Private Equity 4.0: Using ESG to Create More Value with Less Risk

A growing number of private equity firms have responded to the increased focus on climate change, social issues, and technology disruption by broadening their corporate mission to encompass all important stakeholders, as well as their limited partners. And in the process, the management of ESG risks and pursuit of ESG opportunities have become increasingly fundamental to the staying power and value creation potential of PE firms by reducing the risk of their investments, discovering new sources of growth, and increasing their resilience to changes in the political and regulatory environment. This article tells the story of how the Nordic PE firm, Summa Equity, has turned its ESG approach into a core competence and a source of competitive advantage that has enabled the firm to distinguish itself from its competitors and bring about significant improvements in the financial performance of its portfolio companies while providing benefits for their stakeholders. Using the U.N. Sustainable Development Goals to guide them, the firm invests in companies they perceive to be addressing major environmental or social challenges in an innovative and commercially successful way. This has led to investments in significant growth opportunities in areas such as health care, education, waste management, and acqua&#8208;culture. And the firm's returns to its investors have been high enough&#8212;and the perceived social benefits large enough&#8212;that the firm recently closed its second fund (which was significantly oversubscribed) for 650 million euros, and received the ESG award at the 2019 Private Equity Awards in London.

T Today, in a movement that might be called Private Equity 4.0, a growing number of PE firms have been adding to their existing capabilities the effective management of "externalities" and environmental, social, and governance (ESG) factors. In this article, we focus on how one such firm-our firm, Summa Equity-has turned its ESG principles and practices into a core competence, a source of competitive advantage that has enabled the firm to distinguish itself from its competitors and, in so doing, to bring about significant increases in efficiency and long-run value.

Externalities Reaching an Inflection Point?
To what extent do "externalities," such as the social costs associated with climate change and rising levels of inequality, affect corporate financial performance and value? While the evidence so far is ambiguous, our investment strategy at Summa Equity is based on the premise of an increasingly positive correlation between companies' profitability and market values, and their effectiveness in mitigating "externalities"-that is, the environmental and other social costs or benefits that arise from their business activities. We believe that investors that fail to recognize this correlation will fail to see the risks of negative externalities reducing the demand for a company's products or services. Such risks may also reduce its ability to attract talent, resulting in a potentially significant loss of its earnings power and market value. At the same time, many of these investors will also fail to see the value creation opportunities in providing solutions to the challenges arising from these negative externalities. Consider, for example, the significant growth opportunities in fields such as health care, education, and renewable energy-and in reducing the mountain of waste and plastic pollution-all investments that are expected to have positive social and environmental consequences on top of and quite apart from the profits and returns they're expected to generate. In fact, the growth opportunities in such areas may well be large enough to create virtuous cycles that end up leading to much broader increases in employment and economic growth.
The private equity firms that successfully incorporate these ESG risks and opportunities into their investment strategy and value creation approach are likely to improve their returns while at the same time reducing their vulnerability to risk. And this, in short, is the essence of the PE 4.0 investment model. by Reynir Indahl and Hannah Gunvor Jacobsen, Summa Equity he private equity industry is evolving. When the 1980s gave birth to the first wave of leveraged buyouts, PE firms created value primarily through financial engineering. This involved the use of high leverage in combination with large equity stakes to motivate managers charged mainly with taking costs out of mature businesses.
Then, in the 1990s, PE 2.0 was focused heavily on increasing operating efficiencies, accomplished often by bringing in proven CEOs from successful public companies.
Starting in the 2000s, PE 3.0 saw the building of large financial institutions that continued to function as value-adding buyers, while responding to tough competition from both strategic and financial buyers by expanding into different asset classes and developing new areas of expertise.
Private Equity 4.0: Using ESG to Create More Value with Less Risk Electronic copy available at: https://ssrn.com/abstract=3604413 tions. The U.S. hegemony that has long provided geopolitical stability is threatened by the deteriorating relationships of China and Russia. On top of all these challenges, the world's population is expected to grow from seven to 10 billion in the next 30 years, which will require a significant increase in infrastructure and agricultural and resources output.8 It is highly unlikely that we can continue to fuel global growth and a steady increase in global prosperity through further exhaustion of the planet's resources, failure to address the significant rise in inequalities, and the continued ignorance (or indifference) of the electorate to the unwillingness of our elected officials to deal with the root causes of these problems. It is also unlikely that multiple disruptions will continue in such a smooth fashion as we have seen in the post-war period. While there has historically been little risk or reward for companies or their investors associated with taking an "agnostic" position on the social and environmental consequences of externalities, the high level of negative externalities and the inflection point we now seem to have reached have significantly changed the risk-reward consequences of continuing to avoid action. All of which is to say: What got us here will not get us there, and those who understand this, and navigate accordingly in the bumpy ride ahead, will be the winners.

