By using ESG due diligence, risks can be properly measured and effectively mitigated

Unlocking hidden value: the critical role of ESG in Private Equity Deals

Blog
04 Feb 2025

Barbara Baarsma

Hoofdeconoom, PwC Netherlands

Leonie Schreve

Partner, PwC Netherlands

The saying ‘unknown makes unloved’ aptly describes the current underutilization of ESG due diligence in Private Equity (PE). PE firms can no longer afford to merely check compliance boxes and allow ESG-due diligence post-investment only. It's too risky and a missed opportunity, PwC's Chief Economist Barbara Baarsma and PwC's ESG Deals leader Leonie Schreve claim.

ESG considerations currently play too little a role in Private Equity deals. Although private equity firms have their ESG commitments, including sustainable labelled funds, investment committees consider ESG due diligence still too much as a procedural check as per PE investor (Limited Partners) demands. This needs to shift, as business models need to transition because of higher energy prices, changing customer demands, as well as the EU green deal regulations across industries.

“It is too risky to allow ESG due diligence post-investment only. ESG must be integral to assessing deal value from the outset.”

Barbara BaarsmaChief Economist at PwC Netherlands

PwC Survey: ‘ESG is top three driver of value’

Higher energy pices, changing demands, and new regulations are only a few of the sustainability drivers. Moreover, a growing number of studies shows that a positive relationship exists between ESG performance and financial performance of private equity firms. According to a PwC survey among 166 PE houses worldwide in 2023, 70 percent consider ESG as one of the top three drivers of value.

Yet, sustainability plays too little a role in current valuations, with much of the ESG due diligence being compliance driven. Most PE firms attach only limited financial and intrinsic importance to it. A possible factor here is that the ESG officer at many PE houses does not sit on the investment committee. Moreover, he or she is often not financially educated and has a focus on post-deal actions to meet the fund’s ESG targets.

“There is a positive relationship between ESG performance and financial performance of private equity firms.”

Leonie Schrevepartner ESG Deals at PwC Netherlands

Neglecting ESG factors pre-deal? Four eye openers

Why is it critical to perform pre-deal ESG due diligence? Neglecting ESG factors in company valuations can lead to surprises at a later date. We cite four examples.

Suppose a PE firm wants to invest in a company that operates trucks, including in city centers. Many cities have committed to zero-emission zones in the coming years. The due diligence should consider how much of the routing will be impacted and whether the company has included electrification in its business plan (capex and opex). If this is not considered, unbudgeted costs will pop up in the near term and should be considered in light of an exit.

Often, we see high sustainability ambitions set by the ESG team, but no or only limited inclusion into the business plan. Conversely, an ESG due diligence would spark a strategic discussion on when to start electrifying the fleet. Should electrification start right now or closer to the deadline when everyone is queuing? Related questions that come into sight when doing an ESG due diligence are: what is the current value of the vehicles to write-off; what will be the costs associated with the investment now versus fuel costs and maintenance costs in the coming years; and has the company set the right ambitions or are these too high or too low to remain competitive? These questions are essential for investment teams to consider.

Suppose a PE firm is committed to equal pay for equal work. It is looking at a software company where the ESG due diligence has identified a significant gender pay gap. The funds’ commitments in this area result in an investment need to bridge the gap. What does this do with the bid price? And what will happen to the valuation if an initially unknown pay gap suddenly surfaces later? To avoid a decline in value, it is necessary to have knowledge of a possible gender pay gap now.

Suppose a PE firm wants to invest in a high-tech metal company. While the Carbon Border Adjustment Mechanism now still allows for exemptions, this will soon change. Starting in 2028, prices for steel imported from outside the EU will rise significantly because of the carbon tax. When investing in a high-tech metal company, strategic ESG questions should be addressed. What does the CBAM taxation imply for a potential exit in a few years’ time? Will the company’s clients accept the higher prices, or will they refuse to pay the increase? What if the high-tech metal company becomes a frontrunner in recycling or buying green steel, which is currently available only in limited volumes?

To claim that market now, it will have to absorb the current higher prices for green steel, which may go down if availability increases. This lower short-term profitability could lower the valuation. At the same time, it does make the company more resilient to price increases due to CBAM in the future, and that long-term perspective increases the valuation. Other initiatives like reduction of material, making products lighter, should also be considered. Moreover, a peer review of how the company performs compared to competitors is needed. If the company is lagging it should negatively impact the valuation, but if they are leading, it should positively impact the valuation as they can grow their market share and strengthen customer relations.

In an ESG due diligence it is equally relevant to look into the climate goal setting of the company’s clients. If these have set ambitious climate goals, the high-tech metal company then enlarges their market if it invested in recycling and green steel. However, if it did not invest in sustainability, it will be at risk of losing their clients. These risks and opportunities must be considered in investment decisions.

Imagine a PE firm aiming to sell a cold storage company that has heavily invested in decarbonisation, aligning with or going beyond the sustainability demands of its retail customers or anticipating on possible taxation or other regulation. They can increase their market share and win new customers. When this was brought out by PwC during the sell-side process, it led to a much more attractive equity story and the potential to create more value for the deal and future growth potential for the buyer. Without an ESG due diligence, these advantages might have stayed hidden during the sales process, potentially resulting in a lower selling price.

PwC's ESG due diligence methodology: from opportunities and risks to financial impact

PwC has developed an ESG due diligence methodology which takes these kinds of operational, financial and strategic questions into account. The methodology translates ESG opportunities and risks into financial impact. In close collaboration with the Financial, Tax, Technical and Commercial due diligence teams, an integrated analysis is prepared leading to better analyses and decision making.

PwC’s ESG due diligence methodology provides insights into the up- and downsides in a value bridge. This 'value bridge' visualizes the value creation of an investment and shows how the value changes due to factors such as operational improvements, changes in capital structure, market conditions, and ESG. We see that this is also increasingly requested by more and more lenders (banks) and corporate finance advisors. The same applies in large government tenders. It is an asset to be prepared. CSRD will help in this regard as much more accurate and consistent data will be available. This enables completer and more quantified ESG due diligence.

The saying “unknown makes unloved” aptly describes the current underutilization of ESG due diligence in PE. Many PE dealmakers remain unaware of its benefits, leading to its limited use. With its methodology, PwC wants to spur the integration of sustainability into valuations. As investors recognise the benefits of integral valuation, ESG due diligence will hopefully gain popularity and acceptance.

To us, it is increasingly clear that PE firms can no longer afford to merely check compliance boxes. It is too risky to allow ESG due diligence post-investment only. ESG considerations must be integral to assessing deal value from the outset.

About the authors

Barbara Baarsma

Hoofdeconoom, PwC Netherlands

Barbara is chief economist at PwC Netherlands and leads PwC’s economics office in this role. Since 2009, she has been professor of Applied Economics at the University of Amsterdam. Additionally, she holds various societal adjunct positions.

Leonie Schreve

Partner, PwC Netherlands

As a partner in ESG Deals Leonie successfully built business lines and managed teams and has driven organisational changes. She fulfilled a variety of external positions. It is her ambition to further drive innovation and lead the way to tomorrow's economy.

Sources:

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