By Manuel J. Amor Loureda
Private Equity (PE) has been historically perceived as lagging behind public companies in recognizing the importance of effectively managing environmental, social, and governance (ESG) issues creating value for its shareholders. However, during past years, many PE players have been deepening their impact from supporting business models that do less harm (e.g., using ESG principles to filter out businesses that harm the environment or have poor working conditions) to making impact investments and building businesses that actively deliver solutions to global issues. These investments are made with the intention of not only generating a financial return, but also a positive social and/or environmental impact alongside.
For years, and in some cases decades, investors around the world have been demonstrating the full potential of the private sector to drive progress in areas such as affordable housing, access to financial services, and sustainable energy—impact areas that very clearly line up with SDGs (Sustainable Development Goals). While it is still early days for the SDGs, the investing community is eager to explore how their impact strategies can contribute to this global effort, and some are already actively leveraging the SDG goals as a framework for their investments.
ESG principles and goals
There are two main organizations that provide a list of principles and goals that help private equities to better manage their environmental, social and governance issues.
PRI: The PRI (Principles for Responsible Investment) is the world’s leading proponent of responsible investment. It works to understand the investment implications of environmental, social and governance (ESG) factors and to support its international network of investor signatories in incorporating these factors into their investment and ownership decisions.
The institution developed a list of six principles, reflecting the increasing relevance of environmental, social and corporate governance issues to investment practices. The process was convened by the United Nations Secretary-General and all the signatories (currently more than 150 PE signatories, growing from just two in 2008) publicly commit to adopt and implement them.
The 6 principles are the following:
- We will incorporate ESG issues into investment analysis and decision-making processes.
- We will be active owners and incorporate ESG issues into our ownership policies and practices.
- We will seek appropriate disclosure on ESG issues by the entities in which we invest.
- We will promote acceptance and implementation of the principles within the investment industry.
- We will work together to enhance our effectiveness in implementing the principles.
- We will each report on our activities and progress towards implementing the principles.
United Nations: on September 2015, the 193 Member States of the United Nations unanimously committed to adopting the Sustainable Development Goals (SDGs), a set of goals to end poverty, protect the planet, and ensure
prosperity for all as part of a new sustainable development agenda. Each goal has specific targets to be achieved over the next 15 years (2015-2030). The SDGs comprise 17 core goals that range from ending hunger to stemming climate change, and that altogether provide a critical roadmap to a sustainable future and more prosperous world. The UN has put out a strong call to action for the private sector to play a fundamental role in achieving these goals.
Are PEs complying with these goals?
As mentioned above, it wasn’t so long ago that the PE industry was viewed as somewhat ‘behind the curve’ compared to the corporate sector. Nowadays, the situation is different. So what has happened?
It’s the story of the stick and the carrot. Investor (LPs) pressure was the original catalyst. They increasingly requested that GPs bring consideration of ESG factors into the heart of investment management and that they duly report on their activities to do so. Today, LPs are better able to influence fund terms and increasingly seek commitments on ESG management and reporting from their GPs.
However, a change is taking place within the industry. There is a growing realization of the contribution that ESG factors can make to value creation as well as to risk management. After a period of high multiple growth and low
costs of debt, which characterized the period 2003-2007, investment returns are now more closely linked to operational improvements in portfolio companies. Yet, this cannot be delivered by focusing on financial factors alone. There is a growing amount of evidence to highlight how ESG factors can manifest as investment risks and opportunities and impact value creation in portfolio companies. To give some examples, one can look at the damage to PE backed Carema’s reputation as a consequence of alleged patient mistreatment, and the long-term damage to Mengniu Dairy’s sales as a result of the 2008 Chinese milk scandal. Looking at the impact of ESG opportunities, KKR’s Green Portfolio Programme is one example of many that demonstrates how better management of environmental impacts can improve company performance.
So, it seems that PEs are taking steps towards being aligned with those goals, but how in which stage of the “work in progress” are they? According to a survey carried out by PWC[1], responsible investment has become increasingly important to PE firms, with around 70% of respondents having made a public commitment to invest responsibly, compared to 57% of respondents in 2013. Translating commitment into more concrete policies within the operation of the firm, too, has seen increases in recent years: from 55% to 83%. In addition, the firm found that of those without such a policy in place, three quarters are developing them.
