ESG Impacting Levers: How Private Equity Firms Can Drive Value Creation

At a glance

• Main Takeaway: In part two of our series on ESG investing in private markets, we discuss how private equity firms can grow EBITDA, lower working capital and reduce the cost of financing.
• Invest with confidence: ESG is quickly reshaping the investment world and PE firms are well-positioned to be leaders in driving value creation by fully embracing ESG-related strategies.
• Next Steps: The hardest part is knowing where to start. Aprio’s ESG team can help you take those first steps to identify what ESG could look like in your business.

Are you ready to build your social balance sheet? Contact our team for a free consultation.

The full story:

Sustainable investing is here to stay, and private equity (PE) firms are recognizing the true impact that can come from implementing environmental, social and governance (ESG) initiatives.

When it comes to their motivations, PE firms are not complex – to generate competitive returns for their investors, institutions such as pension funds, endowments and foundations, so those limited partners can meet their obligations. Typically, when a PE firm purchases a company, it controls the board or negotiates a seat at the table, and over the last year that seat has focused heavily on ESG goals.

To stand out in the market and drive value, you can’t afford to slouch on your ESG objectives, especially the governance segment.

Sustainability can be a source of value creation

The model of a PE firm is to raise money from outside investors, also known as limited partners, to purchase ownership of a company. Once a PE firm buys that company, there are two ways it can increase its returns – growing EBITDA (earnings before interest, taxes, depreciation and amortization) and the valuation (i.e., multiple of EBITDA) that the next buyer is willing to pay.

PE investors are naturally focused on cash flow, which in the PE world is known as EBITDA. Over the years, EBITDA has become an industry standard to measure a company’s cash flow. Often, when a PE firm buys a company, it works alongside management to increase the company’s profitability and growth rate so that when the company sells, the PE firm can increase its returns by the company receiving a higher multiple of its EBITDA. There are ways to influence the multiple of EBITDA when a business is sold, however, the ranges often depend upon which industries are performing better at the moment.

Reducing inventory can lower working capital

One of the main ways that PE firms grow EBITDA is through acquisitions. A cost-effective way for PE firms to fund buying companies is finding hidden sources of cash. If a PE firm can continuously find money within a company, they won’t have to borrow as much and as a result, lowers their debt, reduces interest costs and increases the value going to the equity investors.

Where can they find this hidden source of money? Working capital is inventory, raw materials, accounts receivables (how fast you’re collecting payments) and accounts payable (how long it takes you to pay vendors, bills, etc.). The shorter it takes to collect and the less inventory on hand, the more terms can be extended with others, means more acquisitions can be made. A lot of PE firms will typically analyze the inventory turns of a company to determine how much cash can be redirected toward acquisitions. 

The rise of green loans can reduce the cost of financing

PE firms are going to keep buying and selling companies. It’s very much the foundation of their role. While finding sources of hidden cash is an efficient way to lower working capital, borrowing money to fund these acquisitions is inevitable.

Within the financing world there are loans linked to hitting sustainability goals for companies. More companies are converting to sustainability-linked loans to potentially receive lower interest rates. These loans are tied to ESG-related metrics whether they be diversity metrics or carbon emissions and renewable energy metrics. Hitting those pre-determined metrics will provide a more appealing interest rate, however the caveat is, missing those metrics will deliver a higher interest rate. Sustainability-linked loans are increasing in popularity, especially if a PE fund is focused on certain sustainability goals to lower the cost of funding, which in turn makes returns higher over time.

The bottom line

ESG can no longer be pigeonholed into a special department. It needs to be engrained throughout every fiber of the business. PE firms can grow EBITDA, lower working capital and reduce financing costs by actively incorporating ESG-related business strategies. While ESG will continue to reshape investing, the governance segment will have a greater impact than most people realize. If you’re interested but unsure where to start, Aprio’s ESG team can help you identify opportunities that align with your firm’s objectives. 

Stay tuned for the final part of our series on ESG investing in private markets where we will discuss how private equity firms can advocate for ESG in the boardroom.

Are you ready to build your social balance sheet? Contact our team for a free consultation.

Related resources

• Aligning Incentives to Drive ESG Strategies and Satisfy Investors
• The Evolution of ESG: From Niche to Mainstream
• Private Markets: It’s Time to Embrace ESG if You Want to Attract Assets