Can private equity meet public responsibilities?

 
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Advisory Partners

 

The FT Moral Money Forum is supported by its advisory partners, High Meadows Institute, Vontobel and White & Case. They help to fund the reports.

The partners share their business perspectives on the forum advisory board. They discuss topics that the forum should cover but the final decision rests with the editorial director. The reports are written and edited by Financial Times journalists and are editorially independent.

Our partners feature in the following pages. Each profiles their business and offers a view on private equity. Partners’ views stand alone. They are separate from each other, the FT and the FT Moral Money Forum.

 
 

Achieving a sustainable low-carbon economy – A critical role for private equity

Chris Pinney, president of High Meadows Institute

As the climate crisis accelerates, the need to dramatically speed up the shift to a sustainable low-carbon economy is ever more pressing. The International Energy Agency estimates that to globally reach net zero by 2050, 70 per cent of global clean energy investments will need to come from the private sector — including from utility and energy companies, clean energy developers, and financing institutions such as banks or venture capital. Achieving net zero, however, will require more than simply financial capital. It will require unprecedented levels of innovation and productivity to scale up new business models. As the fastest-growing sector of capital markets, with an estimated $11tn under management and a focus on innovation and productivity, private equity is uniquely positioned to address this challenge.

When it comes to innovation, a 2015 study reported in the Harvard Business Review showed that three years after an acquisition, PE-backed firms had filed 40 per cent more high-quality patent applications than regular firms. Private equity investment also acts as a key driver in scaling up innovation and improving productivity. An EY study analysing the performance of 3,200 private equity-backed companies with more than 150,000 establishments from 1980 through to 2005 estimated that, on average, two years after a private equity investment, the productivity of a private equity-backed company increases significantly with a near-zero net employment change relative to a comparable company without private equity investment. Similarly, a recent Boston Consulting Group study showed that private equity financed companies also see higher rates of job creation, net of employee attrition, than their publicly owned peers. This finding is consistent across geographies and industries and indicates that contrary to popular perception, private equity firms can be highly effective job creators across their portfolios. Research also shows that private equity exerts positive externalities on entire industries, as productivity and innovation not only accrue to the target firms, but also spill over to competitor firms.

Another advantage of private equity is its ability to focus without being subjected to the competing ESG expectations of activist investors and stakeholders that public companies face. When PE funds do turn their attention to climate issues, they have the capacity to focus on measuring climate transition indicators that matter most and establishing clear long-term targets, while working closely with management to ensure improvement and track progress over time. Combined with their innovation and productivity focus and ability to maintain ownership and control within a long-term mindset, private equity is well-positioned to be a crucial driver in the transition to a low-carbon economy.

While well-suited to be key players in the transition to a low-carbon economy, recently most PE firms have lagged their public company counterparts, according to BCG and the ESG Data Convergence Initiative. This lag is expected to narrow quickly, however, as PE firms move from seeing ESG through a risk management lens to seeing its potential for value creation, the essential driver of PE strategy. Growing worker and customer ESG expectations coupled with government incentives like the US Inflation Reduction Act of 2022 and increasing ESG expectations from institutional investors and limited partners are helping drive this shift to a value perspective. 

The business case for ESG integration is further supported by recent research by McKinsey, which found that publicly traded ESG outperformers that also outperformed peers on margin and growth delivered 200 basis points in excess return to their shareholders over companies that only outperformed financially. Not surprisingly, according to a June 2023 PwC poll of more than 150 PE houses, some 70 per cent of respondents now place value creation among the top three drivers for their organisation’s ESG strategy. This change in perspective is already having a dramatic effect on PE investing. For example, in the 12 months since the passage of the IRA, private equity firms have committed more than $100bn to new renewable energy investments that would qualify for tax credits. This new deployment has the potential to transform the US power markets, with more than 350 gigawatts of new generating capacity.

 
 

The lure of making a direct impact

Christel Rendu de Lint, head of investments at Vontobel

“You don’t need to worry about shareholder resolutions – you just call the chief executive.” This statement by Andrew Howell, senior director of sustainable finance at US advocacy group Environmental Defense Fund, is referenced by Sarah Murray in her editorial. It reflects one of the main benefits of private equity: an investor has increased opportunity to enact change or influence strategy more directly.

