ESG and the U.S. Middle-Market: What's Holding It Back?

Environmental impact, social criteria, and corporate governance (ESG) topics are undoubtedly playing a larger role in the private equity world today - movements like Black Lives Matter and #MeToo are calling out for reinforced focus on social issues, worsening natural disasters showing ripple effects of climate change, and engaged consumers are demanding brands take a stand on political debates; investors are well-aware of ESG's enlarged influence. More and more LPs want to engage with private equity firms that consider the environmental impact or diversity of a company’s leadership in its investment decisions. But findings from AlixPartners’ 6th Annual PE Leadership Survey show a wide disparity between middle-market investors' priorities about the importance of these topics, and their progress in incorporating ESG criteria into their deal theses and operating metrics.

What We Found:

Combing through the findings of our PE Leadership survey, we found a very fragmented outlook among middle-market GPs (categorized as funds with less than $5 billion in AUM). One-third of respondents are not considering ESG factors at all when generating their investment theses, or might be looking at ESG issues but overwhelmingly are weighing pure investment returns as the most important factor. Yet in the same set of survey findings, over 50% of middle-market respondents stated that ESG factors were either “Somewhat Important” or “Very Important” in crafting their investment theses and selecting target opportunities. What might account for this dichotomy among middle-market investors?

Clear Definitions and Alignment

One hypothesis as to why there exists such a divide between middle-market GPs is the often-vague understanding of what ESG encompasses. ESG can mean a lot of different things to different people – so it’s critical for everyone in the PE firm, from the investment committee down to the individual portfolio and deal teams define what ESG principles they are committed to and building off of that.

Lack of Integration

Many middle-market firms might not look at ESG factors as value capture opportunities across the entire PE value chain, from target scans to due diligence through ownership and exit. Simply seeking to track random KPIs isn’t going to achieve the goal of truly embedding ESG considerations across the value creation strategy and making them bedrock principles for investment teams. Not every deal is going to have ESG fit neatly into an investable theme, but likely there is considerable space for ESG to be factored into every diligence process.

Metrics and Measurement

Lastly, many investors may simply not have the necessary benchmarks and measuring processes to track year-over-year improvement and monitor ESG performance across their portfolios. This is understandable, skepticism still abounds on whether ESG actually benefits performance due to lack of empirical evidence. But as the larger funds (especially in Europe) see the shift of the market towards prioritizing ESG, it will likely become more and more important for these middle-market GPs to be willing to experiment and develop their own successful approaches into processes and playbooks that can lead to repeatable results.