More Red Tape?
For those who do not know or, like many of the rest of us, who know but can’t consistently retain each of the individual components of the acronym, ESG refers in a very general way to the environmental, social and governance practices of sponsors and their portfolio companies. These factors are increasingly being discussed by investors, including labor unions, political pundits, regulators, management teams and other observers, as a potential means of both developing a reasonably uniform set of best practices for the industry and otherwise evaluating more generally the global economic and societal profile of private equity firms and their portfolio companies.
A few years ago, when ESG policies were even more nebulous than they are now, many PE professionals and other free market advocates, may have viewed these kinds of policies as an example of overly aggressive global regulation. In the current geo-political environment; however, particularly following the prominence of private equity in the 2012 U.S. Presidential election, and other related developments, most private equity firms understand instinctively that the kinds of considerations embodied in the development of ESG are likely to intensify and potentially lead to standards that, if not met, could have broader implications for the industry.
A leading private equity advocacy, research and resource organization has adopted a sector framework for ESG to assist industry participants in this regard. The standards adopted by the Private Equity Growth Counsel, known as the Private Equity Growth Guidance for Responsible Investments (the “PEGCC Guidelines”), provide very broad and, in some cases given the early stage of many of these considerations, necessarily incomplete guidance on ESG. While fund managers can begin to demonstrate commitment to ESG integration by adopting the PEGCC Guidelines or similar standards at this time, concerns linger in many corners of the private equity community about a “pandora’s box” -type dynamic with respect to the evolution of ever more stringent and return inhibiting standards governing a broad array of non-economic matters.
Still, many PE professionals are coming to believe that, at least on balance, the private equity community may ultimately have more to gain than to lose by the ESG initiative, particularly to the extent it can play an active role in cooperating with others in developing policies acceptable to it and the various other interested constituents. These advantages include (1) the proactive PR and practical benefits associated with the industry’s active cooperation in the development of the ultimate comprehensive standards in this area, as opposed to the seemingly greater risks associated with adopting a more passive role; (2) maintaining access to those investors who may ultimately demand ESG compliance as a condition of investment, to one degree or another, as these standards continue to evolve and, all cynicism aside; and (3) obviating the lost opportunities associated with being late adopters of the greener, more sustainable and more profitable operating practices associated with ESG programs (at least according to their advocates).
Giving Meaning to ESG
The specific contours of an ESG investment policy will likely vary based on the geography, sectors and asset classes the funds target, and other investment strategy features. Most governance and social criteria may arguably be relevant to all funds to some extent, while environmental issues are more likely to vary with the investment strategy. General operational sustainability practices (water/energy management and recycling practices) will, however, apply to most companies; it is, for example, the funds investing in real estate, infrastructure or taking control positions in commodities or manufacturing companies that will need to consider a much wider variety of environmental issues. Social criteria (e.g., attention to diversity and equal opportunity in employment practices, government and community relations, labor conditions and relations, product safety management and other human rights issues) will come into play in most investments. From a governance perspective, virtually all fund managers would also consider portfolio company accounting practices, attention to bribery and corruption risks, lobbying practices, political contributions, anti-competitive behavior and executive compensation to mention but a few aspects.
As noted above, a number of reasons are driving the development of ESG standards across the industry. These include:
- Investor Requirements; Fund Raising Edge. Institutional fund investors are themselves, as part of their investment policy mandates, increasingly adopting socially responsible investment philosophies, such as the UN Principles for Responsible Investment (“UNPRI”), which are geared towards global sustainability and believed to be consistent with the duties they have to their stakeholders and the public. Such fund investors are encouraging, and in some cases requiring, fund managers to adopt ESG policies that incorporate such “SRI” principles. As noted above, there appears to be an expectation among fund managers and the industry, more generally that fund investor attention to ESG issues will continue to increase over the next five years.
- Reputational Considerations. U.S. state pension plans and other governmental investors also tend to be especially focused on ESG integration in their investments to manage “headline risk” and to avoid potential public embarrassment for government officials. Fund managers, fund investors and the portfolio companies themselves would seem to be largely aligned in their interests to appropriately manage various reputational ESG exposures.
