recent ruling from a German court requiring companies claiming to be “climate neutral” to clearly define environmental terminology when advertising aims to limit greenwashing. This ruling occurs alongside not only a general increasing awareness of climate change amongst both consumers and businesses alike, but also growing climate regulation in the region – creating both pressure and valuable opportunities for PE firms.

Data from the PRI illustrates the strong interest in ESG among European firms. Approximately two-thirds of PRI signatories are based in Europe, according to 2020 reporting data. With increasing regulatory support and government initiatives in Europe, the environment is conducive for PE and VC to invest more in climate and sustainability. These investments can help close the vast estimated $150 trillion funding gap needed by 2050 to reach net zero goals. 

Encouragingly, climate-focused investments have recently increased by 40% according to BCG data from March 2023. Dedicated climate funds now have $37 billion earmarked for deployment. The EU is mobilizing efforts to spur green tech investment and approvals through initiatives such as the EU Green Deal Industrial Plan, which aims to speed up investment and financing for clean tech production in Europe. As regulatory environments improve in Europe, private capital can play an important role in financing the transition to a low-carbon economy.

More on the topic: The Case for a Green Industrial Deal: An Interview With European Greens Lead Candidate Bas Eickhout

Regulatory developments in Europe are driving increased sustainability commitments across the PE industry. New regulations such as the Sustainable Finance Disclosure Regulation (SFDR) and guidelines from the European Securities and Markets Authority (ESMA) have significantly reshaped how PE managers position themselves and how investors now expect funds to approach ESG. The SDFR, which came into effect on March 10, 2021, requires financial service providers and owners of financial products to assess and disclose ESG considerations publicly. 

A survey by Arthur D. Little and Invest Europe highlights how Europe’s leadership in developing robust sustainable investing regulations, such as SFDR, have changed PE manager strategies and investor expectations. The majority of limited partners now want funds to register as Article 8 or 9 “green funds”. In response, managers are increasingly targeting these higher sustainability benefit designations themselves. The demand for green funds and their extensive reporting requirements is having a major impact on firms; for example, around half of firms anticipate needing to increase staffing and dedicate more roles to ESG. Moreover, the ESMA released guidelines establishing thresholds for environmentally-focused investment fund names. Noting the sharp rise in sustainability-related terms used by funds, ESMA introduced an 80% minimum investment requirement for funds using terms like “ESG” or “sustainable.” It also created a “transition” category to promote green economy transitions. The finalized ESMA guidelines aim to provide investors clarity on funds’ true sustainability alignments while still enabling capital to support climate challenges. Firms will have three months after multilingual publication on the ESMA website to implement the new guidelines.

Challenges and Emerging Best Practices

The PE industry faces several challenges when it comes to sustainable investing. Regulatory frameworks around ESG reporting are still evolving globally, creating flux for managers to navigate changing transparency rules. Additionally, many needed climate technologies remain in early development phases that will require further scaling to reach full market potential. As of November 2021, half of net zero solutions were still in demonstration or prototyping. Moreover, the PRI notes that consistent, integrated ESG disclosures are still needed from investee companies. 

A key challenge for GPs looking to consider ESG is a lack of disclosure from private companies, which do not face the same reporting mandates as public firms, making relevant ESG data difficult to obtain. Even with improved material data availability, PE firms will need to build internal capacity to effectively analyze sustainability factors and train staff on value creation from an ESG lens.

Nevertheless, despite these difficulties, PE firms are increasingly adopting new practices to strengthen their ESG performance. Notable emerging best practices include examples of European PE funds establishing science-based climate targets and collecting supply chain emissions data. Other approaches seeing more adoption include undertaking ESG due diligence at portfolio company exits and linking sustainability metrics to carried interest compensation. Additionally, collaborative projects aimed at standardizing ESG reporting benchmarks and committing funds to net-zero emissions goals by 2050 demonstrate alignment on addressing material issues. As sustainable investing regulations and expectations continue evolving rapidly, these types of leading practices can help PE managers further systematize their ESG integration.

More on the topic: There’s Growth in Sustainable Investing, But Are the Benefits Worth It?

Given the tremendous scale and influence of the PE industry, funds have a unique opportunity and responsibility to advance progress on pressing sustainability challenges. As long-term owners of portfolio companies spanning numerous sectors, PE firms are well-positioned to accelerate the transition to net zero and more equitable business models, with Europe leading the way as a vanguard in promoting ambitious ESG practices through robust regulations and initiatives.