Summa's Investment Strategy: Challenges as Opportunities
Summa's investment strategy is based on the view that our biggest challenges are also our biggest investment opportunities, given that the demand for solutions to these challenges is growing. And the reality of comparative advantage suggests that the financial markets and the businesses they choose to fund are the best bet to provide these solutions, while operating within constructive regulatory frameworks provided by

The Challenges
To be sure, the current investment environment now appears to be as volatile and uncertain as at any time since World War II. In each successive decade, global economic growth seems to have slowed somewhat, especially in Europe and the U.S.1 Across the globe, national debt-to-GDP ratios and financial assets-to-GDP ratios have increased substantially, even after the global financial crisis in which such debt and assets played a major role.2 Adding to these economic risks, weather volatility likely attributable to climate change3 is increasingly seen as a cause in natural disasters.4 Furthermore, the effects of CO 2 emissions on the ocean and temperatures could disrupt sectors affected by climate volatility and increased sea level. The biosphere is also under threat, where we are now said to consume resources at a level 70% above the planet's perceived limits,5 and where the ecosystems providing nutrition to a growing population are believed to be so overburdened as to be losing their long-term carrying capacity.6 Digitization and Artificial Intelligence are rapidly changing and disrupting industries and workforces,7 which in turn is likely to increase inequality and reduce trust in public as well as private institutions to the point where such inequality and lack of trust threaten the globalization of the world economy. As a result, we are seeing riots and rapidly changing demand for foreign mass consumer products, and distrust in democratic institu-" Summa's investment strategy is based on the view that our biggest challenges are also our biggest investment opportunities, given that the demand for solutions to these challenges is growing.

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Electronic copy available at: https://ssrn.com/abstract=3604413 building "purpose-driven "companies may well be the key to increasing the commitment to the firm by employees, customers, and other stakeholders, and in attracting and motivating top talent. And by removing waste and inefficiencies in the value chain-which also reduces the environmental footprint and cost of resources-and in creating innovations and solutions that reduce externalities and help manage the challenges we are facing, these companies are leading the way to a more prosperous future.9 All companies fulfill a valuable role for their customers; if they didn't, our market system would put them out of business. All businesses also create external costs and benefits for society. For some industries, there is a more direct correlation between positive externalities and business success. Take the case of health care companies, which must improve their customers' health if they are to succeed in the market. In other cases, however, such as oil and gas companies, it is obvious that negative externalities have not been adequately accounted for. Though regulation has recently been catching up, the costs assessed such companies for these externalities have historically not been high enough. But this is changing as regulations become stricter and customers are increasingly considering such costs in their decisions. New regulatory requirements and growing demand for fuel efficient and electrical cars in Norway provide a good example.

Summa's Use of the SDGs
Hence, how "future-proof " a company is, depends on its external ESG impact. But how should investors-and the companies they invest in-assess this impact?
Summa was among the first private equity firms to use the UN Sustainable Development Goals ("SDGs") as a framework for assessing the relative size and importance of the social costs and benefits associated with positive and negative externalities when evaluating investments. The 17 Goals, as represented by Good Health and Wellbeing (#3), Quality Education (#4), Responsible Consumption and Production (#12), and Climate Action (#13), identify and help define the key problems and challenges we now confront as a society. And although federal and local governments can develop strategies and design regulatory policies to address these problems, it is essentially the businesses and the marketplace that are likely to play the greatest role in developing and carrying out the solutions. In this sense, while regulation certainly encourages the private sector to respond to ESG concerns, another force driving the increasing correlation between business opportu-governments. Though we as investors are confronted with an uncertain world, there are a number of things we can profess to know, with a very high degree of confidence: • The population on earth will increase from seven to nearly 10 billion by 2050. This rapid growth is straining our resources, but creating opportunities and growth in areas such as recycling and agri-tech.
• We are living longer, thereby creating growth in the health care sector and infrastructure.
• People are moving because of urbanization (and sheer unrest), which is providing investment opportunities within education, security, public services, real estate, and infrastructure.
• Humans are influencing the climate system, creating a need to reduce carbon emissions, improve energy efficiency, and promote renewable energy consumption. This means that energy-efficient technologies, energy infrastructure solutions, and the urban sharing economy are all providing attractive investment opportunities.
• While technology is disrupting many of the old industries, it is also providing the tools needed to solve some of our major challenges. Digitization, Big Data, and social media are also providing a transparency revolution that dramatically increases the risks of being exposed to ESG issues.
In sum, to the extent these megatrends are causing challenges and concerns, they are also providing some large and attractive investment opportunities. And thus although there are significant headwinds in the general economy and major sectors of the economy, the megatrends are providing tailwinds in the sectors creating solutions to the challenges.
In response to these megatrends, we at Summa are investing within three main "themes": resource efficiency, changing demographics, and tech-enablers. Within each of these areas, we have identified and committed our limited partners' capital to companies operating in established industries that include waste management and recycling, aquaculture, education, health care, and security, as well as relatively new areas called "agri-tech," "regtech," and "fintech."

Winners Will Have to Compete in a World Where Externalities Now Matter
All companies have employees, customers, suppliers, and financiers, and all companies are regulated-and so they must compete for and satisfy the needs of all these groups while also complying with regulation.
There is growing evidence that disciplined strategies that call for investments in addressing environmental and social issues have positive effects on corporate competitiveness, operating performance, and long-run value. In particular, Electronic copy available at: https://ssrn.com/abstract=3604413 nities and the externalities targeted by the SDGs is coming from corporate stakeholders-from customers' demand for more positive social impact, employees' desire to work for purpose-driven organizations, and a growing number of investors' preference for funding such companies.
For this reason, we at Summa avoid investments that are "net negative" on externalities, as measured by the SDGs. And this means that we favor, for example, energy-efficient companies over coal-based or CO 2 -heavy companies, aquaculture over livestock investments, and ed-tech over gaming companies. For each investment that we consider, we use the SDGs to help us understand its potential for value creation as well as how risky or "future-proof " it is. We use an ESG framework to assess risk. We believe the risk from ESG factors has increased as the transparency and information-sharing associated with negative ESG events have increased,10 including significant negative effects on customer behavior and willingness to pay.11 As regulation has also increased, the consequences of failing to meet ESG criteria are becoming more apparent as the market multiples of listed companies show an increasingly positive correlation with corporate ESG performance.12 For private equity investors like us, this is important since our financial goal is not to maximize our profit margins and earnings, but, more important, to increase the multiples at which we end up selling our companies in a way that maximizes their longrun value, both for us and the next owners of the businesses.
And since we expect to own our portfolio companies for at least a five-year period, and often sell to buyers that look out another five years, we need to make a roughly 10-year assessment of how "future proof " the company is when considering our initial investment. Within this time frame, negative externalities are likely to come with much higher costs and reduce the attractiveness of the business for a future buyer. Furthermore, we need to assess how the situation in the world at that point is affecting the value and performance of our companies. In the case of climate risk, companies face a significant ancillary potential risk in the sense that we may be only 10 years away from knowing which of the two main 11 Dagher, Grace, and Omar Itani, "The influence of environmental attitude, environmental concern and social influence on green purchasing behavior," Review of Business Research, Vol. 12, No. 2 (2012) climate change scenarios is more likely to materialize.13 The risk to certain sectors is significant in these various scenarios, and so we need to evaluate potential downsides that may not emerge until the time we plan to exit the companies.
Hence, at Summa we believe that evaluating and choosing to invest in companies based on their alignment with the SDGs and the associated value creation opportunitieswhile at the same time understanding the ESG risks to the companies under different climate and social scenarios-are fundamental to creating high returns while minimizing the risks of the investment.

Identifying and Creating Winners Via Summa (the Summa Way)
Summa's mission, then, is to invest in companies that are solving our global challenges while at the same time providing competitive returns for our limited partners. Our strategy and approach are designed to achieve this mission.
The megatrends and challenges are viewed from the perspective of the SDG framework that defines the challenges we are targeting, which in turn has helped us identify the three major themes of our investments: resource efficiency; changing demographics, and tech-enablers. At Summa, we have further selected some key areas within our themes. Within these industries, we have built internal expertise and we continuously monitor the trends and developments. We have a proactive "sourcing" strategy in which we approach sectors and companies we believe are uniquely positioned to grow because they are either addressing some of the key bottlenecks and problem areas in the industry, or because they have a strong platform and the organizational capabilities that we can use to enlarge the scale of the business.
Approximately half of our investments have resulted from a proactive approach of targeting and engaging with the company. But even in the acquisitions in which we have been contacted by the sellers in limited or full auctions, Summa has often been the preferred buyer. This expressed preference of sellers can be viewed as confirming the differentiating effect of our focus on ESG themes, combined with our industry expertise and approach to assessing value creation partly through SDGs. And since management-and usually the sellers tooare co-investors with us after the acquisition, they are more likely to choose a buyer they believe will be the most effective in increasing the long-run profitability and value of their companies.
the SDG framework, it is not worth our spending time on it, since the likelihood of promising both strong growth and a "future-proof " risk profile appears lower. Once we establish the importance of and opportunity provided by the challenge, we evaluate the company's competitiveness in solving this challenge. From a value creation and reward perspective, we want our companies to outperform and provide the most effective-and at some point the market-leading-solutions to its customers in the market place. Hence, we need to ensure that our waste management and recycling companies, like Norsk Gjenvinning and Sortera, have leading recycling technologies In the case of each of the companies we identify as targets, we go through the exercise of identifying what challenges they are solving, assessing how competitive and differentiated they are in solving this challenge in their industry, and evaluating their ability to scale. When defining the challenges they are solving, we use the SDG framework. The 17 goals and 169 associated targets are a good analytical tool for assessing what material and important benefits a company can provide its customers and stakeholders, since they are based on areas where there is a large gap relative to what is needed. If we cannot see that the company is solving a challenge defined by CASE STUDY: SALMON FARMING INDUSTRY P roducing over a million tons of salmon a year, Norway provides 50% of the world's supply, and the salmon farming industry is Norway's second largest export industry with sales of about 10 billion euros. * The industry has shown high growth over several decades. Such growth is expected to continue, and the SDGs provide indications why the industry is future proof and where the risk is: • Attention to SDG #2, Zero Hunger, has increased as the industry scales up. Global population growth requires further growth in aquaculture. Animal protein production uses significant input raw material that could be used for human consumption. Salmon has the highest conversion of feed into protein produced, requiring only about 1.3 kg of feed to produce 1 kg of salmon, with the main ingredients from sustainable and vegetarian input.
• Interest in SDG #3, Good Health and Wellbeing, is also a strong consumer trend. Fish is rich in Omega 3, which improves longevity and health; and there is a clear trend for consumers to substitute fish and vegetarian options for red meat.
• SDG #12, Responsible Consumption and Production, has a strong focus in Norway. Regulation of food production is very strict, and hence both mechanical and medical treatments of disease, which is an issue in the industry, are restricted compared to other countries. While there has been criticism of the input factors in salmon feed, the Norwegian industry does not use antibiotics (which is common in raising livestock), and the regulation of feed is strict to avoid health safety risk.
• SDG #13, Climate Action, is helped by the replacement of other protein sources by salmon. Salmon production does not require deforestation and increased agricultural land, since it is done at sea or in buildings. Salmon does not emit methane gas as livestock does, and does not deplete fresh water resources.
• The effect of salmon farming on SDG #14, Life Under Water, is mixed. Though regulation is the strictest in the world, the industry is still plagued with fish-transmitted disease and high fish mortality, and the treatments can have negative effects on their surroundings. For the industry to scale further, these issues have to be solved.
The industry has relatively limited risk from climate change, as compared to agriculture and livestock. Salmon is very versatile and can survive ranges in sea level temperature from zero degrees to over 20 degrees Celsius.
Regulation is strict, and consumers are also quite sensitive to problems that arise for certain producers. Hence, the risk within ESG and compliance is significant for producers that do not comply with regulation of feed, disease, and treatment management, or that do not have a high-quality value chain-one where, for example, consumer health could be affected by Listeria bacteria.
