Global ESG Focus
is Reshaping
Private Equity
For two weeks from November 30, Dubai will host COP28, the 28th United Nations Climate Change Conference. The program will focus heavily on accelerating action to keep the global temperature increase within 1.5C, as well as a broad range of topics around a just transition to a greener economy. Gender equality, low-carbon cities and infrastructure, and sustainable agriculture will all feature prominently. Pervading each of these topics are themes, notably finance and technology, demonstrating policymakers’ recognition of the importance of global businesses and start-ups, as well as the financial firepower of investors, to meeting environmental and social goals1.
As countries around the world continue to recover from the impact and costs of the global pandemic and contend with a new set of challenges posed by persistent inflation and higher interest rates, it is clear that public finances are insufficient to meet ambitious goals. In contrast, there is sizeable and growing investment firepower in private markets. According to data from S&P Global Market Intelligence and Preqin, private capital dry powder hit $2.5tn in mid-2023, some three times the level seen a decade earlier2. Global private equity groups KKR and Blackstone alone had more than $40bn of investment capacity across private asset classes, followed by a large universe of private equity, growth capital and venture firms with multiple billions of undrawn commitments.
Governments and supranational bodies are hopeful that private capital can help drive change, leading to heightened levels of focus from policymakers. At the same time, increased attention is also amplifying calls for greater transparency and higher levels of sustainability within portfolios and across sponsor firms themselves.
As countries around the world continue to recover from the impact and costs of the global pandemic and contend with a new set of challenges posed by persistent inflation and higher interest rates, it is clear that public finances are insufficient to meet ambitious goals. In contrast, there is sizeable and growing investment firepower in private markets. According to data from S&P Global Market Intelligence and Preqin, private capital dry powder hit $2.5tn in mid-2023, some three times the level seen a decade earlier2. Global private equity groups KKR and Blackstone alone had more than $40bn of investment capacity across private asset classes, followed by a large universe of private equity, growth capital and venture firms with multiple billions of undrawn commitments.
Governments and supranational bodies are hopeful that private capital can help drive change, leading to heightened levels of focus from policymakers. At the same time, increased attention is also amplifying calls for greater transparency and higher levels of sustainability within portfolios and across sponsor firms themselves.
PE Adopts Climate and Social Action at Portfolio Companies
Research from industry association Invest Europe showed that only 9% of private equity-backed companies in its European sample had net zero targets at the end of 20213. However, momentum is growing, and more firms are aiming for carbon neutrality across their portfolios.
EQT was an early mover, adopting Science Based Targets for the firm that align it with the Paris Agreement’s 1.5C temperature increase goal4. This involves absolute reductions in Scope One, Two, and Three carbon emissions by 2030, and reflects practical measures such as 100% renewable energy use at its offices5. The firm is also encouraging portfolio companies to sign up to the initiative, with 40 of its businesses having started to set their own Science Based Targets by the end of 2022. More firms are joining the movement, including Astorg, Hg, and InvestIndustrial, with CVC more recently announcing its intention to have its emissions reduction targets validated6.
PE Adopts Climate and Social Action at Portfolio Companies
Research from industry association Invest Europe showed that only 9% of private equity-backed companies in its European sample had net zero targets at the end of 20213. However, momentum is growing, and more firms are aiming for carbon neutrality across their portfolios.
EQT was an early mover, adopting Science Based Targets for the firm that align it with the Paris Agreement’s 1.5C temperature increase goal4. This involves absolute reductions in Scope One, Two, and Three carbon emissions by 2030, and reflects practical measures such as 100% renewable energy use at its offices5. The firm is also encouraging portfolio companies to sign up to the initiative, with 40 of its businesses having started to set their own Science Based Targets by the end of 2022. More firms are joining the movement, including Astorg, Hg, and InvestIndustrial, with CVC more recently announcing its intention to have its emissions reduction targets validated6.
In parallel with greater environmental focus, firms are enhancing their social and governance efforts. KKR’s sale of C.H.I. Overhead Doors, a maker of garage doors based in Illinois, generated payouts averaging $175,000 for company employees as a result of a profit-sharing scheme7. The Ownership Works organization founded by KKR’s global co-head of private equity Pete Stavros currently has 25 private equity members, including Advent International, Apollo, Silver Lake and TPG, with initial signatories to the plan having committed to introduce employee ownership in at least three portfolio companies by the end of this year8.
