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PE Firms Intensify Focus on Responsible Investments

02 December 2016

Private equity firms are increasingly factoring in environmental, social and governance issues at potential portfolio companies when making investment decisions, and experts say that the consideration of such nonfinancial parts of a business is quickly becoming a standard practice within the industry.

A recent report from PricewaterhouseCoopers LLP showed that so-called ESG factors are taken into account by private equity professionals more and more, with 41 percent of the 111 private equity general partners polled saying that they would be willing to pay extra for a target company with "robust ESG metrics." About 40 percent, meanwhile, said that poor ESG performance has led to them demanding a discount on a deal or even walking away.

"Private equity is changing fast," PwC private equity director Phil Case said in a statement. "Still only a relatively youthful industry, it's reinventing itself from a perception of 'ruthless' to 'responsible,' and from opaque to transparent.

"The majority of PE houses now have made a public commitment to invest responsibly," he added.

When making deals, private equity firms are taking into account environmental factors that include how a target company handles carbon and carbon dioxide emissions, overall waste management, energy efficiency and sustainability. Social factors include labor conditions, employee rights and consumer protection. And governance factors include risk management, transparency and how the board of directors is run.

There are even firms that consider the emphasis of these ESG factors integral to their business. One such firm, Pax World Management LLC, describes itself as a sustainable investment firm. Its website says that there is "growing evidence that suggests that ESG factors, when integrated into investment analysis and portfolio construction, may offer investors potential long-term performance advantages."

Kenneth Juster, a managing director at private equity giant Warburg Pincus LLC and the partner in charge of the firm's global public policy on ESG, told Law360 that "ESG is just really good investing."

"We don't look at this as a separate issue apart from how you act as a good investor," he said. "You always want to make sure there's first-rate corporate governance. You always want to make sure that portfolio companies operate responsibly in terms of how they treat their employees and how they interact with local communities. And you always want to act in an environmentally responsible way."

"In the past five years, we've seen an explosion of interest [in ESG]," noted Nadia Murad, a partner at Kirkland & Ellis LLP.

Murad, who is a member of Kirkland's investment funds group, told Law360 that the explosion came about thanks in part to a proliferation of major private equity firms that have put into place ESG policies and guidelines, including Warburg Pincus and peers like The Carlyle Group LP, KKR & Co. LP and Bain Capital, among others.

These industry mammoths have done so in large part because of the growing evidence that factoring in ESG can actually lead to better investment performance, she said.

"The larger, more sophisticated firms have really been at the forefront," Murad said. "They've not only developed robust policies and guidelines, but they often have full-time investment professionals dedicated to these issues.”

Smaller private equity shops don't always have the resources to dive so deep into the world of ESG, but as with many PE trends in the past, they are finding ways to follow in the footsteps of larger and more sophisticated industry players.

"While middle-market or smaller firms may not necessarily have full-time, dedicated staff, many of them are looking at their operations and examining whether they should at least nominally commit to incorporating ESG principles into their investment programs," Murad said.

ESG factors may be considered to be nonfinancial considerations, but industry experts say firms that have the right policies and guidelines in place stand to benefit financially down the road.

The thinking is that companies focused on such initiatives will be more sustainable and competitive — but it's not a one-size-fits-all situation, according to Murad.

"An early- stage investment and investments in different industries might face different ESG risks than an industrial investment," she said. "It's important to have policies and guidelines in place that can adapt to particular companies."

There isn't a common set of metrics firms can use because it all depends on a given investment, according to Juster. For instance, if Warburg Pincus is making an investment in an emerging market, the firm will emphasize issues such as anti-bribery programs and community engagement activities.

"It's important to focus on what may be of interest to the stakeholders in the host country where you're investing, as well as what we regard as necessary for our own operations in that locale," he said.

Meanwhile, the trend can also be traced back to the desires of investors, who experts say are asking more questions about private equity firms' ESG policies and guidelines. According to Murad, investors inquire about ESG factors at all stages of investment discussions, from the due diligence stage to the monitoring stage to when the time has come for an exit.

Private equity firms taking ESG factors into account may not be an entirely new phenomenon, but the practice is certainly permeating the industry as a whole, experts say — and for any firms that aren't yet considering such factors, the time to take notice is now.

"PE firms have evolved," Murad said. "There's a sense of institutionalization where they're really making commitments to communities at large, and having their portfolio companies do so as well."

Nadia Murad

Practices