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Winna Brown

You’re listening to the EY NextWave Private Equity podcast. I’m Winna Brown, and I am your host.

It’s hard to turn on the news these days without ESG being a top headline. And in every conversation we’re having with business leaders, ESG is always featuring strongly on how they’re thinking about and executing their strategy for the next three to five years. And this certainly is the same story within private equity.

In today’s episode, we’re going to discuss why private equity is really in a unique position to lead the world’s transition to a low-carbon circular economy. We’re going to look at the different types of opportunities that private equity is pursuing. We’re also going to try to understand how the financial and commercial relevance of ESG is being measured, and finally, we’ll discuss the role of scenario planning in determining how well an asset is positioned for growth in a world that is accelerating climate change.

Joining me today is my co-worker Hanne Thornam, an EY partner and the Head of Climate Change and Sustainability Services in the Nordics. Hanne works with private equity clients on ESG Strategy and Diligence, and her focus is on the E. Helping Private Equity evaluate climate change risk and preparedness across their portfolio. Hanne, welcome to the show.

Hanne Thornam

Hey, great to be here too. Thank you.

Brown

Why do you think PE is in a unique position to lead the world’s transition to a low-carbon circular economy?

Thornam

I think there are three main reasons. The first one is the time horizon. It’s a bit longer actually in terms of planning than a lot of companies have. Looking at the five to seven-year horizon, but also looking at the next buyer, ownership phase, means that the private equity company needs to be looking at more than 10 years to understand the success of the company. I think the second thing is that as active owners, private equity has that opportunity to build competence and awareness of the opportunities and challenges that lie ahead for the next 10 years and move companies so that they can capture those opportunities. The third thing is, I guess it should be and it is in many ways private equity’s role to understand the next big thing.

Brown

As we think about the way private equity invests across many different sectors of the economy, do you think that they play a role, not only in investing in green technologies, but do they play a role in moving the traditional dirty industrial products, or sectors, and moving them to be more green so that holistically, as a world, we’re moving in one direction?

Thornam

I really do believe that it’s not only about investing in the already green companies, but also helping all kinds of companies to see the opportunities that they have in the future. And I could just mention some of those opportunities that we have. Climate change is probably one of the major opportunities and challenges over time. We need to cut global emissions by 50% by 2030 if we are going to reach the goals of the Paris Agreement, and so far, global emissions have only gone down a few percent. So it’s a huge task, which also of course includes a lot of business opportunities, and a lot of different players need to be part of that. And another example is the circular economy. We more and more realize that it makes sense for the economy, not just to be linear, that you buy something and throw it away, but that you buy something and then it’s reused for something else at the end of its life. And at the moment, there’s an estimate that the world is about 8% circular and countries like Norway are actually maybe just 2.4% circular because there’s such a huge level of consumption, and we want to go to a world that is completely circular. And I really think that that’s also an example of where there are lots of business opportunities if we are to reach those goals as a global community.

Brown

So, potentially there are opportunities in businesses that don’t even exist today, in order to achieve that goal?

Thornam

Definitely.

Brown

It takes someone who thinks outside the box and someone who sees the possibilities in order to grab onto those opportunities. Do you think that investors will actually reward private equity for taking on this challenge?

Thornam

Definitely. Actually, I’ve been working with private equity on sustainability and ESG for the last 10 years. And already 10 years ago, the institutional investors were the main drivers for thinking about ESG, and actually all along in these 10 years, the LPs have been focusing on whether the private equity company understands the relevance of ESG and understands the risks related to ESG topics, and also the possibilities for value creation.

Brown

Do you think that that learning curve has moved? I mean, certainly in the conversations I’ve had recently with private equity, the narrative is around “We need to focus on ESG; we need to focus on our people,” and those two are the key strategic drivers that are going to move the needle for us in the short to medium term. And I’m hearing that more today than I did over the last few years. So do you think this is driven by the investor sentiment and the imperative of the world to move our economy?

Thornam

The reason that institutional investors have been interested in ESG has not just been for ethical reasons from a moral perspective, it’s also been because of an understanding that ESG is relevant if you are going to create value in the long term.

