Exploring Private Equity’s Sustainability Challenges
By Elizabeth Arenz Hosbein
When I graduated from Harvard Business School with a resume in finance, it was perhaps unexpected that I joined Environmental Defense Fund (EDF), a leading environmental NGO, to spend a fellowship year investigating private equity (PE) from the outside. I had big questions to answer: to what extent are PE firms integrating sustainability – and especially climate – into their investment processes? Does a sustainable investing approach create value for PE investors? And what can groups outside the financial sector do to mobilize private capital toward global climate goals?
Having worked in the private equity industry prior to pursuing an MBA, I was eager to explore these themes at HBS. Over the course of my studies, we had many discussions about the conflicting priorities that companies encounter when striving to do good by both shareholders and stakeholders. My EDF fellowship gave me the chance to pressure test these classroom learnings surrounding impact, sustainability, and the ability of the finance sector to grapple with changes demanded by many investors.
At EDF, I researched resources on sustainable investing, learned from colleagues with experience in climate finance and sustainability, attended conferences and surveyed industry insiders. What I found was that many private equity groups are taking steps toward sustainability – but the industry must do more to integrate the risks and opportunities associated with global climate change.
Regulatory and investor pressure
The finance industry overall is shifting rapidly, as regulators become more involved in clarifying how climate and other sustainability metrics correspond to shareholder value. Key standards are emerging, like those of ISSB, and guidance from TCFD and EDCI are aiding convergence. Still, regulation is crucial in establishing an even playing field for all industry participants, but it is slow and imperfect. Fortunately, it’s not the primary driver for sustainability with private equity.
Overwhelmingly, the parties I interviewed reported that while regulation is necessary, private equity firms’ limited partners (LPs) have pushed the industry further than what regulators are proposing, an insight captured in a recent ILPA-Bain survey. Current fundraising pressures have accelerated this trend: as public equity valuations have gone down, LPs have become overexposed to private markets, driving up competition for new capital among PE firms and providing LPs with additional influence. For some LPs, that has meant more leverage to call for improved sustainability performance.
Three big challenges for private equity
Due to this pressure from LPs, many private equity firms would like to build or improve on their sustainability program. Three challenges came up repeatedly in my conversations with private equity insiders.
1. Questions about the financial value of sustainability
The most foundational challenge preventing large uptake of sustainability work within private equity is the question of its value – does it contribute to the bottom line? Some view environmental, social and governance – ESG – as critical for compliance, but of little use beyond that to the firm and its investments. Even PE firms and their portfolio companies that do use ESG metrics and frameworks have struggled with attributing value to these practices, jeopardizing their widespread use.
Sustainability frameworks, when leveraged properly, can go beyond a risk mitigation tool and present value creation opportunities. In order to do this, firms need a clear way to evaluate and prioritize ESG-enhancing projects based on their returns. The ROSI™ methodology from Professor Tensie Whelan at NYU relies upon this more rigorous evaluation of ESG, which would build credibility internally for firm- and portfolio company-level projects. Tracking data on ESG metrics is critical to yield definitive proof of its value to shareholders and supporting its alignment with a firm’s fiduciary duty.
2. Lack of resources
There is a lack of resources internally within private equity firms to make operational improvements that would boost both ESG and financial performance. This ranges from a shortage of qualified personnel and time to a lack of off-the-shelf tools tailored to the PE industry.
As long as ESG is seen as a nice-to-have and not a critical value creation tool, resources will be pulled away from it toward more easily recognized and traditional methods of boosting returns. Thus, once the question of the value of ESG has been addressed, firms should then focus on capturing this value with adequate resources. To prioritize the opportunities available, firms should focus on material sustainability issues based on asset type, level of control, and relevant sector. Beyond the tracking of ESG metrics based on relevance, firms need operational expertise to fully realize the value of sustainability.
3. Data gaps and quality issues
While financial data on portfolio companies as well as private equity firms themselves are plentiful, ESG data on the same institutions are sorely lacking. This stems from the aforementioned lack of resources as well as lack of conviction around which ESG metrics to prioritize due to the proliferation of standards, frameworks, and groups offering broad-based guidance. Additionally, though some ESG metrics like board diversity are easily assessed, others like greenhouse gas emissions are not as easily observed or calculated. Further, some relevant metrics like water use are ignored due to their absence from prevalent frameworks.
In order to improve data access and quality, PE firms should hire for and prioritize data integration. The clarity promised by upcoming ESG regulations from the Securities and Exchange Commission and convergence around frameworks from ISSB and TCFD can help here.
My work on this subject is further captured in this presentation. As the global economy reorients toward net zero emissions by 2050, there is a significant need for capital to invest in transitioning high-emitting industries using lower-emission solutions. Meeting global targets will require leveraging the private equity industry’s operational dexterity to revolutionize high-carbon sectors. For the PE industry to achieve attractive returns doing so, its investment professionals will need to incorporate ESG metrics that can serve as guideposts. Reframing our thinking of sustainability as a tool for value creation rather than purely risk mitigation is critical to the success of ESG programs and the relevance of sustainable investing in the future.
Elizabeth Arenz Hosbein worked at Environmental Defense Fund as part of Harvard Business School’s Leadership Fellows program from 2022-23, where she engaged the private equity sector on sustainability and climate. She previously worked as a private equity investment professional and in investment banking across CPG manufacturing, air pollution control, business services, and technology. Elizabeth is a graduate of Johns Hopkins University and Harvard Business School.