Private Equity: A force for good?

Private Equity: A force for good?                                                             

Peter Dunbar

Welcome to this PRI podcast focusing on private equity and the positive and negative impacts the asset class has on a variety of stakeholders through its investment practices and structures. My name is Peter Dunbar. I’m Head of private equity here at the PRI, and I’m delighted to be your host today.

Private equity often brings about polarized views. On the one hand, we have the American investment council, a private equity industry association telling us the, that private equity invests in businesses across the us improving the lives of millions of Americans each day. Specifically, they say that it helps companies grow, saves local jobs and boosts the retirement savings of millions of Americans. On the other hand, and I quote here from a recent newspaper article in the UK “private equity firms, critics say they are blood suckers, that load healthy companies with debt, then assets strip them leaving lifeless husks”. So as always, the, the truth probably lies somewhere between those two polarized views and it’s no doubt complex and nuanced also.

So that is where our guests today come in. We have Delilah Rothenburg who is Executive Director and co-founding partner of the pre distribution initiative and Tensie Whelan, Director, NYU stern center for sustainable business and former president of Rainforest Alliance. Both are working to understand private equities impact on stakeholders and create improved investment practices that could help create value for all. So Delilah to kick us off, I wonder if you could elaborate on some of the issues you see private equity contributing to and comment on where you stand on the spectrum of private equity as a, for force for good versus it being highly problematic in certain ways.

Delilah Rothenburg

Sure. Pete, well, thanks so much for hosting us and, it’s a real pleasure to be here to answer the question. I started my career in private equity because I saw it as a force for good. And I still do. I went into private equity because I was interested in a attracting capital to underserved areas of the world like Sub-Saharan Africa. And for the first four years of my career, I was working in public markets. And I realised that the, it, that was not really where the support was going be for small and growing businesses and more illiquid markets. And so I went into private equity, with sort of with this mindset. And I worked in a space that focused on Sub-Saharan Africa for quite some time. And eventually, also started to focus on North America and I worked across a number of different job functions.

And, you know, I started to see some issues with private equity, really in 2017, when I was spending more time with the larger private equity fund managers, I actually wasn’t working for a large private equity fund manager. I was working for a 2 billion AUM middle market fund manager focused on primarily north America, but also investing internet nationally, working with a sister company of theirs. That was a permanent capital vehicle on that sister Hold Co was focused on Sub-Saharan Africa. So I still had sort of a foot in both worlds, but I was spending a lot of time with peers of larger fund managers. And I was going to, to big investment conferences. And I sort of started to realise that economic inequality was something that we should be focusing on our investments in North America. And I was looking at how can we address this?

Can we pay our workers, a living wage? Can we help them build wealth by sharing some equity in the portfolio companies for those workers who work for those companies? Can we narrow executive to average worker compensation ratios and a friend of mine pointed out that it was great. I was looking at executive to average worker compensation ratios, but in private equity, often the compensation ratios between the executives of the fund managers are way more than the pay ratios between corporate executives and workers in, in portfolio companies. And so, you know, that was an issue I started to pay attention to and think about. And I became very interested in sort of the structure of private equity, how it could be reformed. I started to spend time with civil society, advocates and stake and other stakeholders, labour advocates to learn about their concerns and private equity, which you mentioned, you know, often have to do with leverage or, you know, tax structuring of the funds or lobbying and political spend on the fund managers. And even, you know, with the smaller funds focused on developing markets, there can be some concern about how much of the return stays in, in the countries that the, that they’re focused on versus comes out. So, those are some of the issues that we’re looking at.

Peter Dunbar

Great. Thanks Delilah. So I guess to bring Tensie in here. Delilah kind of in the camp of it’s a force for good, but perhaps with some, you know, unintended or, or possibly intended consequences on ne on the negative side, maybe if you can kind of answer the same, same question.

Tensie Whelan

Absolutely. Pete, and again, I’m also so thrilled to be here. Thanks for inviting Delilah and I. And congratulations on the great work that you do at UN PRI, so first of all, I mean, when I, when we look at PE globally, it is responsible for about 7 trillion. When you look at the United States, it’s about 6.5% of GDP and, employees, 12 million workers. So it has a really significant footprint as Delilah pointed out. I mean, the key areas that I think private equity can really help with is bringing capital to companies is bringing knowhow, and also bringing their network. Right. And what we see from a sustainability or ESG fund is that they can help companies make a pivot, move from a conventional problematic approach to a more sustainable approach. They can help create jobs et cetera.

