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Industry Voices

 

January 25, 2024

Commentary: Sustainability promises to drive private market value creation for years to come

By Letitia Webster

Letitia Webster

The operating environment for private markets has become more complicated. After many years where low cost of capital created fertile conditions to buy, grow and sell companies, investors today must navigate higher interest rates, unpredictable consumer demand and turbulent geopolitics.

 

It is no surprise that in this environment limited partners are increasingly methodical in allocating capital. Despite this, pension funds and institutional investors have continued to channel capital towards alternatives, with private markets reaching over $15 trillion this year, according to Preqin.

In this context, sustainability has emerged as a powerful value creation driver. While not a silver bullet, it now sits firmly alongside traditional areas that remain critical to improving businesses, like scaling revenues, building operational excellence, hiring the right talent, and equipping companies for a rapidly evolving digital and cybersecurity landscape.

 

To investors, for many years there was a perceived trade-off between sustainability and delivering performance. In private markets, the opposite is now true.

 

Private equity owners can be hands-on with portfolio companies to upgrade their sustainability efforts. This isn't about being virtuous, but as a lens to mitigate risks, increase revenue and improve bottom-line performance, as well as contributing to a stronger equity story when an exit is being considered.

 

This work can be detailed and often requires specialist knowledge, but there can be quick wins. Many private companies have never had a sustainability strategy and private equity owners can push for progress.

 

Often this includes things like simple energy efficiency changes. In a huge manufacturing company, upgrades to lighting, heating and energy management systems can drastically cut emissions and costs. For logistics-heavy businesses, switching fleets to cleaner fuels can save millions of dollars and cut pollution.

 

Some of the biggest opportunities in sustainability relate to innovation — finding profitable solutions to the complex problems posed by environmental and social challenges. We see huge potential for those companies that are enablers of sustainability of other companies — for example through providing complex energy management systems or detailed certification work on supply chains.

 

There are also enormous opportunities for businesses that can turn waste streams into new raw materials or energy sources on a massive scale, focusing on areas as diverse as cotton recycling, battery components, and agricultural waste.

 

Certain businesses are explicitly focused on the circular economy, but for many it's an incidental discovery that they can take a stream of waste that used to be a cost burden and turn it into a revenue source.

 

With human capital too, portfolio companies are paying closer attention to building meritocratic and inclusive cultures that reward hard work and enable talent from all backgrounds to succeed. These efforts are important in a competitive marketplace for talent, and done well they can help to increase morale, creativity and productivity. In private equity, where there are opportunities to have employees participate in value creation through equity schemes, it can build impetus and buy-in for the journey a company is on. Ownership Works, a non-profit initiative which seeks to increase employee ownership in private companies, has been a powerful voice for employee ownership in private equity and we expect to see continued uptake.

 

Viewing operations through a sustainability lens can help managers, limited partners and companies identify and mitigate risks in their supply chains — such as environmental degradation or labor issues — that could negatively impact their reputation or materially damage their businesses. It is also a source of opportunity to cut costs and grow revenues.

 

Because LPs recognize this, it is driving conversation and capital flows. In a survey of 200 investors by Goldman Sachs earlier this year, most investors reported that they are staying the course in private markets — increasing allocations to many strategies, deepening their relationships with managers, and seeking more co-investment opportunities.

 

We also learned that, beyond track record, the biggest factor that LPs consider when selecting a private markets manager is operational expertise. In private markets, whether through full ownership or minority stakes, the ability to influence outcomes is in a different league compared with public market managers.

 

Without healthy M&A and IPO markets as straightforward exit routes, managers are holding portfolio companies longer. Instead of applying leverage and hoping for valuation multiples to expand, managers need alternative routes to value creation. Meanwhile, many of these portfolio companies face a plethora of headwinds ranging from inflation, supply chain disruption and higher energy prices to artificial intelligence and climate risk.

 

A sustainability lens, we believe, is critical to navigating the coming years in private equity.

 

Even if the macro environment stabilizes in 2024, leading to more constructive conditions for dealmaking, the importance of intensive operating partnership between private markets managers and portfolio companies should remain a major performance driver.

 

The importance of sustainability promises to quietly endure for decades to come. This should lead to better outcomes for investors who allocate to managers who can put in the hard, detailed work associated with sustainable value creation.

 

Letitia Webster is head of sustainability for private investing at Goldman Sachs Asset Management, based in New York. This content represents the views of the author. It was submitted and edited under Pensions & Investments guidelines but is not a product of P&I's editorial team.

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