In 2018, Blackrock CEO Larry Fink, who then oversaw more than $6 trillion in assets, issued a stark directive to Wall Street – prove that you’re making a positive contribution to society, or we won’t invest in you. As part of that warning, he wrote that: “A company’s ability to manage environmental, social, and governance (ESG) matters demonstrates the leadership and good governance that is so essential to sustainable growth, which is why we are increasingly integrating these issues into our investment process.”
Two years later, he doubled down, claiming that climate change has become a “defining factor in companies’ long-term prospects.” And CEOs were listening. The past few years, most of the 30 largest companies in every industry have made commitments to reach net zero by 2050, and in March 2021 the SEC formed the Climate and Environmental, Social and Governance Task Force (ESG Task Force) to crack down on ESG violators.
SOFTWARE COMPANIES SEE VALUE
It’s clear that ESG has become more than a window-dressing issue, and sustainability commitments (and costs) are now thought of as one of the key puzzle pieces necessary to maximize the long-term value of the company as part of the path to sale. Software companies are no exception, but while many of them have adopted climate-friendly commitments, some still feel their carbon footprint is negligent given that “software doesn’t consume energy or emit any harmful discharge.” However, as a Harvard Business Review article points out, “Software runs on hardware, and as the former continues to grow, so does reliance on the machines to make it run.” In fact, by 2040, it’s estimated that the IT and communications sector as whole will account for 14% of the world’s carbon footprint.
Many of software companies are now taking advantage of the sustainability movement by finding ways to reduce their emissions, and consequently attract investor interest. The strategy seems to be working, as PE firms are snatching up much of the enterprise software industry of late. As a recent article put it, while “private equity has been a big buyer of enterprise software for years…lately, as valuations across the once-hot enterprise software sector tumble hard, the math on acquisitions looks even better.” The piece goes on to reference Thoma Bravo’s recent $10.7 billion deal to buy Anaplan, a maker of business planning software, and Vista Equity Partner’s $16.5 billion purchase of Citrix Systems in January.
While the current market for ESG investing remains hot (72% of respondents to a Morningstar survey expressed at least some attraction to sustainable investing), the future looks even brighter. Millennials and members of Gen Z are more likely than earlier generations to make purchasing or investment decisions based on personal and ESG values. In a 2021 survey of college students, 51% of respondents said they see sustainable investing as the trend with the biggest investment potential; and another 40% claimed their investments decisions are driven by “companies with a purpose.” With their income expected to grow by 140% in the next five years, these attitudes have the momentum to encourage further interest in impact investments.
MAKING THE CONNECTION
Public commitments are one thing, but actually transforming the operations of a company to be more sustainable is quite another. Operational improvement is a key ESG investment component to assess value. PE firms must “evaluate their portfolio company’s current performance, compare its year-on-year earnings, look at its position within the market, and use current trends to project future performance”. Among these future performance considerations might be:
- What changes/updates have been made to modernize core IT operations? By 2025, data centers alone are projected to account for 3.2 percent of the world’s greenhouse gas emissions. And updating legacy systems doesn’t just cost money, modernization takes time. All factors to take into account when modeling potential ROI.
- What partners, vendors, and service providers are the company working with? While an individual company’s footprint is important, so too is the footprint of their various suppliers. PE firms must appraise sustainability across a company’s entire value chain – who are its cloud partners, data partners, and (if they are developing on blockchain) what is the sustainability of that specific blockchain?
- What is the physical footprint of the company? Especially as companies in the new normal are trying to reduce their real estate and go fully remote, carrying physical office locations might be a burden if they don’t meet modern green building standards (i.e., LEED certification).
HOW TO GET STARTED
Basic compliance aside, analyzing the ESG bona fides of a target acquisition should start at the beginning of a deal lifecycle (not the end), and strategies must move beyond traditional value creation techniques. Here are some things to remember:
- Dedicate the appropriate time and resources to the effort. Management needs to decide the degree that a company’s ESG strategy plays in its valuation, and then dedicate an appropriate percentage of time and resources towards studying its impact on their larger ROI goals.
- Lean into data and analytics. PE firms must be able to find and interpret ESG data so they can assess the measurable output of their investment. Analytics is key in identifying trends, creating forecasts, and making decisions based on projected outcomes. The resulting data can deliver critical insights and reveal patterns that allow for more informed judgements on valuations.
- Evaluate external factors. Individual company performance is one thing, but certain industries are more exposed to sustainability factors than others. It’s also important to study how the net-zero transition is likely to play out in certain parts of the world, as lower-income countries and fossil fuel resource producers would spend more on physical assets than other countries.
- Develop a robust marketing plan. With so many sustainable products and opportunities to invest in sustainably-minded companies, PE firms need the right marketing to leverage their ESG pitch and establish a special connection with clients/customers.
Despite the various challenges companies have faced over the last two years of the pandemic, ESG has remained a key priority, whether due to growing attention on the impact of climate change or because of the added interest from investors. It’s clear though that making ESG a consideration across all aspects of the investment process can be advantageous for PE firms, and businesses that demonstrate strong ESG policies are likely to command a higher valuation on exit.
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