Firms are also found to be investing more resources into the management of ESG: 78% said that they have dedicated some resources, compared to 62% in 2013. The resources also tend to be more closely tied to investor activity, rather than marketing or legal, with investor support involvement falling to 33% this year from 64% in 2013, while deal team involvement increased to 66%.
The research also found that more and more key investment team members are expected to have formal Responsible Investment (RI) training, up from 29% in 2013 to 46% this year. However, key training programmes remain absent at around half of surveyed companies.
The research further found that PE firms are increasingly vigilant regarding the ESG performance of potential targets. 40% of respondents note that poor ESG performance has led to a material discount in their valuation and/or led them not to invest in a company, while 41% say that they would be prepared to pay a premium for a target company due to its strong ESG performance.
The number of respondents actively screening companies on the ESG performance has increased in recent years, from 52% in 2013 to 60% in 2016. An increased number of respondents (77% vs. 59%) also say that it is mandatory to include ESG issues in their final investment committee papers. Screening companies for risks and opportunities
related to ESG during the 100- or 180-day transformational plans drawn up following acquisition, is regularly
included at 60% of respondents’ portfolio companies, up from 50% in 2013. However, while firms are often keen to have clear due diligence on ESG as part of the acquisition process, few regularly include ESG issues in the programme on exit, at 38% in 2013 compared to 36% in 2013.
To sum up, PE companies are taking a strategic, value creating approach to ESG issue management. Deal teams are increasingly being trained on responsible investment and there’s more structure around measuring and reporting the value of ESG programmes, with the LPs receiving more transparent, insightful information.
Case studies
Encourage Capital
Encourage Capital ($255M AuM) is an asset management firm specializing in strategic investments to solve critical social and environmental problems. It is currently managing and/or developing investment strategies in five impact areas, all of which are aligned with the SDGs: financial inclusion, climate change, sustainable infrastructure, sustainable seafood, and water conservation. Encourage is currently launching a private equity strategy in financial inclusion in emerging markets. This strategy invests in companies that contribute to the development of financial systems of emerging market economies in order to enable poor and marginalized groups to generate income, build assets, protect against shocks, and sustain livelihoods. Encourage posits that financial inclusion empowers individuals, businesses, and countries to reach their full economic potential, and contributes to the achievement of the SDGs.
PGGM
PGGM (€8.9b AuM) pursues risk-adjusted, market-rate returns through impact investments in four impact areas: climate change mitigation, water, food, and health. These themes were selected according to three criteria:
- Fiduciary duty: how does the impact area contribute to PGGM’s fiduciary responsibilities?
- Capacity: does PGGM have some comparative advantage in the impact area, such as through expertise or track record?
- Identity: does PGGM want to be known for its contributions to the impact objective?
By applying these criteria and actively pursuing their impact objectives, PGGM signals to both current and potential impact investors that long-term positive impact on society and the environment can be created alongside commercial returns. PGGM collects and reports data on three to four impact metrics that correspond to each theme. In the last year, PGGM has mapped each of these four impact themes to the SDGs, identifying six global goals that are supported through its impact investment portfolio.
Triodos Investment Management
Triodos Investment Management (Triodos IM) is a fund manager based in Zeist, Netherlands with $3.5b in AuM in sustainable investment funds. Of this, $2.2 billion is allocated toward direct impact investments in inclusive finance, energy and climate, sustainable food and agriculture, sustainable real estate, and arts and culture. Triodos has allocated $1.3b toward sustainable and thematic public equity and debt. It invests in most emerging markets and in Europe in companies that build a sustainable future for individuals, communities, and the environment. The company views the SDGs as a framework that will galvanize investors to support these global efforts for development.
