The acronyms ESG (Environmental, Social and Governance) and SDGs (the United Nations’ Sustainable Development Goals) have become ubiquitous in how both public and private companies talk about their corporate strategies and operations in recent years.
This has extended to private equity firms, that are increasingly under pressure from their investors to account for both the environmental and societal impacts of the companies in which they invest and in the diversity within their own investment teams.
It is worthwhile considering this alongside another major trend within private equity over the past 10+ years. In the previous decade, technology evolved from a relatively niche and high-risk sector, targeted by a small minority of specialist GPs, to a theme that underpins the global digital economy and one that is now a key driver of returns for many PE firms. Yet the intersection between these two critical themes of technology driving PE returns, on the one hand, and ESG and sustainability, on the other, is rarely discussed in the private equity community. Instead, these issues tend to be treated in isolation.
Time and again, we see our clients addressing some of the core challenges at the heart of sustainability debates.
In fact, there is significant overlap between the digital economy and questions of sustainability and social responsibility. Invariably it is sophisticated, bleeding-edge technology companies that are best-placed to develop solutions to the most intractable problems facing humanity today – whether that’s a manufacturer of hardware detecting forest fires or a software provider that can improve efficiency in pharmaceuticals development. The longstanding debate about whether investors must sacrifice returns in order to back those companies they deem more ethical seems academic in the context of a high-growth SaaS business commanding a valuation multiple in the high teens.
ESG software for the supply chain is mission critical and the related market is expected to grow between 16-28%. Supply chains account for up to 90% of a company’s environmental impact, but visibility and reporting are complex due to fragmentation and lack of transparency. At the same time, regulations such as the European Corporate Sustainability Due Diligence Directive (CSDDD) or the German “Lieferkettenschutzgesetz” (Supply Chain Due Diligence Act) are pushing companies to take responsibility.
For example, Once For All, supply chain risk management software provider for the construction industry, was acquired by GTCR in July 2023, a transaction advised on by Arma Partners. EQT Growth invested €100 million in supply chain sustainability software Integrity Next and Armira Growth invested €25 million in Osapiens.
Another prominent theme we see is that of reducing material consumption and waste.
Reducing material consumption and waste takes place through both the circular economy, which involves sharing and reusing existing products for as long as possible, and consumer supply chain efficiencies: avoiding food wastage and the inefficient storage, display and pick-up of products.
In the past two years, Arma has advised on a range of capital-raising transactions involving leading online marketplaces that facilitate the circular economy: Swappie, an end-to-end online marketplace for refurbished smartphones, raised $40m; Catawiki, an online auction platform for special items and collectibles, raised $185m; and MPB, the world’s largest online platform for used photo and video kit, raised $70m.
Energy efficiency, particularly in terms of how the digital infrastructure that supports the technology ecosystems is used, is another closely related and recurring theme we see across the transactions on which Arma has advised. Compared to on-premise computing, cloud-based operations offer significant reductions in energy consumption.
For example, the Microsoft Azure cloud platform can be up to 93% more energy efficient and up to 98% more carbon efficient than on-premise solutions. Arma Partners is globally recognised in public cloud M&A, with recent sale processes for cloud services companies including CTS to Marlin Equity Partners, Sapphire to NTT and Nordcloud to IBM. Further, WeTransfer, the internet-based computer file transfer service advised by Arma last year on its $40m growth investment, is another company working to improve the utilisation of energy-intensive internet infrastructure.
These examples illustrate that there are a range of high-growth technology companies with compelling financial profiles that also meet GPs’ growing appetite for responsible investment propositions. However, the focus on the former attributes can sometimes obscure the latter, and to do so runs the risk of missing out on the value creation possible through sustainability.
Good ESG performance means good governance and can impact profitability directly, for example:
- meeting customer sustainability requirements and preferences increases sales;
- successful diversity, equality and inclusion initiatives decrease turnover and higher engagement, thereby lowering personnel costs; and
- lower reputational and legal risks decrease overall costs of doing business.
In addition, operating sustainably enhances the long-term viability of the business. Examples range from winning in the war for talent to preserving license to operate in an increasingly regulated environment. Sustainability-focused companies also may have valuation premiums at exit and the scarcity of suitable assets, paired with an increasing number of sustainability-dedicated funds, creates a high demand for top sustainability performers – thus driving prices.
There are four main strategies to create value through sustainability:
- Sustainability as a core product of the business, ideally with a quantifiable positive impact;
- Brown-to-green strategies, shifting from a non-sustainable to a sustainable business model, such as electrification;
- Investing in ESG leaders, i.e. businesses that are top performers when it comes to how they run operations with respect to environmental and social governance; and
- Driving ESG performance across the entire portfolio.
For investors, strong ESG credentials or quantifiable metrics are currently unlikely to be the sole driver in a transaction, but they are a differentiator between companies. As greater rigour is applied to the disclosures that companies make, and greater value ascribed to the businesses that perform best against these metrics, we should expect to see further convergence between the best-performing (and highest-valued) digital economy businesses and those that can demonstrate and quantify the positive environmental or social impacts intrinsic to their business model.