Environmental, social and governance (ESG) factors are set to shape the financial investment industry in the coming years.
Investing with ESG criteria is no longer a tangential and purely regulatory criteria for long-term investment such as Search Funds or Private Equity, ESG must be considered as a key driver to ensure long-term value creation and profitability.
Investment focused on generating positive impact can not only be achieved alongside attractive financial results but can also help investors determine the long-term sustainability of a company and any intangible ESG risks arising from these issues.
Why is ESG important for Search Funds?
Besides the obvious ethical reasons, we can distinguish some key motivators and ways in which ESG criteria can generate value for SMEs and therefore for Search Funds:
- Improving long-term returns while minimizing risk: It was believed that ethics and finance did not mix well. While people used to think that ESG investing would lead to weaker returns, the data shows that this is not true. In fact, studies in recent years show that ESG investing achieves similar returns while minimising the associated risks.
- Capacity of reaction of SMEs: small businesses can benefit from faster decision-making, flexibility and closer contact with their customers which helps them better understand their needs and concerns towards ESG factors. In general, the implementation of ESG measures in SMEs can be carried out much more quickly and objectives can be measured or set more easily. The impact of these measures on the culture and performance of SMEs also tends to appear more quickly.
- Financing considerations: banks and private lenders analyze all the risk associated with SME financing, so ESG criteria will become increasingly important to ensure good financing conditions.
- Solution to SME succession challenge: Search Funds offers an exit strategy for Europe’s ageing business owners, while revitalising the businesses by bringing in highly skilled young entrepreneurs. This solution to the succession problem, which can be directly related to the social part of ESG, is a very important factor to take into account when assessing the viability of the purchase and the reasons for the sale.
- ESG can affect employee productivity and retention: companies with good ESG scores attract better talent and have longer retention. Millennials and other younger generations prefer to work for companies with stronger commitments towards society. According to a recent study, around 65% of Millennials consider a company’s social and environmental commitments when deciding where to work.
- Meet investor expectations in the exit: ESG can improve investment performance by allocating capital to more promising and sustainable opportunities. This fact is pushing private equity firms to focus on companies with a strong ESG culture.
Measuring difficulties: Scoring ESG factors
Arada Capital Partners completes a scorecard when analyzing different investment opportunities in SMEs. One of the criteria’s considered is related to ESG.
Investors can compare a company’s performance with its peers and with companies in other sectors by assigning an ESG score. Each investor is free to use their own formulas and assess the different variables that affect the ESG score in the way they choose. There has been controversy over how an investor should assess or calculate this score and that metric will vary from investor to investor.
In our view, each company should be assessed independently to get a full picture of the ESG impact it may be generating. In addition, the same factor could be assessed differently depending on the sector being analysed, and it is therefore very difficult to create a framework or standard.
Due to the difficulties in creating a framework or standard, investors are increasingly demanding transparency on ESG key performance indicators and measurement. To meet investor demands, it is essential to establish a set of targets, collect data and analyse them, showing investors the progress made. To do this, it is important to start building a history of data and to continuously analyse the progress made by the company.
In the future, investors will be able to make more informed decisions thanks to greater access to data, which will improve real-time analysis of a company ESG score.
ESG and Search Funds work in the same direction
Companies targeted by search funds can certainly benefit enormously from a culture that takes ESG objectives into account.
If the main objective of a Search Fund is to generate value for the acquired company, ESG criteria must be considered, not only for risk mitigation as many might think, but also as a key driver to ensure long-term value creation and profitability.