New ways to raise funds for sustainable investments – Sustainable Development Bonds
A 2014 report from the United Nations estimated that there is a yearly gap of $2.5 trillion in funding for the achievement of the Sustainable Development Goals. At a high rate of participation, $1.8 trillion per year could be invested by the private sector to bridge the gap[2]. However, this high rate of participation will be difficult to achieve
without adapted tools that facilitate private sector investment in the SDGs. Over the last few years, the development and impact finance sectors have developed numerous innovative investment instruments to attract both private and public investors. In addition to popular layered funds, a fund structure in which risks and rewards are differentiated by investor type, various types of bonds instruments such as green bonds, social impact bonds, and project bonds have emerged. This section aims to clarify and present the different bonds currently available on the market that can help solve the SDGs investment gap.
The financing instruments created to respond to the investment needs of the SDGs can be grouped under the general term of Sustainable Development Bonds (SDBs). SDBs are debt securities issued by private or public entities to finance activities or projects linked to sustainable development.
These bonds are usually differentiated by their focus sector. With the current instruments available, investors can focus their support on both social and environmental projects around the world. The most common instruments are Green Bonds, Microfinance Bonds and Charity Bonds, Social Impact Bonds, Development Impact Bonds, and Environmental Impact Bonds. The size of the market for each of these bonds, as well as the expected return (based on the risk profile of the projects funded with the money raised) can vary greatly across the different types of bonds.
Case studies
Green Bond: Unilever issues first ever green sustainability bond[3]
In 2014, Unilever announced the issuance of the first ever green sustainability bond. The £250M 2% fixed rate notes are issued by Unilever PLC. Unilever has worked with DNV GL, an independent leading environmental consultancy, to develop a Green Sustainability Bond framework, based on the Green Bond Principles.
The current pipeline of projects in which the proceeds of the bond will be invested includes: a liquid laundry detergent factory in Johannesburg, South Africa; a laundry powder facility in Sichuan, China; a Home and Personal Care factory in Selcuklu-Konya, Turkey; an ice cream factory in Johannesburg, South Africa; the expansion of a spreads factory in Kansas, US; and the ‘Lean & Green Freezer’ cabinets project in Turkey, Russia and the US.
DFIs Bond: The World Bank Bonds for Sustainable Development[4]
The World Bank (IBRD) offers investors a broad range of products in 56 various currencies, with a spectrum of maturities up to 50 years and ranging from benchmark bonds to tailor-made notes designed to suit specific investor needs. It is rated AAA/Aaa based on its capital, reserves and prudent financial policies. It has projects in various sectors: Agriculture, Education, Energy, Finance, Trade, Industry, Governance, Health and Social Services, Transportation, Water, and Sanitation.
The World Bank partners with investors and financial intermediaries to connect the investors to their purpose (the expected social and environmental impact). In 2015, the funding volume reached $58b.
Microfinance Bond: Symbiotics Issues $10m in Bonds to Benefit China’s CFPA Microfinance Management[5]
Symbiotics, a Switzerland-based investment company that focuses on emerging markets, recently completed a bond transaction. Bonds worth $10M were sold to unidentified investors to benefit CFPA Microfinance Management, a microfinance institution (MFI) in China that is affiliated with the China Foundation for Poverty Alleviation.
Social Impact bond: UK Career Connect[6]
In 2012, Career Connect, a charity providing career-focused guidance, advice, and support, was commissioned by the Department of Work & Pensions (DWP) to deliver a three-year ‘New Horizons’ project helping disadvantaged 14-19 years-old. The aim was to help them improve their attendance and behavior at school, achieve educational qualifications, and move on to further education or employment. Bridges Ventures and Big Society Capital were the lead investors and the Department for Work and Pensions (DWP) agreed to pay for a pre-determined range of positive outcomes. Triodos Bank was responsible for structuring and performance-managing the SIB.
The Career Connect SIB delivered over £9M worth of positive outcomes to the Department of Sustainable Development Bonds Work & Pensions at a cost of just £4.5M and has been able to repay all of the risk capital to its social investors, plus interest. It was therefore re-commissioned in 2015 by the DWP to deliver a second three-year program with young people with mental health and emotional wellbeing issues.
[1] https://www.pwc.com/gx/en/sustainability/publications/assets/pe-survey-report.pdf
[2] UNCTAD. (2014). World Investment Report 2014.
[3] Unilever. (2014). Unilever issues first ever green sustainability bond.
[4] The World Bank Treasury. (n.d.). Bonds for Sustainable Development.
[5] Symbiotics. (2015). