ESG in Private Equity: What Does It Mean and How to Get Involved

Both sustainable finance and the integration of environmental, social, and governance (ESG) factors in investment decisions have gained momentum in Canada this year across all asset classes. In the private capital space, ESG is no longer just a topic of interest to impact investment firms but has become mainstream with conventional sponsors of all sizes. Here we break down the difference between ESG integration and sustainable finance in the context of private equity (PE), and provide examples of how to get started on your firm’s ESG journey.

Knowing the Difference: ESG Integration vs. Sustainable Finance

ESG integration is a term used in responsible investment and focuses on ensuring that ESG factors are considered alongside traditional financial metrics in the investment decision-making process. For PE firms, ESG integration is applicable across the entire investment lifecycle from decision making on initial investments, through the hold period, and at exit.

Sustainable finance by contrast refers to financial instruments that can be conceptually divided into two categories: use of proceeds-based (e.g., green, social, and sustainable bonds; green loans) and incentive-based (e.g., sustainability-linked bonds and loans). Use of proceeds products facilitate investment in projects with concrete environmental and/or social benefits while sustainability-linked products offer a financial incentive (e.g., improved interest rate) tied to the achievement of ambitious key performance indicators related to the company’s most material ESG issues. There has been an explosion of interest in both categories of sustainable finance products from businesses across all sectors.

PE firms are increasingly using ESG integration to identify opportunities to evolve their portfolio companies’ sustainability strategies and then leveraging sustainable finance products to support and reinforce these efforts. For example, if a company was focused on reducing their overall emissions, they could consider a green loan to finance the electrification of their fleet of vehicles or use a sustainability-linked loan to tie their cost of capital to their annual emissions reductions. Overall sustainable finance is a tangible way for firms to demonstrate their ESG commitments and strategy in the market.

ESG Funding Considerations

One way for firms to demonstrate their commitment to integrating ESG considerations into their overall investment thesis and to set up supporting structures (e.g., develop an ESG investment policy) is to become a signatory to the UN Principles for Responsible Investment. These principles also provide signatories with tools and insights to integrate ESG across the fund.

Some sponsors have also laid out firm expectations and commitments for their portfolio with regards to investor priorities, such as diversity. These fund-level commitments can be reinforced with sustainability-linked loans. For example, Carlyle’s recent sustainability-linked loan was structured to tie its cost of capital to its goal of having 30 per cent diverse directors on the boards of Carlyle controlled companies within two years of ownership.

Initial Investment

While there’s a rush of capital into the companies providing solutions to climate change and other environmental challenges, sponsors are increasingly looking at the ESG strategies and structures in place at investee companies as an important value driver across all sectors . A recent PwC report noted that nearly 50 per cent of PE firms now integrate highly material ESG issues in their due diligence processes and ESG is seen as a value creator by most funds surveyed.

Sustainable finance instruments can be put in place at this stage to reinforce a sponsor’s goals to further integrate ESG into the company’s strategy or to demonstrate the company’s ESG credentials to the market.

HSBC Bank Canada recently structured two sponsor-backed transactions that leveraged sustainable finance, in particular green loans, for financing acquisitions. In each case, the takeover target was determined to qualify as a “green” asset because the company’s core business met the market definition of “green.”

In 2020, HSBC partnered with Frontenac to support the acquisition of Newterra, a wastewater treatment business based in Ottawa. Ronald Kuehl, Managing Director at Frontenac said “the green financing helped Frontenac publicly display our commitment to increasing sustainability performance across our portfolio companies, in a way we hadn’t previously considered. This added a great deal of value to the transaction with little additional work required on our part.”

More recently, HSBC partnered with Instar to support its acquisition of PRT, a leading reforestation company in British Columbia. HSBC acted as Joint Bookrunner, Co-Lead Arranger and Green Loan Coordinator on the $130 million transaction. Instar’s commitment to sustainability is significant and the company is considering further green transactions.

A Responsible and Green Future

Investor focus on environmental and social issues is not just a matter of preference, but the evolution of societal values and an important lens to manage risk and optimize returns. The alignment and sustainability positioning of a target is a key point of consideration for investors and should be reflected in all communications with investors.

If you’re just getting started, we can help. HSBC was named the World’s Best Bank for Sustainable Finance and has brought its capabilities to the Canadian market with the broadest suite of sustainable finance products supporting companies of all sizes and across all industries, including green and sustainability-linked loans and bonds, green trade finance products and green deposits.

HSBC is a trusted advisor who can help you determine how to best leverage sustainable finance for your own operations and your portfolio companies. Reach out to myself or anyone on the HSBC Bank Canada team to explore how we can support your ambitions.

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