In a world that is increasingly grappling with the challenge of climate change and boosting global sustainability, Murray, and those polled by the FT’s Moral Money team, are debating the role private equity will play in this effort. The quote from Howell stands out because – though we are a publicly listed company and clearly adhere to shareholder resolutions – the sentiment that appears to underpin it is arguably intuitive: real and effective change can feel more possible when you’re in a position to talk directly to the people who can make it happen in a more intimate exchange and discussion. 

Balancing risk, return and impact

As an asset allocator, we witness first-hand the increasing appetite among investors for making a positive difference in environmental, social and sustainability issues. Sustainability-related challenges often require a longer time horizon to address, and this is where private equity-backed companies have an edge: due to their shielding from the public market, they generally have an increased risk tolerance for the implementation of transformational changes that might create value and/or positive impact in the medium or long term but could negatively impact the performance of the company in the short term. 

Private equity therefore enables a type of investing public markets often can’t offer in the same way, with investors into public markets looking to annual and quarterly results reporting for evidence of returns. The J-curve in venture capital is a good illustration of this – it is expected and allowed that an enterprise takes time before it shows an increased financial return. This is somewhat comparable to a high-level start-up that’s lucky enough to be able to find its feet in a funded and protected environment. For the firms, private equity offers time for the nurturing of bold ideas, so they can take root and take shape. For investors, private equity can be a gateway to access unique growth opportunities.  

The closest we can get to a longer-term vision in public markets is most likely impact investing, generating long-term financial returns alongside a positive impact on the world. At Vontobel, we embarked on our impact investing journey about 15 years ago. A bold idea at the time, it has been described by fourth generation family member Björn Wettergren, who is also on our board of directors, as a direct reflection of the founding family’s commitment to impact.

The importance of transparency

It is also important to note that part and parcel of investors’ appetite to make a difference is their demand for certainty regarding the non-financial impact an investment can bring. I’m reminded of a comment a Danish portfolio manager made in our 2023 Impact Investing Survey: “We want to be a responsible investor, but we also want a return. The two should go hand in hand.”

Indeed, from the nearly 200 institutional and professional impact investors we surveyed globally, a clear message arose that purpose and profit need to work in harmony. The impact investors we spoke to also emphasised the importance of transparency in building trust, including around processes, decision-making and reporting. 

This is also true when it comes to the question of whether private equity can help finance a sustainable economy. As the poll by FT Moral Money confirms: if private equity activities appear opaque to outsiders, this has the potential to raise concern. Transparency is an area in which the transition of expertise from public to private markets can only benefit investors. And here I once again refer to the editorial by Sarah Murray: in her closing paragraph she argues that private equity needs to bring itself “out from the shadows”.

My takeaway is clear and simple: considering the sums of money private equity has at its disposal, it certainly has the potential to leverage positive change. Private equity can serve as a delicate tool carving out the space and time necessary for companies supporting a sustainable economy to bear fruit. But this tool needs to be sharpened with transparency, trust and knowledge to avoid harming the companies in the process. With the high demand from clients wishing to access private markets and make an impact, confirmed by many surveys we’ve conducted in recent years, and a growing number of opportunities in the field of sustainable finance, we all have a role to play. As asset and wealth managers we can keep building a sustainable economy and equitable society by bringing together our clients and moonshot ideas of young entrepreneurs.

 
 

The legal implications of ESG in private equity

Clare Connellan, Ian Ivory, Lachlan Low, Janina Moutia-Bloom at White & Case

Traditionally, asset owners’ investment strategies focused on short-term financial return. Investors funding projects with social or environmental objectives would have needed to seek out philanthropic investment opportunities, without expectation of financial returns. 

The past decade has seen the growth of an “impact economy”, which is a move away from the traditional investment strategies where investment opportunities are followed which do not require a trade-off between financial objectives and positive outcomes for people and the planet. This is illustrated in the British Private Equity & Venture Capital Association’s “Spectrum of Capital” (published in 2014 for the G8 Social Investment Taskforce) which identifies three investment strategies sandwiched between “traditional” and “philanthropic” approaches, comprising: “responsible”, “sustainable” and “impact-driven”.

