As a greater number of European businesses become targets for a private equity buyout, there is hope that companies will find the critical support they need to comply with environmental and social governance.

“Private equity houses have considerable influence over whether a corporate complies with ESG. They own the company,” says Douglass Welch, portfolio management conducting officer at private debt manager Pemberton Asset Management.

And the debt package supporting the deal can also play a role. 

“As banks draw back from leveraged buyouts we see a huge opportunity for closer collaboration between private equity and private debt funds when it comes to ESG,” Welch says, “because otherwise the corporate has two sets of ESG policies to follow and it’s a lot to deal with.”

Greening up the corporate

A typical private equity-owned business might be new to ESG best practice due to its small size or its prior focus on financial growth. “Depending on how small it is, it’s likely to be falling outside the directives as currently enforced,” points out Welch. “It’s also the financial owners who have to comply with ESG, not the corporate, so there’s another disconnect there.”

“Depending on how small they are, they’re likely to be falling outside the currently enforced directives,” points out Welch. “Also it’s the private equity funds, as financial institutions, who have to comply with ESG, not necessarily the corporate, so there’s another potential disconnect there.”

Themselves incentivised by their institutional investors, PE firms will draw on a number of tools to encourage responsible behaviour in a portfolio corporate. “They decide how to remunerate company management, how to share the capital gain at exit--a mix of financial and ESG metrics, what growth to support, what projects to invest in,” says Welch. “Their limited partners (investors) have their own ESG requirements so will only give money subject to certain conditions.”

The debt package too can pack an ESG punch. “At the credit analysis stage, the private debt investor may identify ESG weaknesses and ask for them to be fixed as a precondition to lending. Then there is the margin ratchet.” Businesses pay certain margins on their debt, and these can be ratcheted up or down on the attainment of certain ESG criteria.

A big opportunity

The retrenchment of banks and the growing participation of private credit funds in leveraged buyouts is a big opportunity for ESG compliance. “Banks of course play a visible role in ESG compliance -- but the challenge we are focused on is how private equity or credit providers funds can play an even more active role.” Like private equity, private credit funds have external investors who are preoccupied with ESG.

Banks, on the other hand, have a more dispersed shareholder base. Private credit funds, due to their relatively smaller size, can be nimble about enacting change over the life of the private equity investment (typically five to seven years). “The beauty of the market is that the institutional investors in both private equity and private debt are in the same universe.”

But equity and debt still independent

Yet private equity funds and private credit funds aren’t working closely enough with one another in this common goal. This, Welch believes, will change in time. “The challenge to the private markets industry is a harmonised set of standards in ESG. The private equity sponsor needs to provide the private debt fund with an overview of what they are doing on ESG. Otherwise everyone’s racing towards the same door when they could slow down and walk through it hand in hand.”