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October 28, 2019 12:00 AM

Problem portfolio companies are an issue for investors

What can investors do when they see conflicts? The options are limited

Arleen Jacobius
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    David Fann
    Nancy Kaye
    David Fann thinks investors typically are in ‘no-win situations’ when they realize portfolio companies are not adhering to core investor beliefs.

    Many investors are laser-focused on ESG, but when a company in their alternative investment portfolios presents a conflict with those principles, there are few good options.

    "Investors typically have three options: fix, sell or suffer through the problem," said David Fann, New York-based president and CEO of private equity consulting firm TorreyCove Capital Partners LLC. "Almost always, these are no-win situations.''

    In many cases, investors do not have power over, or sufficient information about, portfolio companies to take a direct role in fixing problems. That leaves them with trying to persuade the general partner to make changes to comply with their ESG policies, Mr. Fann and other industry insiders said.

    If they sell their limited partnership interests in a fund with a troubled company, they might have to take a loss. Selling limited partnership interests also is a time-consuming and arduous process, they added. And should the investor choose to stick with the general partner over the fund's 12-year or more lifespan, their reputation could take a hit.

    "Most public pensions operate under intense public scrutiny," Mr. Fann said. "Any association with a firm that has a bad reputation spells trouble."

    Some 42% of institutional investors either do consider or may consider environmental, social and/or governance factors in investment decisions, compared with 22% in 2013, according to the results of a Callan LLC ESG survey released in October. Investors started out focusing on ESG factors in their public equity investments; now that attention has extended to private equity, real estate and infrastructure, Callan said.

    However, when portfolio companies violate limited partners' ESG policies, win-win options for investors are as rare as actual unicorns. That's a big difference from public equity investments, in which investors have the option to quickly exit the investment.

    This sets up a conflict for asset owners that are more than ever keenly focused on ESG factors and less tolerant of sexism, racism or other bad behavior.

    "There has been a sea change over the past five years," Mr. Fann said. The #MeToo movement has changed workplace rules, he added.

    In the extreme, ESG issue poses an existential threat to the general partner and creates jeopardy to the accused, he said.

    "We've seen situations where partners (at the GP level) were pushed out after an investigation substantiated allegations," Mr. Fann said.


    TPG terminates exec

    In March, TPG terminated William McGlashan Jr., co-founder and CEO of TPG's The Rise Fund and founder and managing partner of TPG Growth, "for cause," a TPG spokesman said at the time. Mr. McGlashan was charged that month with conspiracy to commit mail fraud as part of a college admissions scandal.

    More recently, a grand jury in Boston on Oct. 22 charged Mr. McGlashan and 10 other parents with conspiracy to commit federal program bribery, accused of bribing employees at the University of Southern California. He and three other defendants also were charged with wire fraud.

    At the time Mr. McGlashan was terminated, TPG was in the midst of raising TPG Rise II, which had collected about $1 billion toward its then-$3 billion target, sources said.

    After TPG took over Abraaj's Growth Markets Health Fund, now called The Evercare Health Fund, TPG executives reduced TPG Rise II's fundraising target to $2.5 billion because the health fund had $500 million in uninvested capital commitments, sources with knowledge of the situation said.

    "The support of new and existing investors has helped us build a market-leading impact investment platform that aims to drive positive social and environmental impact alongside business performance," a TPG spokesman said.

    Early investors in TPG Rise II fund include Washington State Investment Board, Olympia, which oversees $139.6 billion in assets, including $108 billion in defined benefit plan assets; New Jersey Division of Investment, which handles investments for the $76 billion New Jersey Pension Fund, Trenton; and $26.5 billion San Francisco City & County Employees' Retirement System.

    All of the investors in the TPG Rise II fund reaffirmed their commitments, the company said.

    When issues arise at the portfolio company level, limited partners rely on their general partners to act, Mr. Fann said. At times, general partners have replaced a CEO or exited the investment, he added.

    Limited partners, especially those on the limited partner advisory committee, should insist that the manager conduct a third-party investigation to determine whether the allegations of misconduct or other ESG violations have merit, he said.


    Congressional spotlight

    Two members of Congress now are pointing a spotlight at an undisclosed number of physician staffing and ambulance companies owned by some of the largest private equity firms: KKR & Co. Inc., Blackstone Group Inc. and Welsh, Carson, Anderson & Stowe.

    The No Surprises Act, a bill introduced by House Committee on Energy and Commerce Chairman Frank Pallone Jr., D-N.J., and ranking member Greg Walden, R-Ore., aims to protect patients from surprise medical billing. The legislation passed the committee in July, but the bill is opposed by companies involved and their private equity backers.

    Executives at KKR, Blackstone and Blackstone portfolio company TeamHealth said they favor another approach. "We fully support legislation to end surprise medical bills through an independent dispute resolution model, which has proven successful in protecting patients at the state level," a TeamHealth spokesman said in an email.

    A Blackstone spokesman said the firm supports TeamHealth in this matter.

    In a written statement, KKR said it also supported the alternate approach. "Our portfolio company Envision Healthcare is advocating for an independent dispute resolution process as a legislative solution to end surprise medical bills," the statement said. "KKR fully supports Envision's patient-centered efforts to end surprise medical billing."

    The $381.5 billion California Public Employees' Retirement System is an investor in KKR Americas Fund XII Fund, which is invested in Envision Healthcare. Like many investors, the giant Sacramento pension fund keeps its engagements with companies confidential, spokeswoman Megan White said in an email.

    But she did point to the pension plan's private equity sustainable investment policy. That policy details such actions as speaking with managers about their portfolio companies and possibly declining to invest in the manager's future funds should CalPERS officials discover that its portfolio companies violate the pension plan's ESG policy.

    The $242.1 billion California State Teachers' Retirement System is another investor in KKR Americas XII Fund.

    While fund officials do not discuss portfolio companies, its general partners "are expected to use CalSTRS' ESG policy to assess the impact of ESG risks when making an investment on behalf of CalSTRS," spokeswoman Vanessa Garcia said in an email. "We work closely with general partners of our private equity funds to address ESG risks"

    The West Sacramento fund in the past has worked with its managers in a variety of ways, starting with discussions about how the matter can be rectified.

    Most limited partnership agreements include what is called a "no-fault divorce" — if an overwhelming majority of LPs wish to terminate the partnership, they can exit the fund, said Michael D. Granoff, New York-based CEO and founder of private equity secondary market management firm Pomona Capital.


    A chance to review

    As a manager that invests in limited partnership interests on the private equity secondary market, Pomona stands in the shoes of limited partners in the funds in which it investors. But unlike the original limited partners that invest in a blind pool, Pomona executives can review the portfolio companies in the fund, he said. If there is a problem with a portfolio company, Pomona would not invest in the fund, Mr. Granoff said.

    If an issue arises with a portfolio company while Pomona is an LP, the firm has the same options as any other fund investor, he said. Pomona executives have an unlimited ability to talk to the general partner about their concerns but limited rights, Mr. Granoff said.

    In the 25 years since he founded the firm, Mr. Granoff said that he has seen maybe two instances in which LPs have terminated the partnership. He also said he does not remember witnessing instances in which limited partners demanded their private equity manager launch a third-party investigation.

    That leaves most limited partners with the option of not investing in the manager's next fund, he said.

    "Everyone has to run for re-election and LPs like voters can vote with their feet. ... It's an open choice whether to invest in the GP again," he said.

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