ESG: PE leading the charge in CEE

Environmental, social and governance (ESG) compliance has evolved from nice-to-have to a compulsory requirement for private equity firms in recent years. And while this is a relatively new concept for the CEE region, the growing maturity of the market has been gradually bringing local standards up to western European levels.

Private equity firms in CEE tend to follow two paths in ESG development. The first is to become signatories to the existing standards of investment designed by international institutions; the second is developing their own principles for internal use, which is mainly adopted by small funds that have a tight budget. As for the former, the Principles for Responsible Investment (PRI) and IFC Performance Standards have been gaining traction with investors.

Polish private equity firm Abris Capital became a signatory to the PRI because its management believed being a good corporate citizen is not enough and that GPs need to go further, says partner Monika Nachyla. She notes that LPs now require a more formulated and systematic approach to ESG, pushing private equity firms to develop in that direction. Moreover, says Dmytro Bondar, compliance manager at Ukraine-based Horizon Capital, development financial institutions (DFI) – which constitute an important LP base in the region – have even higher requirements: "Under the influence of DFIs, the ESG bar keeps rising, having a positive impact on shaping the broader responsibility of businesses."

An additional aspect of ESG compliance has arisen in the region recently: decarbonisation as an aspect of policymaking has not been regulated in CEE, missing a reliable measurement approach. "In addition to the standard ESG work we do, each year has a specific theme," says Abris's Nachyla. "In 2020, the theme is carbon-footprint management. Together with an external adviser, we have defined both a mid-term and a long-term reduction programme, and on top of that, we want to set for ourselves a carbon-neutral ambition at portfolio level."

Corporate governance is also a crucial component of ESG for identifying businesses that are often related to so-called "grey-zone" practices. This is especially relevant for eastern Europe, where some businesses have not moved to transparent, responsible operations, or are built on capital with doubtful origin.

Challenges remain
The impetus for getting ESG right is strong beyond securing commitments from LPs, too, especially when it comes to improving EBITDA and increasing multiples with exits in mind. "We call it the ESG premium," says Vasile Tofan, a partner at Horizon Capital. "Western strategic buyers are ready to pay a higher price for companies with sound ESG and broader corporate governance practices."

However, due diligence on exits is also becoming increasingly thorough. Tofan argues that it is more efficient to beef up the ESG aspects during the holding period, even if that comes at a material cost, as it is preferable to the alternative of providing extensive warranties or indemnities for any shortcomings or risks identified during the due diligence process.

Meanwhile, ESG advisory companies are strengthening their positions in the region on the back of increased demand. There are a few regional companies and specialised global advisers with local teams in CEE, providing enough expertise for investors. This is complemented by the growing trend of having a team member responsible for ESG compliance at the GP level, with third-party experts brought in to match the scope of a transaction if required.

But implementing ESG principles in CEE portfolio companies is not always an easy process. For family- and privately owned businesses it often implies a cultural change, which is a significant and time-consuming undertaking: "Our approach is always very pragmatic," says Abris's Nachyla. "We try not to force revolution but go for evolution. We explain to the management teams what the risks and opportunities are, and what mitigating factors we can introduce. Then we explain how the actions we want them to implement will translate into improved earnings and profitability."

Ultimately, investors believe that ESG is crucial in highlighting that private equity in emerging markets has a dual mission – not only delivering good returns to LPs, but also pushing the standards of doing business to a higher level.

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• Topics
• GPs
• CEE
• ESG