Sustainable development for private equity: Integrating environment, social, and governance factors into partnership valuation

General partners (GPs) of private equity (PE) are facing increasing pressure from limited partners (LPs) to make investments that meet environmental, social, and governance (ESG) targets. We develop a tractable model to analyze an LP's valuation of participating in PE investment when the ESG factors are objectives. Integrating the ESG factors makes the LP commit to investing capital in ESG demand spending and choosing sustainable PE, which has an inverted U-shaped effect on the LP's certainty-equivalent wealth. At the optimal ESG demand spending, the LP tends to choose more consumption but less public equity investment due to his or her positive expectation about higher certainty-equivalent wealth from PE investment. However, an endogenous risk-aversion attitude and exogenous idiosyncratic risk will have an adverse effect and make the LP less eager to integrate the ESG factors for sustainable development. Thus, the optimal ESG demand decreases, and the LP requires a higher break-even excess return. Our analysis provides new theoretical insights for both PE partners and regulators when integrating ESG factors and sustainable concepts into PE valuation and management.