Embedding transparency and purpose into business models will be a critical driver of success for private equity firms, according to a white paper from EY.
The paper, “How can private equity firms transform to find new routes to value creation,” asserts that while the industry has matured quickly and impressively, it is now at an “inflection point” brought on by advances in technology, globalization, shifting demographics and environmental issues, which pose significant challenges to current business models.
A major component of successfully addressing these challenges will be embedding transparency and purpose in PE strategies, said Pete Witte, global private equity lead analyst for EY. “From a deal perspective, entrepreneurs and family business owners often want to sell to someone who shares their values,” he said. “With how competitive the market is now, it does make a difference.”
And the next generation of talent is more concentrated on ESG issues than any of their predecessors, meaning firms’ success at recruitment and retention will hinge in large part on their values and how integral they are to the culture and business strategy of the firm. Witte says that at EY-sponsored events for MBA programs, sessions on ESG and sustainability are often “standing room only.”
And of course, increasing demand from LPs and heightened regulatory and political scrutiny add to the imperative of focusing on ESG. The report’s authors say that “social pressure and the question of PE’s license to operate” mean the industry is “under greater scrutiny than ever before, and PE firms must do a better job of capturing and tracking the value they are creating and the impact of their activities.
The authors note the “abundant statistics” supporting the importance of embedding purpose and transparency into PE strategies, including that 95 percent of LPs are “either already evaluating ESG risk factors or will be increasing their focus on ESG risk factors in the coming year.” Also, an estimated $3 trillion-5 trillion per year is required to meet United Nations Sustainable Development Goals, with the still-growing PE sector likely to be a significant contributor.
To this end, the firm recommends establishing a “long-term value” framework that expands beyond financial metrics to include consumer, human and social metrics. Four steps toward measuring how firms create and protect value are laid out by the Embankment Project for Inclusive Capitalism, an initiative led by the EY organization and the Coalition for Inclusive Capitalism.
First, establish the business context, purpose, governance and strategy. Then, determine stakeholder outcomes. Third, understand drivers of value creation and value protection. Finally, develop metrics to articulate value by creating key performance indicators and drivers.
In order to develop those metrics, EY suggests following seven principles:
- Align the metric with the purpose of the company. The metric should “be aligned with the business model and strategy, and [influence] internal decision-making,” according to the report. It should be “oriented to stakeholder outcomes and [reflect] the health of the strategic capabilities the company needs to invest in to achieve those outcomes.”
- Completeness and balance. The metric should be comprehensive and measure “financial or pre-financial outcomes in an unbiased way, including the net change in both positive and negative outcomes or impacts.
- Empirical testing. The metric should be based on an established methodology, with no significant deviations or alterations, and should be supported by evidence and credible data “assured to an appropriate level.”
- The data underlying the metric should be of high quality, based on credible internal and external sources and include few estimations. Data reporting should be standardized, and data security should be high. Underlying methods and approaches should be publicly available and follow “accepted approaches and leading-practice data-gathering procedures.”
- The metric should “be founded on reliable underlying processes with high standards of internal governance and effective controls.” Data should be verified, ideally by an internal second party and an external third party, and assumptions and underlying information should be traceable back to their sources.
- The metric should present results “in a transparent manner that is clear and understandable for stakeholders in the context of the company’s operations.” Criteria, concepts and assumptions should also be accessible and understandable.
- The metric should use data both before and after an action (such as investment) to monitor outcomes versus the baseline so that “any change in outcome can be attributed to the action.” It should measure a result that wouldn’t have happened without the relevant action, and its scope should be defined as relevant to a part of the company’s value chain “and is monitorable at the relevant scale, in the relevant location, and across a relevant time-bound period.”