(This article forms part of KudosAfrica’s just-published 2020 ImpactAfrica Report. Download a free copy here.)
ESG Value: Moving from Why to How
By Carl Reynolds
In the absence of any standardised way of assessing ‘sustainability’ across civil, commercial and governmental spheres, The UN SDG’s are slowly emerging as a convenient lens for multi-stakeholders to understand their responsibilities in terms of the growing needs of our society and the planet. Achieving these 17 goals, is arguably the single biggest challenge of our generation and our success or failure to do so will ultimately determine the course of history.
Various stakeholders will inevitably be motivated by different means to engage with these goals. Governments have different needs than businesses, as do individuals, and so it becomes important to frame the urgency for change effectively for each sector. People are more motivated by a moral or ethical case for sustainability than by an
economic one. According to the research, for individuals, the moral case is significantly more likely to yield results. Companies, however, have an altogether different set of drivers. Even though they are run by people, the separation of individual from collective (company) action, coupled with the need to address only the needs of shareholders leaves us with a different dilemma. Do corporate morals exist beyond what is legally enforceable?
Fortunately, we don’t need to answer that question right now. We’re more interested in how we mobilize the significant power of small businesses across Africa to address the challenges of the next 10 years and in particular, their ability to aid the world in achieving the SDGs.
In the case of Africa, SME’s represent approximately 80% of the economic activity on the continent. Indeed, without harnessing their potential, achieving the SDGs is not even remotely a likelihood. Most of us will know the difficulties
associated with running a small business. The daily pressures leave little time to spend on any activity not associated with profitability.
However, if we were to conclusively show that there are financial benefits to more responsible business practice and at the same time remove the combined obstacles of admin and time constraints, the opportunity to grow an entire economy with sustainability in its DNA is too big to pass up.
We have already written extensively on the business case for sustainability and increasingly the evidence is unavoidable, companies that score high on ESG criteria are better performers. Neilson reported U.S. companies with a
demonstrated commitment to sustainability were growing at a rate of 4% over the past year. This is compared to a growth rate of less than 1% for companies without demonstrated commitments to sustainability.
The UK reported that United Kingdom certified B Corp’s are growing 28 times faster than the national average. Unilever reported that its sustainable brands are growing 50% faster than their traditional brands. The University of Oxford conducted a literature review of over 200 studies where they looked at the relationship between
sustainability performance and financial performance. The findings of their review included:
• 90% of the studies indicate that sustainability leadership leads to a lower cost of capital.
• 88% of the studies indicate sustainability leadership leads to increased operational performance.
• 80% of the studies show that sustainability leadership leads to better stock performance.
“The opportunity to grow an entire economy with sustainability in its DNA, is too big to pass up.”
It has become clear that sustainability must be an important component of any business strategy in the coming years and decades to ensure long-term health and success. As the information and research on this topic continue to come out, the business case for sustainability will only become stronger.
Private equity (PE) remains one of the asset classes with the least systematic data analysis but with possibly the greatest variety of case studies emerging of the tangible value being created through strategic ESG interventions.
For responsible investing to gain traction in PE, this return on investment (ROI) through ESG needs to be systematically tracked to inform more effective investment and engagement strategies, and to satisfy growing LP interest.
So, how do we harness the power of active ESG management to grow value in companies and investment portfolios? Although many and varied an approach exists, they can broadly be divided into the following three categories:
Risk reduction & management:
Aside from the obvious climate-related risks, supply chain disruptions, water shortages and all the environmental risks consider too the public relations risks. A proactive approach to sustainability is going to help companies avoid those PR-related risks in a world of rapid transparency where information is shared at an instant across the world.
Sustainability also helps mitigate regulatory risks. Across Africa municipalities, cities, provinces, and governments are developing climate action plans and developing new policies and regulations to reduce greenhouse gas emissions.
Risk reduction has long been one of the main drivers for integrating ESG issues into the PE investment process. However, PE firms are in the business of creating value, not just avoiding risks and a compliance mindset anchors the engagement with investee companies in a risk management frame, with an emphasis on pre-investment due diligence and post-investment monitoring. These are often perceived more as burdens and costs to a business which leaves much value unrealized during the life of an investment.
The most straight forward benefit of sustainability, and the easiest to understand and quantify, is the reduced operating costs. When a business is reducing waste, reducing energy, reducing water use, reducing greenhouse gas emissions, operating more efficiently, obviously they will be saving money. William McDonough is a sustainability and circular economy thought leader, architect, and author of the books Cradle to Cradle and The Upcycle. McDonough will point out that when we look at nature, there is absolutely no waste. Everything has value and everything has a purpose. Waste is really just the result of a design flaw. We need to rethink and redesign the way we make our products, rethink the way we operate our facilities and rethink the way we operate as a society. Sustainability is all about eliminating waste and maximizing efficiency, which of course leads to cost savings.
