Private equity’s transformative power can accelerate ESG’s impact

In the last 12 months, 62% of respondents said ESG or ethical factors had been significant contributors to the decision not to invest in one or more companies. This is up from 58% a year ago and 55% before Covid-19. 

The UK and the US slightly lagged the rest of the world in terms of the regional variation, while continental Europe led the way.  

“The pressure is rising for PE firms to create value in a meaningful and sustainable way. Furthermore, the speed with which ESG trends are transitioning from public to private is rapidly accelerating,” said Head of Advisory and Co-Head of Private Equity Jonathan Arrowsmith.

"The vast majority of firms remain private – and thus embedding ESG into private equity is crucial if we want to succeed in reaching targets such as a reduced carbon footprint.”

He believes this represents a challenge and an opportunity to inject additional value into the private equity proposition.  

“Private equity’s edge has always been that it can drive value by enabling transformation at a more rapid rate. Traditionally, this has meant creating efficiencies by unlocking value and repositioning assets. But in the future, we see private equity increasingly bringing its transformative power to key ESG themes, such as decarbonisation and impact investing.  

“While publicly-listed firms must unify potentially very disparate shareholder groups around ESG issues, the private equity ownership structure has the potential to affect radical change. Moreover, the vast majority of firms remain private – and thus embedding ESG into private equity is crucial if we want to succeed in reaching targets such as a reduced carbon footprint,” he said.  

When asked about the greatest influence on their attitude and activity regarding ESG and sustainability, 52% of respondents indicated their respective firm’s core values.

Helen Lucas, Co-Head UK Origination, Growth & Leveraged Finance, said the survey results suggested change is coming from within, and that the industry is beginning to find real alignment among General Partners (GPs), which bodes well for the long-term adoption of ESG.

“From a banking perspective, we are seeing a major shift in the perception of ESG’s importance. We expect it will be become more unpalatable to lend or invest in companies that have a negative perception around ESG. We have, as an industry, gone from needing to explain why ESG factors are important, to having to justify when they are not present. This is real change,” she said.  

When asked which sector would be the most attractive investment over the next 12 months, 68% of GPs indicated healthcare was their preferred sector, while 47% stated the technology, media and telecom (TMT) sector.

“The optimism on the TMT and healthcare sectors is well-founded. Since the outbreak of coronavirus, it is clear the health sector has enhanced opportunities and long-term structural trends that have extended dramatically – from vaccines to diagnostics. The question is finding those companies that will disproportionately benefit from multiple tailwinds,” said Arrowsmith. 

Lucas also agreed that healthcare is experiencing strong tailwinds. “The pandemic has undoubtedly put a greater focus on healthcare. The challenge is to try and identify those businesses that can harness evolving trends. Healthcare firms are also good candidates for leverage, and we expect this area to attract debt, which will support asset price growth.”

"The buoyancy of the market also reflects the wall of money that has flowed into private equity and the need for allocators to deploy and get things moving – which has been influenced by extraordinary monetary policy rather than traditional demand dynamics."

Arrowsmith said GPs would also increasingly focus on TMT in the new post-Covid world due to its phenomenal potential for scale. “The pandemic has hastened our entry into the virtual world, and tech-enabled businesses have demonstrated remarkable resilience. The pandemic has presented a challenge and many of these businesses have shown their business models are even stronger than previously expected. Furthermore, their proven ability to scale up will fuel earnings growth and attract even higher multiples,” he said.

Relative to 2020, GPs believed private equity returns, both at a firm and industry level, would perform strongly over the next two years.

Lucas agreed that returning optimism was driving sentiment around returns but cautioned that this might not be a one-way street.

“The results are surprisingly high, suggesting we are back to normal. The buoyancy of the market also reflects the wall of money that has flowed into private equity and the need for allocators to deploy and get things moving – which has been influenced by extraordinary monetary policy rather than traditional demand dynamics. While I am optimistic on returns in the long term, there is room for caution given the short-term threat of variants, US-China tensions and the potential for spikes in inflation,” she said.  

Jonathan Harvey, Head of Client Relationship Management in Investec’s Fund Solutions team, said he believed private equity’s ability to weather liquidity events had boosted returns sentiment. This was echoed in the survey, which indicated growing confidence fuelling an increase in commitments. 

“The continual rising trend of year-on-year fund commitments underscores the level of optimism in private equity’s returns potential. Not only is there a willingness from GPs to back themselves more with increased commitments to their own funds , but there is also an increased level of available capital and financing solutions. The funding mechanism we offer can support an entrepreneurial generation of GPs to capitalise on opportunities that were once prohibitively difficult to access due to funding dynamics,” he said.

As investors look to harness the increased confidence, the survey identified some shifts in debt structures. For example, asset-based finance has more than doubled since last year, suggesting shifting fundamental structuring dynamics. 

“It makes perfect sense to use assets to lower the cost of capital. However, in our general lending, we have not seen a disproportionate move into asset-based lending. What we have seen is a general shift to unitranche structures"

“Our combined Asset-Backed Lending (ABL) and Cashflow team has been exceptionally busy,” Lucas said. “It makes perfect sense to use assets to lower the cost of capital. However, in our general lending, we have not seen a disproportionate move into ABL. What we have seen is a general shift to unitranche structures and into more private debt structures than bank structures.”

Lucas explained that Investec’s unique offering and broad mandate offers something bespoke and different from the offering of traditional banks and private debt funds.

“On one hand, we do not have minimum hurdle rates that private debt providers demand. On the other side, we are less risk-averse than traditional banks, where the pricing falls into more senior structures. Our Growth and Leveraged Finance team offers options across the spectrum. This means we can price for the opportunity. Hence, if an opportunity suits the unitranche structure, we can support a solution. Equally, if a client wants more leverage than what a high street bank is offering but not a full unitranche solution – they might need some amortisation, for example  – we can offer a tailored solution,” she said.

Lucas said that Investec flexibility reflects the journey of most companies.

“Very few companies move from A to B in a straight line. What underpins our philosophy is fostering long-term relationships with our clients. These relationships are strengthened during crisis periods, such as the Covid-19 pandemic, where our clients can depend on our holistic approach, flexibility and established way of working. Private debts funds’ ability to support business through the cycle has yet to be tested,” she added.