For a holding period measured in years rather than quarters, ESG stops being a reporting exercise and becomes a driver of value — and SMEs can move faster on it than large companies.
Environmental, social and governance factors are set to shape the investment industry in the coming years. Investing with ESG criteria is no longer a tangential or purely regulatory consideration for long-term investors such as search funds or private equity: ESG must be treated as a key driver of long-term value creation and profitability.
Investment focused on generating positive impact can be achieved alongside attractive financial results, and it also helps investors assess the long-term sustainability of a company and any intangible risks arising from these issues.
Why ESG matters for search funds
Beyond the obvious ethical reasons, there are several ways in which ESG criteria generate value for SMEs and therefore for search funds:
- Improving long-term returns while minimising risk. It was once believed that ethics and finance did not mix well, and that ESG investing would lead to weaker returns. Studies in recent years show this is not the case: ESG investing achieves comparable returns while reducing associated risk.
- The reaction capacity of SMEs. Smaller businesses benefit from faster decision-making, flexibility and closer contact with customers, which helps them understand needs and concerns around ESG. Implementation can be carried out much more quickly and objectives measured more easily. The impact on culture and performance also tends to appear sooner.
- Financing considerations. Banks and private lenders analyse all risk associated with SME financing, so ESG criteria will become increasingly important in securing good conditions.
- A solution to the succession challenge. Search funds offer an exit for Europe's ageing business owners while revitalising businesses by bringing in skilled younger entrepreneurs. This solution to the succession problem relates directly to the social dimension of ESG and is an important factor when assessing the viability of a purchase and the reasons for the sale.
- Employee productivity and retention. Companies with good ESG scores attract better talent and retain it longer. Younger generations prefer to work for companies with stronger commitments towards society.
- Meeting investor expectations at exit. ESG can improve investment performance by allocating capital to more promising and sustainable opportunities — a factor pushing private equity firms to focus on companies with a strong ESG culture.
The measurement problem
Arada Capital Partners completes a scorecard when analysing investment opportunities, and one of the criteria considered relates 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 weight the variables as they choose, and there has been genuine controversy over how such a score should be calculated — the metric varies considerably from investor to investor.
In our view each company should be assessed independently to get a full picture of the impact it may be generating. The same factor could reasonably be assessed differently depending on the sector, which is why creating a single framework or standard is so difficult.
Because of that difficulty, investors are increasingly demanding transparency on ESG key performance indicators and their measurement. Meeting those demands requires establishing a set of targets, collecting data and analysing it to show progress. It is important to start building a history of data early and to review progress continuously.
The same direction
Companies targeted by search funds can benefit enormously from a culture that takes ESG objectives into account. If the main objective of a search fund is to generate value in the acquired company, ESG criteria must be considered — not only for risk mitigation, as many assume, but as a key driver of long-term value creation and profitability.