So there’s a lot of great opportunities. And we’ll talk more about positive examples later, but we also see that there’s a certain kind of tribe of private equity that really rather than focusing on value creation, focuses on what I would term value extraction. And we’ve had through stern through one of my colleagues, Sabrina, how doing a lot of research, looking at that value extraction model by private equity in areas like nursing homes, where we see nurses being fired, length of stay going up, cost going up and mortality going up when private equity purchases, those homes, our own research at the center of sustainable business, which I run at Stern. We did a deep dive into a Wisconsin based paper company that was the largest in the country, bought by an international buyer and then went through two successive private equity owners over the last 15 years.

And what was instructive about that evolution was that we saw in each instance of the private equity ownership that they basically acted value and, and in fact destroyed the company. So, during both, PE 10 years, they were each had them for about seven years. They loaded up the company with debt in the first, in during the first PE ownership, they sold off important assets. They did not invest and make capital investments that were needed to sort of pivot the, to where things needed to go. They laid off the R and D folks and ultimately took the company into bankruptcy. Then we had the second, and by the way, they had seven CEOs over seven years. Then we took then another PE firm bought it from the first PE firm who by the way, made a lot of fees on that transaction. The second PE firm began to reduce some of the debt, but did not make any investment continued to sell real assets. And also took the company into bankruptcy after I think, five CEOs, every seven year period. So this is the kind of problematic private equity approach that we’re concerned about and are now working at stern on an initiative to tackle

Peter Dunbar

Well, that’s actually a great segue into the next question. Maybe if we can just stay with you for a moment, because you’re both working on various projects related to this and how private equity and other investors can impact stakeholders. How those impacts could be measured better, what better investment per right. This might be. So could you just tell us a little bit more about what you’re actually focusing on right now?

Tensie Whelan

Absolutely. So we are working on with a collaboration with Delilah and others working on a responsible investing framework that looks at things like societal impact and ESG, but actually moves beyond that, to understanding all the different kind of categories of impact that PE has both in terms the firm governance and in terms of their portfolio company governance. So this framework, we divided into two parts with a variety of different impact categories. As I mentioned on the PE firm front, we’re looking at TOPEX such as management and human capital. So for example, what about diversity, ESG credentials, looking at things like fund management, strategy and innovation approach and societal impact, and for the PE firms themselves, we’re looking at those categories, but also reporting transparency and, financial engineering. And as I mentioned, this financial engineering, particularly with distress companies is a signal when you load up a company so much with debt, that it doesn’t have the ability to kind of invest pivot, et cetera, that can be highly problematic. So those are the, that, that’s the sort of framework that we’re designing. Our goal is to have this plug into the work of groups like Delilah’s, ultimately develop some tools, both for institutional investors and PE firms that can help them. And also civil society brings some accountability to what is often a very opaque process.

Peter Dunbar

That’s great. And look, if, if we can just switch to Delilah as well. Maybe you can say a few words about your work and also, perhaps just comment on, you know, how that compliments or how it diverges with the work of Tensie as well.

Delilah Rothenburg

Sure. So once I left private equity, I partnered with a few others to launch the pre distribution initiative, which is a non-profit that supports investors in addressing systemic or systematic risks, including inequality, biodiversity loss, and climate change. And we have four main pillars of work. So the first is transparency, standard setting and disclosure. The second is supporting asset owners and allocators in reflecting on their own internal governance so that they can address systemic risks, our systematic risks, as we really say, and focus more on these kinds of issues that we’re talking about with private equity, because, you know, at a structural level, they really have to, these issues have to do with systematic risks that aren’t captured by our traditional ESG and impact investing frameworks. We also have a pillar of work, the third pillar on supporting asset owners and allocators as well as fund managers on alternative models of financial analysis and valuation.

And then the last pillar is researching models of what good looks like, how it can be scaled. And so our work really aligns with toy’s work, particularly around pillar, number one on transparency, standard setting and disclosure. We have two initiatives, one we started in 2020 with impact the impact management project, where they recognize that they have some guidance on investor contribution, looking at the positive impacts of investor contribution. If an investor is providing technical assistance to portfolio companies, if they’re providing catalytic capital, but there’s not a framework, there’s not sort of another side of that framework looking at potentially unintended negative consequences that have to do with the several categories of concern that I mentioned before, as well as others. So we’ve reached out to other stakeholders in the market and beyond the market, including civil society to provide input on what metrics could look like to evaluate these issues.

