The price of ESG disclosure: an experiment with private equity investors

It found that businesses with poor ESG behaviour are likely to suffer limited access to private equity, and incur a higher cost of capital, which could have implications for a company’s fiduciary duty.

The study tested how private equity investors react to good or bad ESG disclosure and quantified the effect of their reactions on their likelihood to invest and their valuation of the company.

“Improving environmental, social and governance practices could allow entrepreneurs to protect their firm price and access to private equity capital.”

The experiment

Thirty-three French private equity investors (venture capital and buy-out) were given case studies of fictitious investment opportunities to assess: a large restaurant chain, a packaging provider to the agrifood industry and a producer and retailer of electronic components to the transport and aerospace industries. Each investor valued two of the three companies and said whether they would invest.

Four layers of additional information were then progressively provided – in particular about ESG practices. After each disclosure, investors were asked if the new information had altered their valuation or their decision on whether to invest.

In total 330 company valuations and 330 investment decisions were gathered, as well as substantial qualitative data. For each case study, the authors also broke down policies into those considered central to a company’s core business (hard) or peripheral (soft), and measured the impact of each and the cumulative impact of both.

A soft practice, not core to the business and not needing many resources, could be saving energy at the head office building. A hard practice could be reducing toxic waste in the production process – requiring substantial resources and input of managerial time.

Creating or destroying value?

The results show that knowing about good ESG policies increases valuations, but by just 2-5%, whereas knowing about bad ESG policies lowers valuations by 10-15%.

For good practices, there was no significant difference in the change in valuations whether the ESG policies were hard or soft. However, when considering bad practices, disclosure of hard or soft practices depressed valuations significantly. Soft disclosures reduced valuations by approximately 3-5% and hard disclosures by approximately 8-10%.

The investment decision

Good ESG practices seem to have little effect on investment decisions, with the exception of environmental policies, which drove a 10% rise in decisions to invest. The disclosure of bad ESG practices, however, reduced the likelihood of investment 30%-50%, predominantly driven by hard factors.

Poor governance practices, either soft or hard, significantly drove down the number of investors wishing to invest. Perhaps this is unsurprising given that private equity stakeholders are usually deeply involved in governance when they do not have complete control of the board.

Where do we go from here?

The experiment shows that when it comes to ESG performance, companies have more to lose from being bad than to gain from being good. Therefore, disclosing good ESG performance can be used as a defensive strategy, to protect company value and access to equity funding.

“Whereas good governance might not be paid for during the acquisition stage because it is expected, a firm poorly governed might be a risk well understood and to which investors strongly react.”

Private equity investors are showing increasing demand for ESG information and, as they incorporate data into their own models, it is likely that companies seeking finance will need to more accurately and quantitatively demonstrate their ESG behaviour in future. If all investors demand greater ESG disclosure, the true risk and reward of each investment opportunity will be more transparent and can be priced accordingly.

In the meantime, the ability to properly evaluate the ESG performance of a target company will increasingly be a negotiating tool in the acquisition stages of a deal and, therefore, a potential lever to increase the profitability of any investment. However, there may be some way to go before the industry achieves this level of specialism.