- Political Focus. The private equity industry and its various participants have come under increased political scrutiny during the last few years. Implementing ESG policies, adhering to SRI guidelines and generally acting as good corporate citizens could help the private equity industry improve its public image.
- Value Enhancement. While some cynicism remains on the value proposition in certain corners of the PE community, there is a growing awareness that optimizing ESG operational aspects may protect and increase the value of investments, for example through detecting and preventing operational disruptions due to negative ESG factors, reducing legal ESG risks and managing ESG publicity exposures that may otherwise impair a portfolio company’s brand. Building better business practices and strengthening management may more generally enhance profitability and create business opportunities, potentially leading to higher returns for fund managers and fund investors alike.
Examples of Value Enhancement
Proponents of ESG policies point to a number of recent examples of what they believe to be value enhancements facilitated by ESG policies. These include the adoption by a major U.S. private equity sponsor of a green investment program, introducing environmental initiatives and facility and operational improvements that have allowed its portfolio companies to collectively achieve an estimated $365 million in savings. They also include (1) a portfolio food service company saving a cumulative $70 million and almost 60,000 tons of greenhouse gas emissions over two years by improving routing technology, increasing the amount of product carried per truckload, and training drivers on more efficient driving techniques, such as when to shift gears or how to break in traffic, (2) an on-line retailer saving $40 million and avoiding 300,000 garbage trucks-worth of waste over a two year period by streamlining and centralizing its recycling efforts and (3) a communication infrastructure company reducing its energy consumption by 2.5% and saving over $650,000 in annual costs by reducing high-pressure sodium lighting in manufacturing facilities.
Integration of ESG Policies
If and when ESG policies are eventually adopted by a particular sponsor, these policies will need to be integrated at all levels of fund and portfolio management, including in the due diligence of investment targets, through active ownership and engagement of portfolio companies on ESG issues, by monitoring the implementation of the ESG policy both at the fund level and with portfolio companies, and via reporting to fund investors and maybe even the public on ESG initiatives, accomplishments and compliance.
Still, successful ESG integration is unlikely to be achieved if no further work is done beyond just the formal adoption of a policy and the taking of the concrete steps noted above. Rather, the highest substantive impact of ESG integration will likely be achieved by senior management with a fund manager tailoring an ESG policy appropriate for the relevant funds and ensuring that such policy is adhered to at all stages of the investment process. Some fund managers that are at the forefront of these matters designate a special ESG committee or an ESG compliance officer to oversee implementation of the ESG policy and train their investment professionals in ESG evaluation.
While perhaps not surprising given all the regulatory and political attention currently directed at the industry, including SEC registration, SEC presence examinations and on-going challenges associated with implementing Dodd-Frank, FCPA and UK anti-bribery requirements, a relatively small number of fund managers, outside of a few market leading private equity houses, have devoted a lot of resources to date to ESG considerations. Still, while not necessarily at the very top of the industry’s “to do” list at the moment, the current status of the evolution of ESG standards seems to us to create a unique opportunity for the industry to burnish its image by working cooperatively in the development of sensible and palatable standards in this sensitive area. Indeed, we are increasingly seeing fund managers starting to think about these issues in connection with upcoming fundraisings. We suspect it may become increasingly advantageous in the future for fund managers to adopt a formal ESG policy in advance of entering into negotiations with fund investors on terms, because in the absence of a pre-existing policy (and perhaps even when a policy exists), certain fund investors may try to impose compliance with their policy upon the fund manager. Such policies would not be tailored to the specifics of the particular fund investment program. In addition, as a fiduciary to a fund with many investors that may have differing views on ESG matters, a fund manager may find itself in a conflict position trying to comply with different investor policies. Plus, broadly speaking, we have found fund investors to be amenable to reviewing a fund manager’s existing ESG policy and taking comfort from the manager’s undertaking to use commercially reasonable efforts to comply with such policy.