So we have a draft of those metrics at this stage on the impact frontiers website that anybody can download and then express interest in getting involved with consultations. And, so we’re collaborating with NYU and Tensie on fine tuning, these metrics, integrating NYU’s research from this project into that project. And then that project we expect will eventually feed into another project that the pre distribution initiative is working on, at least for the, for the issues that relate to inequality. We are a part of a coalition that’s launching a task force on inequality related financial disclosure. So all of this great work can feed into that framework and hopefully other, other standard setting frameworks as well.

Peter Dunbar

That’s great. And it’s clear there’s a lot of work kind going on and has been going on for some time you know. As we’ve spoken over the last couple of years. So that’s great. I think maybe just to bring a bit of balance into the discussion, you know, we’ve spoken around some of the negative aspects, so far, and you know, I for one, you know, you spoke of systemic issues, Delilah, you know, we, the PRI supports an initiative called ICI initiative (Climat international) which is now like 160-170 private equity firms, all focusing on trying to figure out how to approach and, and kind of integrate climate risk, for example, into their investment practices. So, you know, they are, you know, making strides on certain fronts, but are you seeing any, any particular examples that you’d like to highlight of where PE investors that are, you know, exhibiting between positive practices?

Delilah Rothenburg

Yeah. I think that there are a few examples that might have already been featured in some PRI programming. So for instance, there’s growing interest in an employee ownership among private equity firms, KKRs certainly doing leading work in that space and now they’ve launched ownership works. We think that’s an important part of the solution. But again, we’re focused on wealth in equality. And so you can’t only address wealth in equality by focusing on the incomes of the less well off. You also have to look at sort of the, the pay ratios, and that means looking at the top pay as well and trying to narrow those pay ratios. So we think that there’s more great work that could be done to build on the movement toward facilitating more employee ownership, including looking at executive compensation narrowing pay ratios, some private equity firms we understand are trying to have, have proposed alternative fee and carry models to LPs.

And it’s interesting because our understanding is that, you know, these are newer fund managers, so it’s already a hurdle for an, and, and difficult sometimes for LPs to allocate to newer fund managers. And then if they have a different compensation structure, then that becomes even more challenging. So, unfortunately those don’t seem to be emerging yet. But we are also seeing some emergence of community ownership models, particularly in real assets and infrastructure sure. Which we’re exploring, there’s revenue based financing and redeemable equity, which can be great alternatives, particularly for smaller and earlier stage businesses more on the VC side, but certainly something for private equity to explore as well. Permanent capital vehicles, you know, having been deeply involved with one really has a lot of great features for addressing short-termism. So, and also, you know, with a permanent capital vehicle or any fund, you could really propose an annual GNA budget as opposed to having a 2% management fee is AUM scales to the point where 2% starts to become excessive. So, there are lots of good feature that we’re exploring.

Peter Dunbar

Excellent. So some innovation in what’s I guess it’s generally been quite an innovative industry as you know, in the past and kind of certainly finances, plenty of it. So, yeah Tensie?

Tensie Whelan

Yeah. So I think Delilah gave some great examples how there can be innovation and some of the mechanism and approaches to private equity, to just come in with a few other examples, you know, at, at the, and, and I, and I think we look at the examples, there’s some PE firms tend to be smaller that are really focused on societal impact as their reason for being, and then there are other firms, the larger, more mainstream firms that are focused on what they’re focused on and then are building sustainability or ESG, or integrating it into what they’re doing. Right. So we you know, in looking at I think it’s helpful to, to look at it through that lens. So if we look at the mainstream approach, you know, we’ll see, we heard about car a KKR, Carlisle, another organization that for some of its portfolio is working on, for example, getting 30%, diversity across all of their boards and creating any, a credit link facility to help do that.

They are focused and committed to scope one and two emission reduction to net zero of their entire portfolio, my 2025, or I think most of their, sorry, most of their portfolio by 2025, all of which is, you know, sort of useful, impact focused. We see companies like invest industrial when we work closely with themselves become a bit benefit corporation by companies, middle market companies that aren’t necessarily a sustainability and play, but actually then invest in a pivot. So they bought a plastics market type business because they saw there was opportunity for that company to use all of its know-how to begin to work on the trends away from petroleum based plastics. And they also are working with their portfolio companies to ensure that they all begin to develop an embedded sustainability strategy. So really, as we talked about earlier, bringing capital and knowhow and networks to their portfolio companies to make the chefs, and then we have companies like so in or generation or others who are really focused on specific impact oriented verticals, where they are tracking those impacts, but again, going to the broader structure, even if they’re really driving better societal performance, we still need to look at those other que questions related to sort of how the PE framework is structured.

