Warts, bruises and all, private equity begins considering ESG

Although the private equity industry is still nursing wounds inflicted by overleverage and questionable valuations, it is beginning to take serious notice of environmental, social and governance issues in its decision-making process. Factors such as the depletion of natural resources, climate change, population growth, income inequality, human rights and corporate governance are increasingly becoming part of that process.

But is this really the appropriate time for private equity investors to adopt ESG? Aren't these factors little more than indulgences in the current troubled environment where the status of company balance sheets, cash flow and debt coverage ratios is coming under increasing scrutiny? And where is the evidence of the impact that ESG can have on the bottom line?

The evidence is still thin. The limited research carried out thus far suggests only that taking ESG factors into account does not affect performance negatively. That was a finding of a 2007 study co-authored by Mercer, “Demystifying Responsible Investment Performance.” Simply put, it is too soon to put hard numbers on the benefits of responsible investing in any asset class.

If we cannot quantify the benefits of ESG, why should private equity investors bother with it, especially in light of other challenges? I strongly believe that in the medium to long term, ESG offers a potentially lower degree of risk and better returns both for investors and portfolio companies that incorporate it into their overall strategy and daily operations. The resolution of potential issues such as pollution and child labor should reduce reputational and liability risk. Taking a proactive stance on these issues should pay off over time because of the positive impact they can have on the sustainability of corporate earnings.

Another positive factor is that companies with higher ESG scores are generally better able to benefit from environmental changes and new legislation. Incorporating ESG also improves the exit potential of investments, and overall, it is an important ingredient in a company's long-term success in areas such as consumer acceptance and access to capital. Why? The political and sociological climate in many countries is changing rapidly to accommodate ESG.

Pension funds and other institutional investors are increasingly putting ESG principles at the core of their business practices and they have a key role to play in keeping up the momentum. If portfolio managers and their managers feel they are too busy to develop their own responsibility guidelines and practices, the pressure to do so from institutional investors will simply increase.

In the U.S., for example, the California Public Employees' Retirement System and California State Teachers' Retirement System, among others, were instrumental in prodding the Private Equity Council to develop responsible private equity investing guidelines that were announced in February. The PEC has said that its members, which include 13 of the world's largest private equity firms, will consider applying these guidelines prior to investing in companies and during their period of ownership.

In the past, companies themselves typically instigated change in taking more responsibility for their actions. Now, though, private equity firms are taking the initiative by devising plans to build sustainable, competitive businesses, working in close co-operation with the management teams of portfolio companies on ESG issues.

Let's look at some examples:

• An aircraft leasing company switches to more fuel-efficient aircraft, not only bringing environmental benefits but contributing to higher future returns thanks to reduced fuel costs.

• A manufacturer of glass packaging that is promoting the consumption of recycled glass converts its production facility to natural gas from electricity, also resulting in cost savings.

Beyond environmental issues, responsibility concerns can and should stop a private equity fund from investing in the first place if, for instance, due diligence reveals unethical behavior or even corruption on the part of management.

If pressure from pension funds and enlightened self-interest on the part of private equity groups is not enough to push the industry toward responsible investing, the final straw will take the form of legislation.

In Europe, increasing clamor for change from politicians, the media and trade unions has persuaded the European Commission to promise legislation. In February, Internal Market Commissioner Charlie McCreevy announced that the commission was committed to bringing forward an appropriate legislative agenda on private equity, although the original April 2009 deadline was subsequently pushed back.

The directive is now being discussed in council working groups with the expectation that views will be exchanged with the commission at the end of August.

If the private equity industry doesn't change by itself, it will be forced to do so. The rules of the game are changing. The days are over when a general partner could say “leave it with me, I'll get you a good return.” Indeed, this is only the beginning. In 10 years — or maybe sooner — responsible investing will be mainstream in our industry.

Ad van den Ouweland is managing partner and chief investment officer of Robeco Private Equity, a unit of Robeco Groep N.V., Rotterdam, Netherlands. The views expressed in this commentary reflect those of the author and not necessarily those of Robeco.