Double materiality for private equity firms – Navigating the challenges along five key issues

The Corporate Sustainability Reporting Directive (CSRD) imposes sweeping sustainability disclosure requirements on businesses across Europe, forcing them to report on a range of environmental, social, and governance (ESG) issues. For private equity (PE) firms, the CSRD poses distinct challenges that go beyond those faced by non-financial companies.

Private equity faces dual complexities: reporting across diverse portfolio companies and managing relationships with limited partners (LPs). Compounding these challenges is the concept of double materiality, which requires PE firms to assess both the financial effect of ESG factors on their portfolios and the environmental and social impacts of their investments on the broader world.

While guidance on how to comply with the CSRD is available, it is very non-financial market participant focused. The financial sector – including private equity – lacks tailored guidelines. This lack of specific guidance forces PE firms to independently develop their approaches to the CSRD, especially concerning double materiality. This will inevitably lead to inconsistencies across the sector.

This article expands on these challenges, with a particular focus on issues unique to private equity, especially in relation to applying and operationalising double materiality, which is a cornerstone of the CSRD.

1. Diverse portfolios necessitate a tailored double materiality approach

At the heart of the CSRD lies the concept of double materiality. Double materiality requires enterprises to evaluate how their activities affect the environment and society, as well as how ESG factors impact financial performance. For private equity firms, this introduces a layered challenge:

• Environmental and Social Materiality: PE firms need to assess how portfolio companies’ activities affect broader societal and environmental issues. Whether it is biodiversity, labour practices, or community impact, these factors must now be reported, even if they do not directly affect a company's short-term financial performance.
• Financial Materiality: PE firms must assess how ESG factors affect the financial health of their portfolio companies and, thus, the return on investment. For example, a company with a reliance upon critical minerals may face financial risks due to supply chain issues or price volatility. Such risks now need to be clearly identified and assessed.

Unlike single-sector enterprises, PE firms invest in a wide array of industries and sectors, complicating the application of a uniform approach to double materiality. Portfolio diversity necessitates tailored materiality assessments, which may require a sector-based or activity-based approach to ensure a meaningful assessment. Some portfolios may benefit from a high-level grouping of activities, while others may need a more granular sectoral analysis​.

2. Challenges in delineating value chains for double materiality assessment

In the context of double materiality assessment, strategic mapping of portfolio value chains becomes crucial for PE firms. This process is essential for understanding where the firm plays a direct or indirect role in causing, contributing to, or being linked to impacts – whether environmental or social. However, the complexity and diversity of portfolio companies add significant challenges to this mapping process, as we just learned.

For example, a PE firm may directly influence the environmental practices of a company through board involvement, thus contributing to carbon reduction efforts. Conversely, a PE firm could be indirectly linked to human rights violations in a distant tier of a supply chain, even if it has little operational control. The challenge here is the data availability and transparency of third-party suppliers and subcontractors in the value chain, which can obscure the true impact linkages. Pinpointing exact responsibilities requires deeper engagement with portfolio companies and potentially entire supply chains.

The CSRD places significant emphasis on value chain transparency. PE firms inevitably will need to apply a phased approach to disclosure, taking into consideration reputational risks with LPs and other stakeholders who may expect a more in-depth approach. Balancing the depth of value chain reporting against resource constraints and data collection hurdles requires a strategic decision for PE firms.

The decision taken in the scoping phase of the double materiality process concerning delineating the role the PE firm plays – whether as a cause, contributor or linked to – can have significant consequences for both a PE firm’s ability to collect necessary data and more importantly the perception of stakeholders (especially LPs).

3. Balancing qualitative vs. quantitative assessment for double materiality

As already mentioned, private equity firms, especially those with broad and diverse portfolios, face a significant challenge when applying the principle of double materiality. The principle requires firms to assess both financial and impact materiality, but the nature of these assessments varies greatly across sectors and geographies, complicating the evaluation process.

Qualitative assessments, particularly around social governance, reputational risks, and evolving regulatory landscapes, are inherently difficult to standardise. For example, assessing the long-term impact of a portfolio company’s labour practices on its brand is subjective and context-dependent, varying by industry norms, local regulations, and public sentiment. These qualitative factors are critical but often lack clear, measurable indicators, making it harder for PE firms to apply consistent evaluation methods across their portfolios.

Quantitative assessments, by contrast, offer clearer metrics in areas like environmental performance, particularly when it comes to measuring carbon emissions or resource efficiency. These are more straightforward to track and report. However, even these quantifiable metrics present challenges in the private equity space. Translating raw environmental data into financial impacts, such as potential costs from carbon taxes or long-term operational risks from climate change, involves complex modelling and forecasting. This adds layers of uncertainty, especially for portfolio companies in sectors where the financial consequences of environmental risks are harder to predict over the investment horizon.

The diversity of a PE firm’s portfolio further complicates the task. A portfolio that includes companies from industries as varied as technology, manufacturing, and healthcare will have very different ESG risk profiles, each requiring tailored approaches to materiality. For instance, data privacy is a critical material issue for tech firms but may be less relevant for a manufacturing company, where water use and supply chain emissions are key. Furthermore, diversity creates challenges in setting relevant criteria and thresholds for materiality assessment. This sectoral variability limits a PE firm’s ability to generate comparable, portfolio-wide reporting.

Ultimately, PE firms must navigate these qualitative versus quantitative challenges by developing flexible yet rigorous ESG assessment frameworks that align with the European Sustainability Reporting Standards. These frameworks must be capable of integrating both subjective, context-specific insights and quantifiable data while recognising that certain impacts may be difficult to measure consistently across a diverse portfolio. Achieving this balance is essential for PE firms to not only comply with CSRD and ESRS reporting requirements but also to meet the increasing expectations of LPs, regulators, and other stakeholders for transparent and meaningful sustainability reporting.

4. Assessing risk & opportunity upstream and downstream

Private equity firms must assess risks and opportunities across both the upstream and downstream segments of their value chains. Evaluating risks and opportunities across upstream and downstream segments of value chains introduces complexity, especially when balancing quantitative financial metrics with qualitative ESG data.

Upstream, PE firms rely on LPs for capital inflows and investment. As LPs grow increasingly focused on sustainability, misalignment between the LPs’ expectations and the ESG performance of portfolio companies represents a major financial risk. Poor ESG performance could result in reduced capital inflows, affecting fundraising ability. On the flip side, demonstrating strong ESG performance across a portfolio can attract sustainability-conscious LPs, leading to potential new funding sources or preferential terms. This alignment can foster long-term relationships with LPs and may result in lower costs of capital or more favourable conditions for raising funds in subsequent rounds.

Quantifying risk can be challenging because it requires predicting LP sentiment and integrating both qualitative factors (e.g., shifts in LP preferences) and quantitative measures. While financial performance data is relatively easy to measure, capturing the evolving expectations of LPs and their reaction to ESG factors is much more complex and subjective, with the social ESRS topics, such as workers in the value chain and affected communities, playing a much greater role in the overall risk assessment than one would anticipate.

Downstream, the challenge is assessing ESG risks across a diverse portfolio, including companies across multiple sectors and regions. Each portfolio company faces different ESG risks—such as regulatory compliance, climate transition risk, operational risk, or reputational damage due to poor social governance. Failing to manage sector-specific risks can result in financial underperformance or regulatory penalties, ultimately affecting the PE firm’s overall financial returns. This complexity makes it harder to apply a consistent risk assessment approach​.

Assessing downstream risk is difficult. The quantitative side of ESG risk assessment varies significantly across sectors. For instance, carbon emissions can be tracked relatively easily for industrial companies but are harder to quantify in service sectors. Qualitative factors, such as governance quality or reputational risk due to labour practices, require in-depth, subjective analysis, often without uniform benchmarks across sectors.

It is important to note that the broader the portfolio, the greater the dilution of downstream risk. When assessing the actual size of potential financial effects coupled with likelihood, a PE firm may find that the risk is actually greater upstream than downstream.

5. Prioritising LP engagement to define material topics

Incorporating LP engagement early in the process of determining materiality is vital for PE firms. LPs, as primary providers of capital, have growing expectations for transparency and alignment with the CSRD as GPs form part of the LP value chain. (Let us not forget that LPs themselves will invariably also be in the scope of the CSRD). As a result, their perceptions of what constitutes material ESG topics directly influence a PE firm’s strategy and reporting priorities.

Aligning Financial and Impact Materiality with LP Priorities is important. Their expectations around ESG issues – such as climate risk, human rights, or supply chain transparency – are critical to defining material topics within a portfolio. By actively engaging LPs, PE firms can better understand the financial materiality of various ESG risks. Ignoring LP perspectives may lead to misaligned priorities, putting future capital inflows at risk and reducing the attractiveness of the fund to sustainability-conscious investors.

Risk Sensitivity and LP Decision-Making come hand in hand. Many LPs have developed internal ESG mandates or guidelines, requiring them to assess the risk exposures of their investments, both financially and reputationally. Understanding LPs’ sensitivity to ESG risks is crucial, as these risks can affect their decision to allocate capital to certain funds. Moreover, LPs may demand enhanced due diligence on certain value chain risks or expect heightened reporting standards for certain sectors. A strong grasp of what LPs consider material ESG risks can guide the PE firm in developing a double materiality assessment that not only aligns with CSRD requirements but also reinforces trust with investors.

Gaining insights into what LPs deem financially and environmentally material ensures that the firm’s approach to double materiality addresses both regulatory obligations and investor expectations. Prioritising LP engagement early in the CSRD compliance process ensures that the PE firm's double materiality assessments are aligned with the expectations of those providing capital. This alignment not only meets regulatory standards but also strengthens investor relations and enhances the firm’s competitive positioning in an increasingly ESG-driven investment landscape.

Navigating double materiality is a strategic imperative

The Corporate Sustainability Reporting Directive represents a seismic shift in the way PE firms must approach sustainability reporting. The distinct complexities of managing diverse portfolios, delineating value chains, and balancing qualitative versus quantitative ESG assessments place PE firms in a uniquely complex position. Navigating these challenges requires a tailored and strategic approach, especially when operationalising the concept of double materiality, which lies at the heart of the CSRD.

For PE firms, double materiality is not just a compliance exercise—it is a strategic imperative that can redefine how they operate, invest, and engage with stakeholders. By thoroughly assessing both the financial and societal impacts of their investments, PE firms can not only meet regulatory expectations but also position themselves as leaders in sustainable finance. This approach enhances their ability to attract capital from sustainability-focused LPs, fosters stronger investor relationships, and mitigates risks across both upstream and downstream value chains.

Ultimately, successful navigation of the CSRD requirements will differentiate PE firms that embrace sustainability as a core part of their business model from those that view it as an obligation. The firms that prioritise tailored, transparent, and thorough double materiality assessments while continuously engaging with their LPs will be better equipped to thrive in a complex and ever-evolving ESG investing and regulatory landscape.