Peter Dunbar

Great. Well, look, we’ve only got a couple of minutes left here but if we can maybe just flip briefly to the other side of the, the equation and just, you know, think about the asset owners, the LPs do you both think that they understand the kind of risks that we’ve been talking about and private equity and, and do you think they’re engaging with the industry around mitigating those? So I guess what would your message to LPs asset owners be?

Tensie Whelan

Well, so I, you know, I think that some understand, I think that there’s some challenges for them and how they articulate fight to share duty, right. In terms of wanting to deliver the highest results to the portfolio and seeing that some of this problematic PE activity in the short term delivers very high returns and that there’s sometimes motivated blindness about that because there’s parallel incentives, right? So there’s some issues there that said, I would say that there’s, if you look at the Morgan Stanley research, for example, they’ve identified 57% of all asset owners, either already are looking at these issues with their portfolio managers or are planning to. And I think as they do that more at the public market level, they are beginning to pay attention at the, at the PE at the private equity level. And I think also as we’re seeing more and more data demonstrating a positive correlation between good practice from a sustainability and responsible investing perspective and medium to longer term financial performance, as well as even short term performance, I think institutional investors will have more and more eagerness around this as also we see regulation driving shifts, as we see most recently with the SEC. So I think there’s real momentum to, for institutional investors to begin to tackle this more systemically.

Delilah Rothenburg

Yeah, I would absolutely agree with Tensie. I think that asset owners and allocators, particularly institutional investors like pension funds or insurance companies that have liabilities to cover and that are very large and need to put capital to where efficiently, um, are in a very difficult situation, particularly over the past few decades in the low interest rate environment we’ve been in. And, there have been incentives to migrate up the risk return spectrum for yield, and that means allocating more to leverage buyout, private equity, high yield bonds, leverage loans, CLOs, all of which are involved with the issues that we’ve talked about today. And, you know, if you talk to anybody within, in one of these organisations, I think they’ll recognise that there are issues, but it’s very hard for them because of their own, as Tensie said, their own internal investment governance, their incentive structures, their policies and procedures.

It’s hard for them to address these issues and see them as a systematic risk to their portfolios. And so sometimes you do have to sort of make the business case of as leverage grows in the economy. and it has grown to historical highs. Non-financial corporate debt has, and leverage levels are very high and covenants are light and underwriting standards are weaker. I mean, what is this, this, these trends are, are growing sort of in parallel with the societal impacts that we’ve been talking about today. And they’re coming from the same sort of investment style and structure. And then of course their secular stagnation from economic and equality, which you can, which you can consider, executive compensation is part of a factor leading to that. And so, you know, all of these, all of these issues lead up to systematic risks that can boom ring back to investors’ portfolios. And yet these investors don’t have the internal tools that they need to actually manage these issues. And that’s what we cover in more detail in our ESG 2.0 measuring and managing investor risks beyond the enterprise level paper. And that’s what really informed our work streams to support these investors and investment governance and alternative forms of financial analysis benchmarking.

Peter Dunbar

And maybe in, in, in just a, in just a few words before we go, what are your hopes for real world outcomes of the work you’re doing?

Delilah Rothenburg

Uh, the goal of course, is to have a better society for people and, um, for the environment. And so I, I know the conversation today to also talked primarily about social issues, but there are some negative unintended consequences of some of the structures and practices that, that relate to the environment as well, particularly biodiversity loss. So it’s standard standard goals of sustainability.

Tensie Whelan

Yeah. From my perspective, you know, I, what I hope is that as we see this broader movement away from shareholder capitalism to stakeholder capitalism, as we see more focus on the need to contribute to society from a net positive perspective, as we see the younger generations demand that employ be more sustainable in their approaches, as we see regulators take this on, I am hopeful that private equity will see the opportunity to lead as opposed to exploit. And I think the urgency and impact of the environmental and issues that we’re all dealing with and the positive potential that private equity has, um, in solving for these challenges is exciting. So I’m looking forward to a future where we can all join hands and work on this together.

Peter Dunbar

Excellent. Well, let, let’s end on the positive note there. I just wanna thank you both very much for, for your time today and for sharing your, your insights and you know, what you’re working on is much appreciated. You can find all of the private equity and venture capital resources that PRI has produced so far on the PRI website, which is unpri.org. And if you click on investment tools, there you’ll find all of our resources under private equity. They’re also obviously a range of other asset class resources that you’ll find there too. So, thanks very much for listening and forget tune in for the next PRI podcast. Thank you very much.