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Why general partners in private equity funds should focus on environmental, social and governance risks in the wake of the global recession
In the wake of a most severe global recession, the private equity (PE) industry is facing enormous challenges: general partners (GPs) must work harder than ever with portfolio companies to create and realize value; debt markets remain uncertain; and many limited partners (LPs) are facing their own liquidity issues, (which in turn is adding uncertainty on drawdowns and threatening fundraisings). In addition, the situation is complicated by US and European regulatory legislation. With Alternative Asset regulation making private equity harder to do and Solvency regulation making it harder to invest in, the global uncertainty in the PE market is on an almost unprecedented scale.
So why would responsible investment, best known as Environmental, Social and Governance (ESG) risk be on the agenda at all? Why should general partners be thinking seriously about ESG opportunities and risks?
Capital from LPs is more limited than before the onset of the credit crisis and recession and GPs should focus on how they will attract future funding for investment. At the same time debt providers are more constrained in what they can do and GPs have to increase efficiency and drive operational improvements in the businesses they back. In both cases, identifying and managing ESG opportunity and risk is an integral part of these processes.
As capital providers to private equity funds, LPs are vital industry stakeholders and their views on this topic are of particular importance to GPs. For this purpose, KPMG commissioned Mergermarket to survey 50 LPs worldwide to gain an insight into their views on ESG management in private equity. This was followed up by in depth qualitative interviews with a further nine LPs conducted by Private Equity Research Limited.
The results of this combined research gives insight into LPs' views on ESG risks in private equity, what they see as the key issues (generally in terms of the industry and specifically in relation to GPs), as well as direction on how their decision-making processes will develop in the future.
Environmental, social and governance opportunity and risk
As you might well expect, the responses we got were as wide ranging as the types of LP surveyed from countries ranging from the UK through to Singapore and the US. However, two key themes emerged that may be vital for GPs to understand:
• Passion. They do not all care but those who do care, care deeply. Those respondents who think managing ESG opportunity and risk is important think it is massively important. Those who do not think it is important do not think it matters at all. KPMG's view is that the agnostics were agnostic because they appear to be confused about the issue.
• Confusion. Responsible Investing, ESG, SRI, Ethical Investment, the Green Agenda, Sustainability, Corporate Responsibility, Corporate Social Responsibility, Philanthropy, Venture Philanthropy, Social Enterprise. It should not be surprising that many LPs and GPs are confused and simply focus on immediate returns.
In addition, three reasons for GPs to act also emerged:
• Fundraising. LPs may not be clear about what exactly they want, but they know they want something. It has long been the case that historic performance has been easier to prove than 'the how'. But now the LPs surveyed want to understand how GPs make investment decisions, how portfolios are managed and how GPs manage ESG opportunity and risk. If some GPs have yet to receive an investor ESG questionnaire they could do so in the very near future. GPs would then need to be able demonstrate quality ESG management or face competitive disadvantage.
• Performance. It starts with the belief that there is a correlation between ESG management and fund performance. Next comes the effort to prove this. GPs should lay the foundations for proving it now. They can do this by demonstrating that they are able to manage ESG opportunity and risk and that they are able to proactively deal with the problems affecting their portfolio companies as they arise.
• Future regulation. ESG issues are rising up the agendas of almost all stakeholders, including those of politicians and regulators. If the private equity industry fails to demonstrate that it has due consideration for ESG issues, it runs the risk of having even more regulation imposed on it than is currently either in place or under discussion.
The dawn of responsible investment in private equity has arrived and many visionary firms know that managing the opportunities and risks under the umbrella of ESG is likely to give enduring investment performance, enhanced value and competitive advantage.
In the aftermath of the global recession many commentators are asking if and for how long the traditional private equity model can survive. Perhaps this is not a concern for the robust and well known brands but earning management fees on unspent funds and losses caused by excessive leverage or even just from paying too much at the height of the boom will not be forgotten. GPs need to ask themselves what the LPs want and how they can meet their needs. Perhaps for the first time across the asset class ensuring the GP has a sustainable business for the long term is a real concern. It is KPMG's view that understanding and effectively managing ESG opportunity and risk is core to the long term sustainability of the GP. It is part of securing the LP funds and core to managing the cost of the portfolio.
What is ESG?
Environmental, social and governance risks include a broad range of issues which can potentially affect portfolio companies and their GPs from both a reputational and financial standpoint. These issues vary between industries and individual companies and as a result, there is sometimes confusion regarding how the term is applied. However, some ESG risks are common to all businesses. These are:
Environmental: •Pollution •Environmental degradation •Carbon and CO2 emissions •Energy efficiency •Biodiversity
Social: •Labour rights and employee relations •Health and safety•Corporate philanthropy •Consumer protection •Data privacy
Governance: •Regulation •Anti-fraud and corruption •Internal financial control •Board effectiveness •Remuneration strategy •Ethics and independence management •Transparency
Do the LPs surveyed agree?
LPs believe good ESG management improves returns. It enables the creation of truly sustainable companies that employees, suppliers and customers want to be associated with. GPs focus primarily on profitability, but they also need to focus on sustainability. They need to look at long term capital generation and if all stakeholders are not satisfied, GPs will not profit over the long term.
LPs need to ensure their own reputations are not at stake. The greatest concern is, of course, investment performance, but if the focus is purely on this and ignore the social and environmental impact of investments, that could end up reflecting on reputation. You cannot separate the commercial aspects from the issues of sustainability and responsibility. For their part, many GPs would say that they already consider ESG risks as part of their day-to-day business. But, how many GPs consider this only in the light of downside protection and ensuring that minimum legal and regulatory requirements are met? So much of the ESG agenda is about seizing commercial opportunity and should be thought of in terms of adding real value to investments. Many GPs believe they are already addressing ESG risks because they conduct environmental due diligence, for example. They also think that complying with legislation is enough. Neither of these views is consistent with the proper consideration of, or management of, ESG risks.