Brown

Tell me about that. If we think about private equity, I mean, that’s what they’re famous for – value creation. How are you working with private equity to help them change the mindset that ESG is not just about risk or risk mitigation, but how do you turn ESG and a focus on ESG into something of value and create value?

Thornam

What we’re doing more and more throughout the whole investment cycle private equity has is that we’re looking at the financial and commercial relevance of ESG topics and really trying to put financial numbers to it as well. Looking at valuations, even for the future of seeing what is the market opportunity, or what is the risk? And through that kind of understanding is where you can start integrating it into strategies and plans to really take it seriously.

Brown

Can you give me some examples of that? How do you measure it?

Thornam

We first start by understanding how a company impacts environment and social sectors throughout their value chain. And then, we try to understand the drivers around that impact that we want to then make it either a risk or an opportunity. We must start quite qualitatively by understanding the megatrends that surround the company, like, for example, regulations. There was a huge wave of time of regulations, for example, hitting us now. But also, the trends that in customer preferences, for example, especially when it comes to business-to-business customers, the kinds of requirements that they will set. But also, normal consumers, what they are looking for. Also, these kinds of translations that I was talking about earlier we need to move through an opportunity that that creates. And once we understand that bigger picture, we can break it down into a more specific level for that specific company of what specific risk or opportunity can mean to them in financial terms.

Brown

You’ve been able to, through this process, bring it all the way down to something that is measurable and something that you can track on a regular basis so you can see the improvement?

Thornam

Definitely, but it’s very specific to each company. So, you must really understand how can we measure the impact that we have and how has that impact improved? But also, how can we measure, for example, the market share that we have on a specific product?

Brown

So there’s no blanket set of “Here’s the 20 KPIs; if you meet these KPIs, tick, tick, tick, you get the value on exit”; it really is specific to each company and each situation and you need to be very thoughtful about how you tell your sustainability and value creation story.

Thornam

Yes. And this is a challenge that we’ve seen quite often when working with private equity companies, because there might be a large difference between the types of companies that are in the portfolio and therefore also different types of indicators that will be relevant to each company. At the same time, the private equity fund will want to report to their LPs to show that they’ve had progress, and a positive impact on the ESG and financial results as well, of course. And so, it’s about finding a balance refined between having aggregate indicators that fit most companies in the portfolio and trying to help each of the portfolio companies in identifying the topics and indicators that are most material to them.

Brown

There has to be some level of almost repeatability across the portfolio companies. A few KPIs that they hold everyone accountable to and then the differentiators depending on the sector that they invest in, they have to capture those because they could be very compelling from a value creation story and really make a big difference so you can’t ignore them, but they probably take a little bit more work.

Thornam

Yes, one of the private equity firms that we’ve been working with here in the Nordics, we’ve gone through this process with them over many years. Our main focus has been to try to understand the specific indicators and goals for each of the portfolio companies, but some of the indicators have been aggregated and they’ve chosen to focus on indicators that are relevant in terms of the people dimension and customer dimension. So, they have the net promoter score for customers and net promoter score for employees. And they’ve decided that that’s a value that is important for them as a firm and something that they want to measure across any type of company regardless of sector.

Brown

I can understand customer sentiment, but I guess I’m thinking about the employees. I think, with the war on talent and the focus on retention, I would imagine that the topics around ESG not only become important from a customer preference, but also to retain your employees. Are you seeing that tension?

Thornam

Yes. I see it everywhere and we see it very well even in EY at the moment. In my role, as responsible for integrating sustainability across EY, I also hear very often how a lot of the younger people applying to EY are now asking for sustainability. What are we doing? And what services do we have? And how can they get involved? That’s not just for us, of course; it’s across all sectors at the moment.

Brown

Do you think that’s a trend or a fad, or do you think it’s a fundamental generational shift?

Thornam

Hopefully it will go away in a couple of decades time when we’ve fixed these problems.

Brown

Yes, of course.

Thornam

But at the moment, there’s a crisis and I think what’s happening is that the younger generation is more aware.

Brown

We’re certainly seeing a trend of private equity firms from the top down trying to understand how do they embed ESG? What is their messaging? What are they going to stand for? And certainly that trend is accelerating, but what’s going to happen to those private equity firms who potentially either don’t get on the bandwagon and start focusing on bringing sustainability into everything they do or those who completely ignore it? How is it going to impact them if they don’t actually embrace sustainability in a real way and in an accelerated way?

