Updated: May 30
Author: Sara Diamante
Date of Publication: 29/05/2023
Private Equity (PE) Background
The term private equity refers to a type of alternative investment that emerged soon after the end of World War II. In 1945, the first company was founded in the United Kingdom. This provided venture capital to companies that were not well established but had high growth potential.
Also in America, a year later, the American Research and Development Corporation was founded with the same social mission. Later, the first legislative and regulatory guidelines related to private equity were published. However, this type of investment has only really developed in the last two decades. More specifically, it exploded after the 2008 financial crisis, and subsequently during covid 19.
Private Equity: what it is and how it works
Private equity refers to a category of investment in which the investor's objective is to finance projects and companies with good growth potential. These are unlisted, often small companies that are unable to raise capital on the stock exchange and take advantage of the banking channel.
Financing is provided through the subscription of newly issued equity stakes or by purchasing existing ones from third parties. In addition, P.E. operators can finance various stages of a company's cycle, from startup to growth, to listing, to delisting.
Importantly, the investor is not merely a lender of funds but plays a key role in the company's decision-making processes. In fact, the latter participates in the Board of Directors of the target company by exercising broad veto powers and monitoring activities.
Characteristics of Private Equity (PE)
Those who invest through private equity funds are usually institutional investors such as banks or SGRs. These first identify a target company, then agree on a project and objectives jointly with the entrepreneur. These are medium- to long-term transactions with a high-risk profile.
In particular, the profit for the entrepreneur has two sources. The first is from the management and performance fees that the target company charges the investor periodically. The second, as well as the most significant, comes from the fee for divesting the stake once the investment project is aimed at completion.
Moreover, there are various ways of divestment:
● listing of the shareholding on the stock exchange
● subscription by old or new shareholders
● zeroing out the shares
Once the investor proceeds with the disinvestment, the transaction is deemed to have ended.
Sustainable Private Equity (PE)
At this point, it is easy to understand the meaning of sustainable private equity. In particular, it is a small variation of traditional private equity. This involves the purchase of equity stakes belonging to target companies that adhere to certain social and environmental parameters.
Sustainable private equity operators provide investee companies with managerial support that pursues different types of objectives. In fact, in addition to traditional technical and managerial intervention, the investor provides various advisory services. These are related to the sustainable dimension of the project. Therefore, these services take the form of offering knowledge and expertise in ESG areas, obtained after a course of specialisation.
When did people start talking about sustainable P.E.?
The first traces of contact between the world of private equity and the world of financial sustainability date back to 2009. In fact, on February 10, the United States Private Equity Council (USPEC) adopted and published the first responsible investment guidelines. These are provisions regarding environmental health, governance, and other social issues. So, these must be adopted both before investing in companies and during the period of ownership.
Operational Strategies used
Initially, the most widely used sustainable strategy used by private equity fund managers was that of exclusion. The latter involves ignoring certain companies while choosing the target one. Thus, at the start-up stage of the operation, all those companies that do not meet certain moral and ethical criteria are excluded from selection. Subsequently, thanks to the continuous evolution of responsible investing, this overly limiting strategy has been replaced and/or supplemented. Indeed, new strategies allow for a broader view regarding the integration of ESG criteria into the world of private equity investing.
At what stage are ESG factors included?
The sustainable private equity market is still small, dealing with issues that have been sensitized in a fairly recent time. However, several pressures are now forcing more and more P.E. managers to include ESG factors within their projects. These include the constant attention to environmental and social issues by investors, stakeholders, and the media.
The latter is often included in a specific phase within a private equity transaction. We are talking about the due diligence phase. Remember that in this phase the investor makes a full assessment of the company that intends to acquire. So, due diligence is divided into areas: legal, tax, technical accounting, and financial.
Although managers are often faced with insufficient information and a lack of expertise, ESG due diligence is now considered necessary. To address the problem of in-house skills shortages, this process is often outsourced to specialised external consultants. However, other funds are moving forward with the establishment of an internal committee responsible for ESG integration. Thus, the members of these committees will undergo appropriate specialization.
Monitoring and reporting on the above dynamics remain one of the main problems that practitioners are facing. This is because of the few tools in circulation. One of the most widely used tools remains the standards published by the Global Reporting Initiative. These are concerned with providing a reference for measuring and reporting sustainability performance.
The sustainable private equity market still appears to hold only a small percentage of the total P.E. market. However, it is a fast-growing market and this tool enables the pursuit of multiple objectives. In fact, in addition to expanding the number of target companies, it allows the corporate governance of companies to be influenced. These will be directed toward not only financial but also social-environmental goals.
A starting point for market expansion might be to start looking at ESG factors from a different perspective. Rather than viewing them as merely a means of risk reduction they could be viewed as a useful means of value creation.