Rob Brown, Lincoln International’s Global Chief Executive Officer, shares five ESG-driven changes he expects to impact private market mergers and acquisitions over the next five years.

Evaluating a company’s environmental and social impact is complicated by a lack of consensus. Competing measurement frameworks, differing limited partner (LP) values, divergent geographical priorities and industry realities add to the complexity. Against this backdrop, ESG impact is currently in the eye of the beholder.

For this reason, we expect both buyers and sellers to assume responsibility for ESG measurement as part of the sales process in an effort to take control of their ESG narrative. Private companies will pursue valuations which include an assessment of ESG. The question remains whether non-financial data will be incorporated alongside business fundamentals in determining enterprise value — or whether ESG will be carved out as a separate, standalone datapoint for the consideration of buyers who care. With rising concerns of greenwashing, third-party attestation from ratings or valuations providers may become essential for credibility.

Likewise, both private equity and corporate buyers will consider available information, including ESG ratings and company ESG reports when identifying prospective acquisition targets. During the due diligence phase, sponsors will ensure that ESG claims are accurate and align with their stakeholder values.

Last month the Securities and Exchange Commission proposed disclosure rules for private company financial data — reflecting a growing trend toward transparency in the private markets. Many PE firms have already begun the process of voluntarily collecting ESG data from their portfolio companies on an annual basis. As PE hires ESG experts and tracks their portfolio impact, we expect to see both fund-and-company-level ESG reporting become expected and standardized — with the ability for investors to meaningfully benchmark against private and public company comparables. Once regular reporting becomes the norm, we expect LPs to align their future capital allocation to fund managers who demonstrate the ability to both deliver ESG impact and healthy financial returns.

The lack of consensus behind ESG measurement frameworks creates headaches for LPs and lenders. While GPs may continue to advocate for customized (or, as critics will label it, “cherry-picked”) ESG measurement, we expect the industry to rally behind a single framework for measurement within the next several years.

Already, certain goals are transcending geography and industry, such as reaching net zero emissions. Evolving official and unofficial regulatory pressures, such as the European Union’s Sustainable Finance Disclosure Regulation, may also drive consensus.

Dedicated impact funds make it easier for GPs to align investment mandates to LPs with a stated interest in ESG investment, and seek lenders focused on green credit. As LPs come under scrutiny to deploy capital responsibly, pressure from asset owners on the PE industry is expected to increase.

Beyond the moral imperative, we expect impact funds to continue to build in popularity due to a compelling investor rationale: outperformance. While more data is needed to demonstrate return of ESG investments, GIIN’s 2020 Impact Investor Survey found that 86% of PE impact investors reported performing in line with or exceeding their financial performance expectations.

One of the greatest challenges that private equity has in creating ESG impact for their portfolio companies is the short time horizon of investments. We expect the rise of continuation funds and growing private equity appetite for longer hold times on attractive investments to allow for more thorough and practical ESG goal setting and realization.