Aligning private equity investment practices and structures with ESG goals

The private equity industry is growing in importance. In recent years, companies have remained private longer. Furthermore, limited partner (LP) allocations to private markets continue to increase as underfunded pensions and endowments search for yield in a low interest rate environment, and in pursuit of diversification as the universe of public companies shrinks.

From our past work with general partners (GPs), we recognise the industry is making progress on ESG integration. In PricewaterhouseCooper’s 2019 survey of both GPs and LPs, 91% of respondents have already adopted or are currently developing a responsible investment or ESG policy. The number of GPs who are PRI signatories now stands at 683 and includes six of the largest ten. GPs are integrating several ESG frameworks, particularly SASB, and some are even launching impact investing strategies.

This is an excellent reason to celebrate, but increasingly, the private equity industry is suffering from a deteriorating public image. The issues driving this are multifaceted, ranging from founders evading tax, to the impact on inequalities from compensation structures. There is also increasing debate and some emerging evidence that certain private equity strategies may not outperform public markets net of fees.

Such concerns could act as significant barriers to the long-term sustainability of the industry.

If the industry wants to continue to grow and attract capital from responsible asset owners in the long-term, then addressing these issues and discussing potential solutions is going to be more important than ever.

Private equity does have a purpose and can play an essential role in society, so how can the industry work towards greater sustainability in the long-term?

We shouldn’t forget that private equity consists of numerous actors, with investment strategies and objectives that can differ dramatically. It is difficult, and improper, to generalise. Private equity can often play an essential role in providing growth capital and value-creation expertise to growing companies, which is especially beneficial in less developed economies, and these companies generate a great deal of employment opportunity as they expand. Private equity firms can also support struggling companies and help them regain their footing.

Upon closer inspection of ESG integration in private equity, a key issue becomes apparent. Existing ESG frameworks mainly focus on the operations of portfolio companies and don’t take into account the investment structure. This can mean that issues like GP compensation and its relationship with wealth inequality aren’t considered – neither are issues such as capital structure at the portfolio company level that can lead to cost-cutting and fragility of their finances. This can lead to bankruptcy and restructuring, with particularly negative impacts on workers and employees. According to Moody’s, private equity was present in 58% of defaults among non-energy companies in Q2 2020. Tax and political spend practices by GPs are also not typically taken into account by ESG frameworks as applied in private equity.

Combined with light regulation around public reporting requirements, gone unchecked, over time these issues can result in systemic risks related to societal inequality and a fragile corporate sector, which can destabilise markets overall and therefore LPs’ portfolios.

Investments into strategies that do not proactively take these risks into account might produce competitive returns in the short and medium term, but will they continue in the long term if left unaddressed?

While diagnosing problems is easier than recommending solutions, some potential paths forward might include the below. We note these are not fully developed solutions, but rather ideas the industry could workshop and fine-tune together. This engagement is important to understand and avoid unintended negative consequences and ensure the effectiveness of any interventions.

Sustainable financial market-based solutions

1. Initiatives that seek to widen the interpretation of financial materiality to not just focus on issues at the portfolio company level, but also on systematic risks to LPs’ portfolios

2. Development of metrics and frameworks to measure and manage GP impacts, including those of investment structures, e.g.:

a. Compensation ratios not just within the portfolio company level, but also including the GP

b. Thresholds and parameters for responsible use of leverage at the portfolio company level (e.g. appropriate uses of funds from loans or debt issuance to avoid financially engineering returns at the expense of other stakeholders, including guidance on dividend recapitalisations)

Investment practice/fund governance solutions 

1. Shifting to longer-dated funds and permanent capital vehicles such as evergreen funds so that:

a. There is less incentive to financially engineer returns in a short timeframe

b. Short-termism in the management of portfolio companies is minimised, and more sustainable and longer-term strategies can be implemented

c. GPs are not pressured into investing capital rapidly or engineering early exits in order to demonstrate liquidity prior to raising a subsequent fund

d. Lower costs to LPs as secondary sale exits and associated transaction costs are minimised

2. Diversification away from Internal Rate of Return (IRR) as a valuation methodology and performance metric that links to compensation: IRR has many known drawbacks and could be used in combination with other multiple-based metrics, such as Total Value to Paid In (TVPI). IRR incentivises investment professionals and management teams to create value as fast as possible, which can be in conflict with sustainable long-term investing and systematic risk management.

3. Implementing investment structures that help build more balanced wealth across society (e.g., worker ownership in portfolio companies, building workers or communities into the distribution waterfall, in addition to living wage, quality benefits, worker protections, etc.).

4. Incorporating aspects of multistakeholder governance into fund and portfolio company management to ensure that concerns, perspectives, and feedback from workers and communities are integrated into operations and risk management proactively. This can be an excellent approach to stay ahead of the curve on “dynamic materiality.” At the simplest level, this could include implementing grievance mechanisms at the GP and portfolio company levels, and for deeper engagement, there is growing interest in benefit corporations, as well as worker representation in governing bodies such as boards of directors.

5. Better alignment of interests between GPs, LPs, and other stakeholders who create value and take risk, such as workers. In particular, for larger funds, this could mean reexamining how the management fee compares relative to AUM and its contribution to overall compensation.

This is a complex and challenging area for advocates of responsible investment to undertake. Still, as the PRI enters its next three-year strategy, these are challenges within the private equity asset class that we will be trying to understand how best to approach.

Historically, the private equity industry has been hesitant to have open and constructive dialogues with stakeholders and the public at large. However, recent stakeholder concerns suggest we are at a turning point. To support the industry in continuing to grow sustainably, we invite the industry to collaboratively and constructively work with us and others to improve.

 

 

This blog is written by PRI staff members and guest contributors. Our goal is to contribute to the broader debate around topical issues and to help showcase some of our research and other work that we undertake in support of our signatories.Please note that although you can expect to find some posts here that broadly accord with the PRI’s official views, the blog authors write in their individual capacity and there is no “house view”. Nor do the views and opinions expressed on this blog constitute financial or other professional advice.If you have any questions, please contact us at [email protected].