ESG — Due Diligence

This is true for both buyers and targets. From the perspec­tive of PE compa­nies, clas­sic topics such as finance or legal aspects still pose more tangi­ble and mate­rial risks during due dili­gence than ESG topics. In addi­tion, smal­ler private equity firms in parti­cu­lar usually do not have the resour­ces and exper­tise to syste­ma­ti­cally consider sustaina­bi­lity aspects. On the part of the target compa­nies, too, ESG is mana­ged only selec­tively in many cases, espe­ci­ally in the SME sector. In many cases, compa­nies do not yet feel any exter­nal pres­sure to actively pursue sustaina­bi­lity manage­ment on a day-to-day basis. Also, for many, ESG as an over­all concept is still too abstract in corpo­rate practice.

Howe­ver, the gene­ral condi­ti­ons are curr­ently chan­ging — with noti­ceable conse­quen­ces for buyers and compa­nies. The man-made chan­ges on our planet are beco­ming incre­asingly visi­ble and with them the vulnerabi­lity of many busi­ness models. To give a few examp­les: The neces­sary fight against climate change has led to unpre­ce­den­ted pres­sure for change in the energy and auto­mo­tive indus­tries (incl. supply chain) — and will conti­nue to do so in many other sectors. Supply chains are disrupted, not least due to severe weather events, water shorta­ges or social grie­van­ces, and raw mate­rial prices skyro­cket because we are not using our limi­ted resour­ces effi­ci­ently while demand conti­nues to rise.

Out of econo­mic self-inte­rest, active ESG manage­ment should ther­e­fore become even more important — as part of due dili­gence and active owner­ship. But also against the back­drop of tigh­tening regu­la­tion, incre­asing ESG requi­re­ments from inves­tors, and rising expec­ta­ti­ons from custo­mers and other rele­vant stakeholders.

Due to global sustaina­bi­lity issues, there is curr­ently a massive wave of regu­la­tion to make busi­ness models more sustainable and to direct finan­cial flows to more sustainable compa­nies and projects. The breadth and depth of the new requi­re­ments are confu­sing even for experts and have a stressful effect on most market parti­ci­pants — also due to the uncer­tainty of what to expect and how this is to be imple­men­ted in ever­y­day life. But regard­less of how you feel about these new rules, it is funda­men­tally important to actively deal with them and adapt to them. After all, ESG is not a tempo­rary pheno­me­non, but will become a central factor in all corpo­rate acti­vi­ties and invest­ments in the coming decades.

Port­fo­lio compa­nies should not be left alone on this path, but must be actively supported. Moreo­ver, effec­tive ESG manage­ment is only possi­ble if manage­ment is convin­ced of its bene­fits and neces­sity. ESG due dili­gence invol­ves taking stock of what target compa­nies have and have not been doing to date, and of risks and market poten­ti­als that have not been adequa­tely mana­ged to date. There is no stan­dar­di­zed process for this — partly because ESG issues and chal­lenges are highly depen­dent on the indus­try, loca­tion, size of the company and type of supply chain. It is ther­e­fore important to consciously address the indi­vi­dual frame­work condi­ti­ons of each company — in addi­tion to stan­dard topics such as envi­ron­men­tal and climate manage­ment, human resour­ces and corpo­rate integrity.

On this basis, it then often alre­ady beco­mes appa­rent what the key ESG issues are for a company. Parti­cu­larly in the case of medium-sized compa­nies, the first step is ther­e­fore not to overtax them­sel­ves and tackle all facets of sustaina­bi­lity at the same time. Rather, the three to five most mate­rial ESG issues that the company should address to remain successful over the long term should be iden­ti­fied. This is also a contri­bu­tion to making the abstract ESG concept tangi­ble and imple­men­ta­ble — an important step in demys­ti­fy­ing the topic of ESG and trans­la­ting it into concrete fields of action. Based on this, a road­map and time­lines for imple­men­ta­tion can then be determined.

Today, large publicly traded compa­nies are under tremen­dous pres­sure to actively manage and report on all major sustaina­bi­lity issues with great trans­pa­rency. If they do not, they are incre­asingly unat­trac­tive to a substan­tial propor­tion of inves­tors. In addi­tion, it is fore­seeable that refi­nan­cing condi­ti­ons will also dete­rio­rate for compa­nies that are poorly mana­ged from an ESG perspec­tive — a clear compe­ti­tive disadvantage.

The private equity market and medium-sized compa­nies are not yet as much in focus. For medium-sized compa­nies in parti­cu­lar, it is ther­e­fore important to use scarce resour­ces to give prio­rity to the ESG issues that are essen­tial for their own econo­mic success. But it is important to reco­gnize ESG as a stra­te­gic issue and to actively embark on the ESG path in the first place in order to be prepared for future regu­la­tion and inves­tor and custo­mer expec­ta­ti­ons. This is often not yet the case. Howe­ver, as the pace of change is incre­asing and new ESG requi­re­ments can be expec­ted at ever shorter inter­vals, it would be negli­gent not to address the requi­re­ments that can alre­ady be anti­ci­pa­ted in a timely manner.

Much of what is curr­ently important for medium-sized compa­nies is feasi­ble and easy to imple­ment — if neces­sary with the help of exter­nal consul­tants. This can include, for exam­ple, the formu­la­tion of a sustaina­bi­lity stra­tegy, the analy­sis of custo­mers’ sustaina­bi­lity requi­re­ments, and the measu­re­ment of the company’s own carbon foot­print. Basic trans­pa­rency on the company’s own ESG manage­ment and certain ESG KPIs is also important — partly because private equity compa­nies are incre­asingly requi­red to disc­lose this infor­ma­tion to their investors.

About Matthias Boenning

As Mana­ging Direc­tor of fors.earth capi­tal GmbH, Matthias Bönning advi­ses clients from the private equity and finan­cial markets in parti­cu­lar on the imple­men­ta­tion of sustaina­bi­lity stra­te­gies. He has more than 20 years of expe­ri­ence in sustainable finance and corpo­rate sustaina­bi­lity ratings: as Head of Rese­arch and Board Member at oekom rese­arch AG and as Mana­ging Direc­tor and Global Head of ESG Ratings at Insti­tu­tio­nal Share­hol­der Services Inc.

matthias.boenning@fors.earth