One of the most extensive deliberations in the private equity industry is whether investors with shares in non-sustainable objectives should hold these ESG laggards or divest themselves of these assets. Assuming that investors are looking to drive toward a more sustainable future, there is no simple answer: an argument can be made for and against divestment. Here we explore both.
When investors should hold
With divesting comes uncertainty about the new buyer and their intentions for the holdings. There is a possibility that the new investor would leave the company worse off than when the seller was in possession, implementing no ESG initiatives or even disregarding those that are already in place. If the current investor is to divest, it is likely that the company would just go to the highest bidder. For a currently profitable company with non-sustainable operations, ignoring the ESG risks of the company can lead to a higher valuation and therefore potentially a higher bid. In this case, if the ESG plans of the investor don't play a big part in who becomes the new holder, the company may be worse off after divestment. To summarise, the possibility that the new owners don’t tackle sustainability challenges or do not implement new initiatives due to their view of it not being financially worthwhile, is a significant risk that comes with divestment.
Divesting means that the investor no longer has the ability to directly impact the ESG performance of investees. So, if the Investor is seeking a real change, it may be argued that they should not divest and instead improve their leverage and apply sustainable goals.
Although for years the E and S in ESG have been largely disregarded by many private equity companies, the industry is now more aware of how visible their environmental and social footprints are becoming. They face all kinds of pressures from global commitments that are translating to laws and regulations, to social media that allows for more collective awareness and forces collective action. The investment community realise that ESG issues are becoming financial risks that can impair their asset value in the long run, and to ensure the longevity of the assets these issues need to be addressed (e.g., INSEAD’s Global Private Equity Initiative’s current study revealed that 90% of investors factor ESG into their investment decisions and 77% base their criterion around ESG goals in selecting general partners). These pressures may be the reason why an investor would now be more open to driving change and begin setting goals for the ESG laggards. In this scenario it is likely that the holdings would be safe in the hands of investors. A cleaner environment or positive social impact could be made possible, should they hold on to the assets and engage to drive positive change.
When investors should divest
In some cases, divestment is the best or even the only action that should be taken. For example, if an investor doesn’t have the willingness or the ability to respond to the specific environmental and social challenges that are material to the asset, then the most viable option is to divest.
First of all, the inability of the investor to drive positive change through engagement with the laggard company holdings introduces a significant risk of impairment of the asset value, if the policy environment or the customer preference on the output of that asset were to change. From this perspective, it would be the investor’s fiduciary duty to divest such assets.
Secondly, considering the betterment of society as a whole and the protection of the environment would create a more favourable business environment for the investor, these holdings should be in the hands of someone capable of creating room for ESG growth. Divestment becomes an even more attractive idea when considering alternative companies to the ESG laggards, particularly an alternative that has a growing interest and has shown promise for the future, and therefore results in lower agency cost for the investor. In this instance it can be argued that the risks outweigh the rewards in holding the non-sustainable option, especially when there is a chance to invest into a new space after divestment. For example, the investors can replace polluting companies with more suitable options and invest into eco-friendly businesses. The profit of selling the company now, when the ESG risks have not yet fully materialised across the board, would be even more appealing to the investors and well worth the divestment. In turn they will be ensuring a more stable and secure portfolio. By thus divesting the riskier assets the private equity industry is ensuring their own continuity and place in a greener world.
Future-proof your portfolio
The bottom line is we cannot create significant change in a capitalist society without the active participation of investors. Private equity companies have grown by quite a bit over the years (the number of active private equity firms has more than doubled in the last decade and the number of US sponsor-backed companies has increased by 60 percent). It is safe to say that society won’t be able to tackle this global crisis and other major obstacles without the active participation of private equity businesses and their holdings. In conclusion, to divest or to hold all depends on the situation at hand. An investor should hold if they are going to take active ownership and exert their ownership rights to effect ESG change and should divest if they have no interest or ability to improve or amend the ESG risks within their holdings.
Developing the correct holding and divesting strategy is of critical importance in future-proofing an investment portfolio, but how can investors develop such a strategy? At the outset, the investor can analyse their internal human capital from an ESG angle and perform a skills gap analysis to rigorously identify the specific ESG topics that the investor is well equipped to address. Following this, an analysis of the current holdings through an ESG lens will help identify assets where the ESG risks are significant and material. Mapping this output with the human capital analysis will help identify the two sets of assets that the investor should hold and divest.
To help you develop a rigorous divestment and holding strategy, ESG Base has developed an objective methodology that takes into account a 360-degree assessment of the potential ESG risks of the holdings, and then narrows down to the most pertinent ESG topics based on their salience.
Get in touch with us to find out how ESG Base can help streamline your ESG journey.
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ESG Base is a global premium provider of advisory, technology and data solutions enabling financial organizations and businesses to achieve their ESG (environmental, social, and governance) ambitions. We offer advisory services and technology solutions for fund managers and investors to benchmark the ESG credentials of their portfolio, determine the ESG risks and impact of their investments, and monitor ESG performance throughout the investment lifecycle.
ESG Base is supported by London Business School, The University of Cambridge, Santander Bank, European Regional Development Fund, London Fintech Innovation Lab, and is part of the G20 InfraChallenge building better, innovative and resilient infrastructure.