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Impact investing: The Hitchhiker's Guide to transition finance in private equity.

It is impossible to achieve the sustainable transition of companies in your PE portfolio solely based on ESG-ratings. You need better sustainability assessments with transition finance.

Hitch-hiker’s Guide through the Galaxy:

Rule #1: Always bring a towel

Rule #2: Don’t panic.

Transition finance in private equity, is the act of facilitating the sustainable transition of companies through investor’s impact, such as shareholder engagement, active ownership, and capital allocation. Transition finance is, in essence, all about transitioning ‘brown’ companies to ‘green’.

Using towels for impact investing

If you want to achieve transition finance with your financial portfolio, you definitely do not want to be fully reliant on ESG. ESG-ratings for transition finance are like having a towel while hitch-hiking your way through space; they apparently seem functional but are not. In Douglas Adams’ classic, the towel helps to keep you warm, and gives some shelter and cover. It can also be used as a weapon, and maybe most importantly: people expect you to be fully prepared when you’re carrying a towel in space.

Strangely, ESG carries many resemblances to this towel. It gives investors a warm feeling of doing good, while the investment manager uses it as a shelter or cover for greenwashing accusations. ESG ratings as a weapon against climate change, is like the towel as a weapon in space; useless. Both are completely missing accuracy and strength to have the necessary effect. And the worst part is: most investors consider funds or investments with ESG characteristics or ratings as prepared for the future. Unfortunately, this resembles the level of preparedness when bringing a towel into space: you can better bring bigger guns.

Rule #2: Don't panic

But: don’t panic. 

Transition finance is achieved by being an active shareholder through shareholder engagement or active ownership. The good thing about our proximity to 2030 is the current time-horizon for investors. When you invest in a brown company now, and facilitate and stimulate the transition towards being a green company: by 2030 your exit-value is most likely benefitted.

Why? Despite many climate change deniers and critics, the general public is increasingly concerned about climate change. Environmental regulations for both business and finance, especially in the EU and the US, are rapidly increasing in stringency. And investors are perceiving climate change as an increasing investment risk. Hence, non-sustainable divestment have increased risks and lower value.

Your guide in transition finance.

Rule #1: Go beyond ESG and embrace company-level sustainability data.

This means the adoption of more detailed assessment methods. The management teams of your company must be brought on board since they have a large responsibility in this. The assessment methodology can be based on life cycle assessments, or adapted methods fitted for your portfolio’s strategy and KPIs.

These methods give the insights to build effective, sustainable strategies on the company- and on portfolio-level. ESG ratings are oversimplifications of the company's actual ESG performance, based on proxy datasets. This makes ESG ratings too generic to build company-level sustainable strategies. In addition, most existing ESG-ratings provide a snapshot of the company’s impact at the moment of analysis. This fails to reflect the change in the company’s impact driven by your investment activity [1].

Company-level and flexible sustainability insights for transition finance require the right tools to zoom in to the right level of detail at the right point in time.

Rule #2: Different sustainability assessments throughout your portfolio’s lifecycle

Be flexible with assessments throughout the investment lifetime and between different companies and portfolios. Different moments need different insights. Firstly, you want to make sure before investing in a company if it allows a transition from brown to green. Hence, a quick screening or due diligence will do the trick before investing. During these scans, ‘classic’ ESG ratings can also be of valuable support. 

Subsequently, however, when a company is added to a portfolio, you want to go into more detail. At this moment, you want to create company-level data that gives you the right insights to be able to steer it towards a sustainable performance. Several parameters determine what company-level data is used, and what insights are provided:

  • Company type: manufacturing, service, assembly
  • Finance type: loan, equity, debt
  • Economic sectors
  • Portfolio strategy
  • Countries and culture
  • Basis for KPIs: Paris Agreement, UN SDGs, SBTi, carbon net-zero

All these parameters determine what level of assessment suits your portfolio’s company at what point in time. 

Assessments at the moment of investment, form a benchmark of the company’s sustainability performance. Subsequently, this allows you to actively monitor and steer on the sustainability parameters that are important for the company, and for your portfolio.

Start impact investing today with transition finance!

As we have outlined above, improving sustainable performance can deliver exit-value. We’re close to 2030, hence investing in brown companies, improving these to ‘green’ companies, and exiting around 2030 is good business. Several studies show that active ownership and shareholder engagement are most effective on a company’s ESG performance. You might feel powerless, but you just have to get rid of your towel and start working with real sustainability insights beyond ESG-ratings.

[1] https://journals.sagepub.com/doi/epub/10.1177/1086026620919202

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This article is written by:
Joost
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