This approach to resource efficiencies also extends to company supply chains. Not only is risk within a supply chain your own business risk it is also an opportunity to grow and secure your suppliers (and therefore supplies). Growing this network of stakeholders makes absolute economic sense and ultimately builds a flourishing and networked economy.
Likewise, the evidence is clear that a happy and engaged workforce leads directly to increased performance. Involving the workforce in the bigger picture of a business, particularly one with a vision and mission, is the surest way to drive both productivity and innovation.
Using sustainability as a lens to look at your business can lead to innovatively creating new ways to get things done. A focus on sustainability in all aspects of a business can lead to process changes, new products or services, the use of new
technology, the creation of new technology, new management techniques, and other innovations. A Deloitte report entitled Sustainability Driven Innovation studied hundreds of companies and labeled them as sustainability leaders and innovation leaders based on a number of criteria. The study found that a company labeled a sustainability leader was 400 times more likely to also be labeled an innovation leader.
An organizing framework
The creation of value in portfolios from ESG is significant3. The main themes in value creation within portfolios are:
Avoidance of eroding of capital and cost by improved risk management improvements, this includes:
• Reducing the potential for business interruptions from significant incidents (health and safety)
• Enhancing supply chain management
• Protecting companies’ social license to operate
Increased efficiencies in systems and operation and enhanced productivity, this includes:
• Resource efficiencies
• Improved supply chain
• Higher employee productivity and improved employee retention
New product and services growth, this includes:
• Developing sustainable products and services
• Improving and leveraging sustainability of existing products to reach new customers or markets
• Brand enhancement and customer satisfaction related to ESG
The case is self-evident but what happens next? How do we scale these learnings into practical and winning investment strategies? Fortunately, there is an array of methodologies to choose from and a growing filed of experts who are keen to show the way. The thing to keep in mind is that your fund is unique. A framework is helpful but real engagement with the issues and a targeted approach are imperative.
Strategies for integrating these approaches into PE
More and more funds are already setting up internal ESG departments that cover everything from screening to risk assessment and implementation strategies. The following are features of successful approaches:
• First of all, PE funds need to communicate to investee companies their awareness and expectations of the concerns around ESG issues from investors and clients.
• The PE funds need to obtain more in-depth material ESG issues in and around the investee company
• Compare risk at the portfolio level
• Embed collaboration between portfolio managers, analyst teams, ESG analysts and the investee companies.
• Develop a methodology to link ESG with commercial impact
• Communicate with their stakeholders, including customers and employees, about how ESG performance improvements have resulted in successful business outcomes, attain a leadership position amongst its peers, and help them realize value at exit.
• Agree on the ESG action plan with the investee company and embed this in the legal agreement.
• Systematically monitor progress and provide ESG implementation support
In a more practical way implement a systematic approach for ESG data collection for PE portfolio. The key is to create and implement ESG metrics that consist mostly of quantitative ESG indicators (ESG KPI’s). This will save implementing and monitoring time. It also provides for progress comparison between the different assets and gives the opportunity to report on thematic portfolio achievements.
Start with screening as many material ESG risks and opportunities to identify which issues are most material for the sector and region and crate an ESG action plan with goals and responsibilities to address those material issues. The periodic monitoring and evaluation reporting need to have a system in place for due-diligence and verification.
In the African scenario, PE and ESG are both in strong growing phases. KudosAfrica is glad about the current development experienced in this industry and aims to facilitate a change. Helping PE funds understand what are the best ways to assess risks and implement strategies can in turn help SME companies to receive further funding and contribute to the company’s and community’s growth.
The Kudos approach can effortlessly deliver great insight into risks and opportunities both pre-investment and during the investment life cycle. By assessing the companies’ performance in the most relevant material issues for investors, while keeping an international investors mindset but with the point of view of African companies, we
help funds navigate the ESG scenarios and make sound business decisions based on hard, reliable data stemming from accurately conducted research.
This is done is a way which promotes the gradual improvement of ESG factors over the course of the investment at the investee company, with an annual review of progress achieved and valuable toolkits and action plan to help both the fund and the company to walk the path towards a more sustainable, and profitable, business process.
This article forms part of KudosAfrica’s just-published 202o ImpactAfrica Report. Download a free copy here.