Rethinking sustainable investment strategies in private equity

Whether it’s renewable energy, technology that mitigates emissions, or companies that focus on social impact, there has been a significant rise in the flow of private capital dollars towards responsible investing initiatives. According to research by Global Sustainable Investment Alliance in November 2023, sustainable investments globally reached $30 trillion USD, a rise of 20% from the start of the decade.

GenerationIM, a private equity (PE) investment fund headquartered in the UK, is leading the way in sustainable investing as a comprehensive business approach. Jonah Surkes, Private Equity Investor at GenerationIM, joined us to explain their strategic take on sustainable investing and why it should matter to every private equity investor, regardless of thematic investing focus.

Key takeaways

• PE firms are expanding their definition of sustainability beyond traditional ESG reporting to consider broader systemic changes and second-order impacts, as exemplified by deals that deliver both business value and environmental benefits.
• Firms should understand the relationship between operational expenditure and growth rates to build companies that can achieve profitability while maintaining their sustainability mission, especially important in a market that values efficient growth over growth-at-all-costs.
• Companies preparing for successful exits need to demonstrate both financial viability and sustainability performance; PE firms should encourage portfolio companies to craft compelling impact reports alongside financial metrics to attract public market investors and differentiate themselves in an increasingly competitive landscape.

Expanding the definition of sustainable investing

Traditional definitions of sustainable investing and impact investing have focused on adding ESG (environmental, social, and governance) criteria to how private equity funds deliver returns: investing in high-growth private companies that are eventually acquired or go public (IPO).

Integrating ESG into the way companies showcase results is certainly important. Deloitte research found that 44% of PE respondents report on ESG to their Limited Partners (LPs). But GenerationIM has found success by expanding on this further. Surkes says, “A lot of investors conceive of sustainability and what we do as a pretty narrow subset of opportunities and ways of thinking around carbon accounting and climate companies that look a bit like software or technology.”

Instead of thinking purely about ESG factors, Surkes encourages dealmakers to think more broadly. What are the big changes that need to happen in the world—be they in energy transition, decarbonization, climate change adaptation, or other aspects of a net zero future—what kind of companies can drive those changes, and what second-order effects do those companies have that might influence those changes?

The firm’s investment in Docusign can be understood in this context of identifying broader change opportunities. While Docusign’s core value proposition is to digitize and streamline the agreement process, their business model does this with a high-impact second-order effect of sustainability: Docusign users have saved 93 billion sheets of paper in just over 20 years.

This expansion in thinking about how private equity makes sustainable investments has the potential to improve long-term value, both in terms of environmental impact and financial returns. This strategy aligns with Bain’s prediction of how private equity will continue to evolve:

“The winners in the years ahead will be the funds that can demonstrate a consistent, differentiated model for value creation today and a clear strategy for maintaining growth and performance over the long term.”

To learn more about the firm’s process, watch the webinar.

Operational excellence is the foundation of sustainable growth

How companies demonstrate growth is a critical part of rethinking sustainable investment strategies. Surkes explains, “Sustainability is not just about what the company does, but very much how it operates. That includes governance, culture, and a bunch of things around operations."

As the broader investment landscape has shifted from one that pushes for growth at all costs to one that emphasizes profitability and cost-cutting, real value can be unlocked for companies that can figure out how to grow sustainably.

Surkes explains how to apply this way of thinking to potential deals and portfolio companies in any vertical. In what is described as “throttling,” the team looks strategically at the results of scaling (or not scaling) a particular company’s operations when they make investment decisions.

Throttling means finding out how quickly a company’s operating expenditure (OpEx) can be scaled back, what relationship that has on the company’s growth rate, and vice versa. Surkes elaborates, “We've seen some companies who've cut OpEx in half, but their growth rate has only moved down by 10% or 15%, whereas with other companies there's a much more linear relationship."

Rather than cutting for the sake of it, this investment approach considers the imperative for companies with the funds to pursue their sustainability mission. If the opportunity is there, they should continue to grow and become dominant in the marketplace.

Surkes continues, "There’s the risk that companies with cash that are still cutting might miss out on the opportunity to take market share from competitors. The idea of cash being king is true, but at the same time, for some, there is an opportunity to—while everyone else is slowing down—continue to grow at a pace that still gets you to break-even."

Profitability and impact are key to portfolio company success

Once a company joins GenerationIM’s investment portfolio, the team focuses on laying the groundwork for a successful exit. Demonstrating profitability, or being very close to it, is paramount.

Surkes describes the shift in public market expectations towards profitability, saying, “It used to be that you could demonstrate new economic positivity, and with leverage of OpEx over time, there were future prospects. But now we would encourage all our companies to demonstrate profitability before they go public for at least a couple of quarters, if they can."

This is only one side of the puzzle, because reporting on ESG and sustainability performance can be part of a differentiated message to the market. While working towards profitability, Surkes encourages companies to “think through their sustainability story and to craft a really great impact report that attracts the attention of public market investors.”

This can provide alternative metrics and benchmarks related to company operations and business practices. Working in tandem with valuation metrics, this data can help potential investors understand a business, its reach, and the positive impact it can have.

Using the network effect to build a stronger portfolio

When it comes to sourcing investment opportunities that meet GenerationIM’s sustainable investment strategies, Surkes believes that a strong network is key. While connections to other General Partners (GPs) and private equity funds can help with co-investment opportunities, conducting due diligence and then helping companies grow requires a more varied network.

Reflecting on how the firm thinks about sustainability in terms of broader positive changes needed in the world, Surkes explains, “Building a network with a targeted group of people who are former executives, operators, and managers—people who actually run businesses can help you think through what these challenges are.”

The evolution of sustainable investing in private equity

GenerationIM's approach to sustainable investing represents an interesting next step in private equity strategy—moving beyond narrow ESG metrics towards a comprehensive business methodology that considers both direct and second-order impacts. By expanding the definition of sustainability, emphasizing operational excellence, and balancing profitability with impact objectives, PE firms can create differentiated value for their portfolio companies in a competitive landscape.

The shift from growth-at-all-costs to sustainable growth reflects an increasing need for companies to demonstrate profitability while delivering meaningful environmental and social benefits. As sustainable investments continue to grow, PE investors have the opportunity to align financial returns with positive change.

Success in this space will require building diverse networks beyond traditional PE circles, including operators who provide other valuable insights. For investors willing to broaden their perspective, sustainable investing offers a pathway to both competitive advantage and lasting impact.

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