More than 80% of private equity fund managers have stepped away from at least one deal due to ESG concerns, according to the 2023 BDO Private Capital Survey. The reasons why are complex, and point towards fund managers’ sentiment towards risk in the current economic environment.
Uncertainty around ESG regulations in the US may be leading dealmakers to tread carefully, Jim Clayton, private equity advisory national leader and private equity national co-leader at BDO, told CFO Brew. “We’re a year past when the SEC said they were going to issue reporting standards for public filers,” he said, which has created “more noise in the system.” Companies are getting conflicting messages about when they will need to comply with regulations.
“People are nervous about what I would call ESG-intense exposed industries,” in other words, those with “heavy carbon footprints,” he said.
And compliance risks are already present for companies that do business in jurisdictions under other ESG regulations. One of Clayton’s clients, for instance, was told by its client, a major UK retailer, that it needed to meet certain ESG standards by the end of the year in order to remain a supplier. These are the types of situations fund managers are now scrutinizing when deciding whether to proceed with deals.
ESG can be a red flag for other risks. ESG issues can also be indicators of broader problems within businesses. In the process of ESG due diligence, a private equity fund may uncover other weaknesses unrelated to ESG that a potential deal partner has, Matt Segal, private equity assurance national leader and private equity national co-leader at BDO, told CFO Brew.
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For example, an ESG study might reveal that a company’s suppliers are all in one country, and that it’s “tied to one currency and one market and [doesn’t] have any alternative,” Clayton said. In that instance, supply-chain resiliency would be “a big variable in its profitability.”
These “business challenges” can be “just enough to spook a potential transaction from going further,” Segal said.
PE investment in ESG is down this year. Private equity investment in ESG has dropped significantly in the past 12 months, the survey found. In spring 2022, 50% of fund managers named ESG investments and impact funds as the area where they’d be deploying the most capital. This year, only 30% said they’d be using the most capital in this area.
That’s partly because private equity funds have been doing less dealmaking overall in 2022 and 2023, as high inflation and interest rates have caused them to focus more on shoring up their existing portfolio companies.
But qualms about when the SEC regulations will go into effect may also play a role, Clayton said. Private equity funds want to take advantage of some of the financial benefits of ESG, such as tax credits and preferential funding rates for green portfolios, but their portfolio companies must demonstrate compliance with ESG regulations for them to do so.
“Some of them are holding back” on ESG investments, Clayton said, “saying ‘Let’s stay away from that [until there’s] more clarity about what the benefits are to the deal thesis.’”