Such approaches require effort and investment but can ultimately be beneficial for private equity returns. As the co-head of KKR’s global impact fund, Ken Mehlman, recently told the Financial Times, “an approach to ESG and sustainability that is focused on issues material to a company’s bottom line can be incredibly accretive from a value creation and value protection perspective”9.
In parallel with greater environmental focus, firms are enhancing their social and governance efforts. KKR’s sale of C.H.I. Overhead Doors, a maker of garage doors based in Illinois, generated payouts averaging $175,000 for company employees as a result of a profit-sharing scheme7. The Ownership Works organization founded by KKR’s global co-head of private equity Pete Stavros currently has 25 private equity members, including Advent International, Apollo, Silver Lake and TPG, with initial signatories to the plan having committed to introduce employee ownership in at least three portfolio companies by the end of this year8.
Such approaches require effort and investment but can ultimately be beneficial for private equity returns. As the co-head of KKR’s global impact fund, Ken Mehlman, recently told the Financial Times, “an approach to ESG and sustainability that is focused on issues material to a company’s bottom line can be incredibly accretive from a value creation and value protection perspective”9.
Investors Expect Higher ESG Standards
The push to integrate ESG at portfolio companies may be voluntary and fueled by what sponsors perceive to be good business sense. At a fund and firm level, it is also driven by regulation and rising investor expectations. According to Invest Europe’s ESG KPIs study for 2021, the year when the EU’s Sustainable Finance Disclosure Regulation (SFDR) was introduced, two-thirds of funds subject to the regulation were classified as Article 6 – meaning that they did not incorporate sustainability factors into the investment process – while a quarter were Article 8 and just under 10% qualified as Article 910.
Perceptions have shifted. Investors are increasingly focused on Article 8 and 9 funds, which are funds that take ESG factors into account, or actively target climate and social benefits. The EU’s review of SFDR which launched in September acknowledged that Articles 8 and 9 are being used as “de facto product labels”, which could lead it to adopt a more precise categorization regime that could support such labelling11. Meanwhile, the UK’s Financial Conduct Authority has floated the creation of three labels under its parallel Sustainable Disclosure Requirements – sustainable focus, sustainable improvers, and sustainable impact – effectively acknowledging investor demand for funds that have explicit ESG aims12.
Standing Out with Compensation and Finances Tied to ESG Performance
Labelling is one way to tie funds and firms to action on ESG – linking GP remuneration to specific targets is another. As the impact fund universe grows, the prevalence of such arrangements has increased, with a total of 21 impact funds raising $22bn in 2022, according to PitchBook data13.
The proportion of carried interest tied to impact goals typically starts at 10%, while EQT links 20% of the carried interest of its Future Fund to targets related to GHG emissions, employee wellbeing, and gender diversity14.
Standing Out with Compensation and Finances Tied to ESG Performance
Labelling is one way to tie funds and firms to action on ESG – linking GP remuneration to specific targets is another. As the impact fund universe grows, the prevalence of such arrangements has increased, with a total of 21 impact funds raising $22bn in 2022, according to PitchBook data13.
The proportion of carried interest tied to impact goals typically starts at 10%, while EQT links 20% of the carried interest of its Future Fund to targets related to GHG emissions, employee wellbeing, and gender diversity14.
ESG criteria are increasingly embedded in firms’ activities and structures, including in portfolio company financing. Green, Social, and Sustainability loans and bonds are a growing focus for corporates, with Italy’s ENEL one of the leaders in Europe. The utilities group raised €1.5bn earlier this year for bonds tied to KPIs on the EU Taxonomy and UN Sustainable Development Goals15, building on its past issuance of ‘green’ bonds. Such products are structured to see coupons step down if the issuer meets its sustainability targets, but increase if it misses. PwC forecasts that issuance of green, social, and sustainability bonds in Europe could reach €1.4tn or higher by 2026, but that only half of respondents in its Global Private Equity Responsible Investment Survey 2023 had used ESG-linked financing in the past 12 months16.
The approaches employed by private equity firms may vary, but the direction of travel is clear. Regulation, investor expectations, higher returns, and the potential to stand out in an increasingly competitive market will continue to drive action on ESG and ever more ambitious targets.
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