Private Equity’s ESG Problem—and Potential

Private equity (PE) has long prided itself on driving operational improvements, unlocking hidden value, and generating superior returns through active ownership. Yet when it comes to embedding environmental, social, and governance (ESG) principles, many PE firms have been slow to adopt—or worse, treat ESG as a compliance afterthought. This hesitancy carries significant risks: growing investor expectations, evolving regulations, and the clear evidence that ESG integration can enhance value creation.

If you’re a fund manager, a founder in a PE-backed business, or the ESG lead tasked with driving sustainable performance, understanding how private equity can elevate its ESG approach is paramount. When PE takes ESG seriously, change happens fast—and returns can accelerate without sacrificing responsibility.

1. The ESG Imperative in Private Equity

1.1 Shifting Investor Expectations

Limited partners (LPs), from sovereign wealth funds to university endowments, are increasingly demanding rigorous ESG integration across PE portfolios. In 2024, over 80% of surveyed LPs reported that they would reduce allocations to managers lacking credible ESG policies. Simultaneously, new pension fund mandates and sustainable investment targets require PE firms to demonstrate tangible ESG progress—or lose access to key capital pools.

1.2 Regulatory and Market Risks

Regulators worldwide—from the EU’s Sustainable Finance Disclosure Regulation (SFDR) to the U.S. SEC’s proposed climate risk disclosure rules—are extending their reach into private markets. Absent robust ESG frameworks, PE firms face potential reporting failures, fines, and reputational damage. At the same time, market dynamics such as consumer boycotts, supply chain disruptions, and climate-related shocks threaten investment performance without proactive mitigation.

1.3 Value Creation through ESG

Far from being a drag on performance, ESG integration can unlock cost savings, revenue growth, and multiple expansion. Studies show that PE-backed companies with top-quartile ESG scores outperform their peers by 5–10% in EBITDA growth, driven by efficiency gains, reduced risk premiums, and enhanced stakeholder trust.

2. Three Essential Steps to Embed ESG in Private Equity

2.1 Make ESG Part of Due Diligence—From Day One

2.1.1 Integrate ESG Screening into Deal Origination

• ESG Pre-Screening: Include ESG criteria—climate risks, labor practices, governance structures—when sourcing potential targets. Develop a proprietary ESG scorecard to flag high-risk industries, geographies, and business models early in the process.

• Materiality Assessment: Identify the most relevant ESG issues for each target segment. For a manufacturing platform, this might mean energy efficiency and waste management; for a consumer brand, supply chain traceability and social impact.

2.1.2 ESG-Focused Commercial and Operational Due Diligence

• Evaluate ESG Data Quality: Scrutinize historical sustainability reports, carbon footprints (Scope 1, 2, and 3 emissions), health and safety records, and board oversight mechanisms. Validate data robustness through site visits and third-party audits.

• Risk and Opportunity Mapping: Analyze how ESG factors could materially impact revenues, costs, and contract terms. For example, compliance with emerging carbon pricing regimes may require equipment upgrades, while strong governance may open doors to premium customers.

2.1.3 Structuring ESG in Transaction Documents

• ESG Representations and Warranties: Include precise covenants around environmental compliance, social licenses to operate, and governance standards in purchase agreements.

• Earn-Outs and Holdbacks: Tie a portion of the purchase price to post-close ESG milestones, such as reducing emissions by a set percentage or achieving diversity targets in leadership.

2.2 Tie ESG Metrics to Value Creation Plans—ESG Isn’t a Sidecar

2.2.1 Incorporate ESG into 100-Day Plans

Once the deal closes, ESG should feature prominently in the immediate value creation roadmap:

• Operational Improvements: Implement energy audits, waste reduction programs, and supply chain traceability initiatives with clear savings targets and timetables.

• Governance Upgrades: Establish or strengthen board ESG committees, nominate independent directors with ESG expertise, and formalize risk oversight processes.

• Social Initiatives: Launch employee engagement surveys, diversity and inclusion training, and community impact partnerships to enhance reputation and reduce turnover.

2.2.2 Monitor and Report on ESG KPIs

Set quantifiable KPIs—such as percentage reduction in greenhouse gas emissions, water use efficiency ratios, or the share of diverse hires—that align with the firm’s broader value creation model. Integrate ESG reporting into monthly management dashboards and quarterly board reviews to maintain accountability.

2.2.3 Incentivize ESG Performance

Align carry structures and management bonuses with ESG outcomes, ensuring that the leadership teams of portfolio companies see sustainability as integral to their personal rewards and advancement.

2.3 Educate Portfolio Companies—Many Need Guidance

2.3.1 Develop a Centralized ESG Playbook

Provide portfolio companies with standardized tools, templates, and best practices for ESG data collection, reporting, and stakeholder engagement. A centralized playbook accelerates implementation and reduces duplication of effort.

2.3.2 Host Workshops and Trainings

Conduct regular workshops—for executives, boards, and operational teams—on topics such as climate risk modeling, TCFD-aligned reporting, diversity hiring strategies, and sustainable supply chain management.

2.3.3 Facilitate Peer Learning

Organize forums and roundtables where portfolio company leaders can share challenges, successes, and lessons learned. Peer networks foster innovation and collective problem-solving on ESG topics.

3. Accelerating Returns—Without Sacrificing Responsibility

By embedding ESG at every stage of the investment lifecycle, private equity firms can achieve superior financial performance and uphold their fiduciary duties:

• Stronger Exits: ESG-savvy companies command higher exit multiples as strategic buyers pay premiums for de-risked, future-ready assets.

• Reduced Downside: Proactive ESG management mitigates regulatory fines, environmental liabilities, and social controversies that can erode value.

• Enhanced Reputation: Firms known for responsible investing attract high-quality LPs, top talent, and partnership opportunities in competitive auctions.

• Scalable Impact: By standardizing ESG integration, PE firms amplify positive environmental and social outcomes across dozens—or hundreds—of companies.

The private equity industry has the capital, expertise, and governance muscle to drive transformative change. But it can only fulfill its potential if it chooses to own ESG as a core value creation lever—not a compliance checkbox.

Private equity’s ESG problem is not one of capability but of commitment. The tools, data, and methodologies exist to integrate ESG seamlessly into dealmaking, operations, and exits. What remains is the collective will to elevate ESG from a peripheral concern to a central pillar of PE value creation. When that happens, the industry will not only generate stronger returns but also deliver sustainable, scalable impact in an increasingly complex world.