Some high-profile players and well-recognised investor brands have raised a series of funds specifically to invest in sustainable and ESG-aligned endeavours. This has proved to be immensely popular in attracting investment and the funds have often been oversubscribed. However, with that growth comes controversy and anti-ESG sentiment, particularly in the US.

But using ESG considerations to identify non-financial risks and opportunities is not new to private equity. For many fund managers, ESG-related due diligence has been integrated into fundraising over the past decade. Increasingly, investors understand that integrating ESG considerations across investment processes is not only about mitigating reputational exposure, but that ESG is also critical to performance and should be viewed through the lens of value creation for the portfolio. ESG can also be a deal-breaker in the context of proposed acquisition activity and IPOs.

ESG-related obligations are increasingly being imposed at the limited partnership, general partnership and portfolio levels, not only as a standard clause in a side letter, acknowledging the UN Principles of Responsible Investment, but incorporated into the LP agreements. 

For acquisitions, many LPs and asset managers are demanding ESG considerations for DD processes. A March 2023 Deloitte survey revealed that US PE sponsors are nearly three times as likely as corporates to approach ESG DD consistently and formally, and nearly twice as likely to include ESG clauses in M&A contracts. The survey also showed that 27 per cent of PE sponsors integrate ESG conditions in M&A contracts, compared with only 14 per cent of corporates. ESG factors which could influence sponsor-side DD include voluntary commitments (eg, net zero targets), fund- or firm-wide exclusion provisions (eg, tobacco or gambling), exit strategy (eg, if the target would be attractive to potential “impact” buyers), investment dynamics (eg, whether the sponsor can control or influence the level of ESG DD). Sponsors are also increasing their scrutiny of how portfolio companies manage cyber security (now considered a core facet of ESG). Whereas cyber-DD previously focused on high-level policies and governance, firms now include more technical pre-acquisition processes such as network scanning and penetration testing.

ESG regulatory overlay is of particular significance in DD processes as part of an acquisition. KEY ESG’s survey of 100 GPs and portfolio companies in Europe, the UK and the US revealed that while 75 per cent of GPs are required to provide ESG disclosures to LPs, 90 per cent of portfolio companies are unsure how to provide such disclosures, with a vast majority of US GPs remaining unclear about which Europe-based fund regulations apply to them.

In the EU, funds registered to market to EU investors must comply with disclosure requirements under the Sustainable Finance Disclosure Regulation. The SFDR has been in force since March 2021, but in September 2023, the European Commission published a consultation to explore how certain concerns around the regime’s implementation could be addressed in the future. Nevertheless, in its current form, SFDR must be considered at multiple stages of a transaction:

  1. Initial scoping phase: identifying the categorisation of the fund making the investment (Articles 6, 8 or 9).

  2. DD request phase: with respect to Article 8 and 9 funds, issuing/responding to Due Diligence Questionnaires which cover “E”/”S” objectives, good governance practices, sustainability risk commitments, and where relevant, Principal Adverse Indicators and minimum safeguards.

  3. Investment Committee memo phase: confirming SFDR diligence has been undertaken and identifying any red flags.

  4. DD report phase: incorporating an SFDR-focused rider in the ESG section of the report.

  5. Post-closing phase: in the “100 days” action plan, including any steps required to address SFDR-related gaps. 

As a recent VentureESG report finds, LPs require integration of ESG considerations as part of investment decision-making and integral fund management. Hannah Leach, co-founder of the non-profit VentureESG and GP at Houghton Street Venture, notes: “Many European LPs are pushing ESG into the ecosystem and are very thoughtful about not making it a tick-box exercise.” Portfolio companies may also be subject to obligations imposed under other ESG reporting or DD regulatory regimes, including at EU-level, at national level in European countries, in the US, Canada and Australia. Any contemplated acquisition requires a fact-specific analysis to determine which regulations (including proposals) may apply.