Friday Letter Who cares?

PEI’s Responsible Investment Forum this week underscored the rapidly growing momentum now behind the implementation of ESG practices in private equity. But it also flagged the many challenges facing GPs and LPs in pursuing ESG-related goals.  

Private equity conferences don’t typically draw attendance from labour unions – unless their members are there to protest LBOs.

At PEI’s groundbreaking Responsible Investment Forum in London on Thursday, hosted jointly with the Principles for Responsible Investments (PRI), union officials did attend – but not to wave hostile banners or to hand out inflammatory fliers. Instead, labour union leaders were among the more than 300 senior private equity professionals from blue-chip firms, leading limited partners, senior advisors and other key industry stakeholders to discuss environmental, social and governance (ESG) best practices in private equity, and their impact on core issues ranging from returns to reputation.

Opening keynote speaker Johannes Huth, head of Kohlberg Kravis Roberts’ European operations, articulated just why so many people had come to the forum: a growing realisation among private equity firms that financial returns alone no longer give them a “license to operate”. ESG must absolutely be factored into the value creation chain, he insisted.

Sceptics tend to regard such rhetoric as little more than “window dressing” or “greenwashing”, employed in order to make private equity more palatable to the public, politicians and indeed, key LPs that increasingly expect their GPs to adhere to an appropriate ESG framework like the PRI.

Yesterday’s conference was a reminder that by far the best strategy to counter such scepticism is to discuss the relevance of ESG in relation to the one thing that no one doubts is close to private equity’s heart: the bottom line. Whilst ancillary benefits to responsible investing like improved public perception were certainly important talking points at the event, speakers and delegates repeatedly stressed that integrating ESG practices at every stage of the investment process,  and not just during due diligence, must have, and does have, clear financial benefits.

Take Elizabeth Seeger for instance, head of KKR’s green portfolio programme. Speaking to PEO on the fringes of the event (click here to watch the video), Seeger pointed to the $160 million in operating costs KKR has saved in two years across eight portfolio companies by eliminating 345,000 metric tons of CO2 emissions, 8,500 tons of paper and 1.2 million tons of waste.

This kind of eco-efficiency is hard to argue with, as is good governance – something private equity has long considered central to its success. But it’s the ‘S’ in ESG that is the sticky issue here,  given its inherent subjectivity and its manifold implications not only at the fund level, but also for portfolio companies. 

An SEIU executive gave the example of a private equity-backed business closing a US manufacturing plant because it made financial sense for the company to take those operations offshore. How should the limited partners invested in this business react to this kind of measure being taken – should they simply accept the GP’s judgment, or is it a matter for the LP advisory board to weigh in on? And how should they, let alone the GP, balance being a good corporate citizen at the local level in the short-term against what may be financially sound for an investment on a global level, longer-term?

“Sometimes tough decisions will have to be made,” acknowledged Margot Wirth, head of private equity for CalSTRS, who added that in part because of such dilemmas, LPs would likely ask for more direct control in the future – which in itself is quite a controversial issue.

Clearly, there are still some big conceptual obstacles to overcome if ESG is to become a cornerstone of the private equity business model everywhere. But as more players wake up to the risk-reward pay-offs that ESG appears to already be delivering to early adopter private equity firms, and as more investors expect managers to implement an ESG framework, the issue will become ever more acute for the entire industry.

Until then, the debate will go on (and PEI will continue to do what it can to help facilitate it). So who cares? Judging from Thursday's event, more industry people than you might think: ESG in private equity is a movement with momentum. Even the unions will acknowledge that.