While the investment opportunities can be found across the entire value chain, the industry is still producing largely by the same methods and technologies as many years ago. The high-growth areas are hence in the shift to new methods-making use of closed cages, big data, and surveillance-and in solutions that improve SDG #14, e.g., salmon lice and waste treatments. year to support the lifestyle of an adult, only five percent of the value of this material is recovered.14 The resources available on the planet are threatened with overconsumption. SDGs #11 (sustainable cities and communities), #12 (responsible consumption and production) and #13 (climate action) all address this great challenge. And growth in the world's population and wealth are all increasing the challenge of disposing of waste.
In 2016, Summa invested in Sortera, a Swedish company that collects and sorts waste from buildings; it is the third largest player in its domestic market. The space Sortera occupies benefits from both market and regulatory tailwinds; and since acquiring it two and a half years ago, we have now quadrupled the company's revenue from 200 million SEK to over one billion SEK, and increased employment from 95 to 350 employees; such increases have been accomplished through bolt-on acquisitions as well as organic growth and synergies. Using innovative industrial processes-which we discuss in more detail below-Sortera is able to turn waste into valuable resources, such as wood and metals; and this recycling of critical materials in turn contributes to significant CO 2 reductions. And while beneficial to the environment, our company's use of these innovative recycling processes increases its company's revenues and margins, thereby doubly enhancing the long-term attractiveness of the business.
As revealed by the SDG-aligned KPIs that we measure and track, Sortera collected 205,000 tons of waste in 2017, of which 86% was recycled. Through its sorting, recycling, and processing of material, Sortera's net reduction of CO 2 was 226,000 tons. This is viewed as the equivalent of saving 558,000 barrels of oil or taking 48,000 passenger vehicles off the road for a year which is real impact.
Since its acquisition by Summa in 2016, moreover, Sortera has significantly increased its focus on sustainability and now publishes a yearly sustainability report that documents its investment in recycling technology, improvements in its value chain, and compliance with ESG regulations and principles. Thanks to the public and regulatory attention received by the waste management industry in recent years, Sortera has come to be viewed as a Swedish model of best-inclass ESG practices. This reputation is giving it a strong competitive edge, allowing it to grow market share and demand premium rates for its high-quality services.
In 2017, Sortera invested in a new electric recycling facility, which was the largest capital expenditure in its history. This investment increased profitability by reducing downstream costs as the recycling rate increased, thereby reducing per unit labor costs by enabling the production of more material per shift and reducing energy costs through electrification. The investment also had strong social benefits, improving the health and safety of employees and reducing the odor, noise, and exposure to fire experienced by neighboring communities. From an environmental standpoint, the increase in material recycling saved valuable resources while reducing carbon emission by shifting to a renewable energy source. And from a regulatory compliance perspective, our facility helped the Swedish construction industry comply with the EU Directive.15 Further, because the largest cost and part of operations is the logistical costs involved collecting the waste, the company capped electronically the maximum speed of its trucks-to the legal limit of 80 km/hour. The result was that its fuel consumption and costs fell by about 10%, further reducing carbon emissions as well as the number of accidents. And while addressing health, safety, and compliance/speeding issues, the company did not see any negative effect on the productivity of the fleet.
In sum, Sortera has shown strong growth in revenues and profits not despite, but rather with the help of, its improvement in ESG factors and sustainability targets as measured by Summa's SDG framework, as the company's operating costs have been reduced, and its customer base improved, as a direct consequence. and providers. And in so doing we have to assess any ESG risk and compliance risk, since failure in any one of these areas can significantly hurt the development of the company and increase exposure to risk. And these risks can be substantial. For a health care company, it doesn't matter that you have the best solution if your patient journals are hacked or fail to comply with GDPR. Or for a waste management company, it doesn't matter if you have the highest recycling rate, but continue to allow hazardous waste into the recycling process.
At Summa, we have created a standard way of assisting our portfolio companies in their growth-one that we call Via Summa. We think of each of our companies as undergoing a journey on the Via Summa, a path that leads to their next owner and, as a consequence of that process, becoming a more efficient company with a higher long-run value and growth trajectory. While many of the elements are traditional private and the infrastructures to increase material recycling rates as well as effective value chains. Our health care companies, like Logex, Hytest and Olink Proetomics, are working toward increasing patient outcomes and improving lives through solutions that are cost attractive and better relative to competitor. Our technology companies, like EcoOnline, are helping their customers comply with regulations at a significantly lower cost and in a more customer-friendly way. Hence, the more positive externalities our companies can create, the more they will outperform, and their revenues and margins should increase as the core of their business is aligned with the need for great solutions.
So, our due diligence is actively looking at how these companies are likely to bring about progress in meeting the SDGs, by providing better health, increased recycling, better education, and better compliance, and doing so in a way that is likely to be more effective and efficient than other solutions  Electronic copy available at: https://ssrn.com/abstract=3604413

