Who cares?

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

Financial returns no longer give private equity firms a “license to operate”. That was part of the message delivered by Johannes Huth, head of Kohlberg Kravis Roberts’ European operations, during his opening keynote address at PEI’s groundbreaking Responsible Investment Forum.

Held in London in June and hosted jointly with the Principles for Responsible Investments (PRI), the conference attracted 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.

Huth and many other speakers stressed that ESG must be factored into the value creation chain.

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. In a video interview on the sidelines of the conference, Tom Murray, head of corporate partnerships at environmental advocacy group Environmental Defense Fund, dismissed such scepticism and discussed the merits of EDF’s partnerships with KKR and The Carlyle Group.

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 – not just during due diligence – must have, and does have, clear financial benefits.

Andrew Musters, global head of private equity for Rabobank’s Robeco Private Equity and SAM Private Equity divisions, has run an ESG-focused fund of funds programme since 2004 and says ESG-savvy funds are producing above-average returns.  “It improves the risk-return profile of our investments, so it makes perfect business sense,” he told PEO on the event’s sidelines. “It’s always good to feel good, but in the end it’s about delivering investment returns. For a number of years we’ve been tracking ESG performance of our fund investments and slowly but surely we see returns increasing.”

Elizabeth Seeger, head of KKR’s green portfolio programme, 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.

A labour union executive in attendance gave the example of a private equity-backed business closing a manufacturing plant because it made financial sense for the company to take those operations offshore. How should the LPs invested in this business react – should they accept the GP’s judgment, or is it a matter for the LP advisory board? And how should they, let alone the GP, balance being a good corporate citizen at the local level 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.