Blog Article

What ESG Is: The ESG Arbitrage Effect

Monday 1 August 2022

Last month, I shared an article on what ESG is not, moved by an agitating sensation that strangely unrelated activities were being labelled ‘ESG’ in error. Here, I take a stab at the most important things that ESG is. The things that render Environmental, Social, and Governance (ESG) information and performance useful to a company or investor go far beyond optics, and far deeper than box ticking. ESG performs both a risk mitigation and value creation service to companies, investors, shareholders and the broader stakeholder community. This article is written largely from the investor standpoint and with the investment life cycle of private equity in mind.

What ESG is:

A way to add value throughout the investment lifecycle through ESG Arbitrage

ESG is not one thing. It is not one box tick or one list of exercises. It’s an orientation and an outlook. It’s a response to stimuli in a fast-paced business environment. ESG tools and interventions add value during each phase of the investment lifecycle. From capital raising, to deal review, to due diligence, to origination & structuring, to holding, and finally exit.

ESG integration along investment cycle

Source: Deutsche Private Equity, 2022.

During the pre-investment period, ESG screening policies will eliminate investment opportunities out of alignment with the ESG strategy of the fund. During diligence, the ESG due diligence process is conducted alongside the traditional financial due diligence to ensure a holistic, comprehensive view of a company. Diligence will also afford the investor the chance to drive down the price of the asset by identifying poor ESG performance or additional risk inherent to the investment by virtue of a weak or non-existent ESG program. During deal origination and structuring, it is common for investors to include conditions precedent (CPs) linked to the satisfaction of ESG deliverables, such that future draw-downs will be linked to ESG performance indicators. These CPs are often tied to an Environmental, Social, and Governance Action Plan, ensuring that a new portfolio company or investee realizes specific ESG deliverables during the first 100 days (…six months…one year) of the investment. During the holding period, which can last from three to seven years, not only is the ESG Action Plan further implemented, but also, the investor is identifying ways to add value to the investment through ESG interventions, policies, systems, tools, and annual ESG reporting. Finally, at exit, the investor will isolate, valuate, and integrate ESG value added over the course of the investment to ensure exit valuations are driven up and the investor is able to exceed her hurdle rate and maximize her carried interest.

This process, which involves driving down the price of an asset during diligence and driving up the price of an asset at exit is known as ESG arbitrage. The ability to buy low and sell high is a core tenet of investment best practice and is executed similarly with regard to ESG performance. Investors who understand how to integrate, articulate, and valuate ESG risk and ESG value at different phases of the investment lifecycle are the enlightened few.

Additional, material information; poised to elevate the discourse around a company and its impacts

The job of company leaders, investors, and partners is to collect information that is most useful and material to a company’s performance and use that information to make decisions. Far from being a distraction or a tangential matter to the core business of investing, ESG data and performance provides a nuanced, triangulated form of insight into a company or a portfolio that can serve decision making.

We can all agree that relevant, material, applicable information is critical to understanding a company. ESG data and performance information serves to broaden the aperture of traditional due diligence to include areas of performance not traditionally captured on the balance sheet. This information is meaningful, helpful, and relevant to a company.

A more complete story of a business: its risks and its value

Traditionally risk tables are tools used by accountants, actuaries, financiers, and careful investors. What is not traditionally captured in these tools are the reputational, relational, contextual, or political roles that a company plays in its ecosystem. And if the experiences of a global pandemic have taught us nothing else, it’s that context matters. A company’s risk exposure has everything to do with its environmental, social, and governance performance. Aggrieved communities, substandard waste management or water management practices, and conflicts of interest at the board level certainly contribute to (or detract from) a company’s impact.

Likewise, investment value addition includes the value created by clear, well implemented environmental management systems and processes; strong relationships with communities surrounding the asset, high staff retention, a loyal and motivated stakeholder community; clear chains of custody and a well-managed supply chain; an engaged board with strong levels of integrity. These assets are not found on the balance sheet; and yet, they lend incredible value to a company. In more nuanced due diligence processes, these pieces of company culture and performance are captured. Critically, they can serve to increase company valuation, or decrease valuation, in their absence.

A key driver for business growth, investment, transparency and long-term success

For too long, some in the financial sector have perceived of ESG as an additional compliance hurdle and failed to harness the power of ESG to drive business growth. I have been part of several rounds of fundraising targeting family offices, PE firms, international private lenders, Development Financing Institutions and institutional asset managers. In each experience, the performance of our ESG risk mitigation and value addition served only to increase valuations, reduce our cost of capital (particularly in the case of private debt), demonstrate our transparency and serve our long-term success.

I have stood before CFOs who write off ESG as a cost center and an utter waste of time. And I have watched their views and their consciousness expanded as we explore the potential of ESG interventions to save money through operational efficiencies, capital raising, employee retention, and reputational risk mitigation.

For investors and portfolio managers, the opportunity is even greater. The alpha created by a portfolio imbued by ESG data and performance metrics cannot be underestimated. Harnessing the power of material ESG information in investment decision making is the way of the enlightened investor.

About the Author

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