Summa Summarum
Throughout the evolution and growth of the private equity industry, the management of externalities was rarely viewed as a core competence or source of competitive advantage. However, in the wake of the global financial crisis, the growing number of PE firms that comprise PE 4.0 have responded to the growing focus on climate change, social issues, and technology disruption by broadening the corporate mission to encompass all important stakeholders. And in the process, the management of ESG risks and pursuit of ESG opportunities have become increasingly fundamental to the staying power and value creation potential of PE firms, both by reducing the risk of their investments and increasing their resilience to changes in the political and regulatory environment. The UN SDGs is an effective framework for PE firms when screening investment opportunities and aligning their strategic direction and value creation plans with ESG principles and practices to ensure that risks are limited and companies well and responsibly run. Although PE 4.0 is in its infancy, the change is happening faster than almost anyone expected. Private equity firms that are late to the table will be less successful in raising funds, lose in the competition for talent, be disadvantaged in deal sourcing, and face significant ESG risks-and as a result, they will achieve lower exit valuations and end up creating less value. By failing to foresee and prepare themselves for this new future, these private equity firms will feel the consequences in both the value of their investments-and in their standing in the business community.
Reynir Indahl is the Founder and Managing Partner of Summa Equity.

Hannah Gunvor Jacobsen is an Investment Director of Summa
Equity and Head of ESG. equity approaches, such as 100-day plans, operating models, organizational assessments, and board cycles, our Via Summa has integrated its distinctive approach to managing externalities and the SDGs into these traditional components. Our companies begin by defining and articulating their purpose, assessing both the contributions and the requirements of each of their important stakeholders, and then developing and implementing key metrics that can be used to evaluate the company's progress in addressing the SDGs and ESG factors that are relevant to each.
The focus of the company's strategy is on improving the products and services they are providing their customersand as part of that strategy, the solution to the SDGs that is effectively provided by such products. Thus, the success of our companies is tracked and evaluated not only through the financial and operational metrics, but also in the alignment of such metrics with SDG and ESG metrics. We have also developed an organizational assessment and framework that guide our companies in creating purpose-driven, high-performing organizations while assessing significant ESG risks. In our experience, companies that frame their purpose in the context of the social problems they are able to solve, and actively incorporate this into their strategic plan and operating decisions, are more likely to succeed in motivating and energizing their managers and employees, while attracting better talent to their organization.
When measured by standard financial measures, the performance of our portfolio has been strong, with the reported Internal Rate of Return to our investors in the top quartile (according to Prequin data). And partly on the strength of that performance, we recently closed our second fund (Fund II) of about 650 million EUR. Since we raised our first fund (Fund I) of around 450 MEUR three years ago, we have experienced significant recognition from investors of the value of our SDG alignment and ESG focus, and some of the leading global limited partners are actively searching for private equity funds that work according to these principles and methods.