Thornam

If I borrow the words of Mark Carney, who used to be the head of the Bank of England and now is working on international climate initiatives, he said that companies that don’t take this seriously will go bankrupt. That was his way of saying it.

Brown

Wow.

Thornam

Increasingly clear over the years what we’re seeing is that because we are going through this massive transition or because we have to and most likely will be going through this transition, if you’re not aware of it, it will be a huge business risk. And what’s very useful and an exercise that we’re doing more and more now with all kinds of different companies is to try to understand how climate entails risks for them in various scenarios. And we’re finding it very useful to think of the future in terms of scenarios. Because the only thing we know is that we don’t know what the future is, but we can try to imagine some possible futures. And when it comes to climate change, there are two possible extremes. Either we’re not able to limit global warming and we will be facing more extreme weather, and as a result of extreme weather and drought, etc., also more social upheaval and perhaps conflict around the world, which will also impact businesses and value chains and where you can produce in the world. That’s one possibility. And then on the other hand, you have a future where we’re able to limit warming to the levels that we have agreed in the Paris Agreement. But that also requires a huge change, change in regulation, change in technologies, customer preferences and just behavior. What we’re doing now is to help companies look at both of these futures and try to imagine how that will impact their business.

Brown

And that’s a technique that you’re using right now with private equity and their portfolio companies, actually trying to imagine where would that business be under both extreme scenarios and then helping them forge a path, hopefully, in the latter example, where we meet the Paris Accord measures, and we have a better future.

Thornam

Exactly. So, we’ve been helping several private equity funds across the world in looking at climate risk for each of their portfolio companies and, also, in having conversations with top management in the portfolio companies and how they will be exposed.

Brown

The skill set that is required today, and will continue to be required, is potentially very different from the skill set that private equity firms and companies are hiring today. So that in itself, just creates a whole new generation of talent that’s going to be required to help us solve.

Thornam

Yes.

Brown

Are you already seeing that change happen?

Thornam

And I think it’s when you start to recruit new profiles is when you really started to see the importance. And I think it’s going to be very important for private equity firms going forward to challenge themselves as well and include people with other types of perspectives and knowledge of how these trends can develop. And just taking my sustainability team here in the Nordics as an example, we have geologists and biologists and we even have an astrophysicist.

Brown

Oh, my goodness.

Thornam

Yeah, but most of them have also a masters in climate change or a masters in natural resources. And we also have people who are focused on human rights and transparency and supply chains and those kinds of topics. And I think importantly, as well, a massive passion and interest for understanding sustainability challenges and how it develops. And that’s what private equity firms also need to include in their teams to be able to meet these challenges. It’s just amazing to see now how we collaborate across different subject fields to work together to integrate the climate risk with IFRS accounting and valuation and how actually the three of them can’t go separately if we’re going to do it properly. What’s really exciting at the moment is that we’re seeing more and more of that with financial accounting. You cannot do a proper financial account without understanding how your assets will be exposed to climate risks because otherwise you won’t know the real value. And you stand responsible for understanding that risk.

Brown

There are so many private equity firms that are either about to start the journey or in the early stages of the journey. How would you advise them to bring sustainability into their culture and into the way they think about their investments and the deal life cycle as they evolve or build value into their investments in their portfolios?

Thornam

The first thing is to move from a compliance-based approach to ESG and toward a more strategic perspective of what you see means to value creation. And I think in order to do that well, it’s important to start thinking in terms of scenarios and potential futures and also to build competence on the possible futures that we are aiming for, and that also entails a lot of business opportunities.

Brown

I want to congratulate you on your new role. I understand you’re now a TV star and featured on a regular finance program.

Thornam

I’ve been invited to speak about sustainability every second week in the finance news on one of the national channels here in Norway.

Brown

That’s fantastic. Congratulations. To your point, it definitely shows how the mindset and the culture are changing and sustainability is actually going to become, not just something, but it’s going to be ingrained in everything we do. And I think that’s the first step to actually making the changes that we need to make. Well, Hanne, thank you so much for your time today. Really appreciate it and look forward to having you back on the show and seeing how we’ve made some progress.

Thornam

Thank you, Winna.

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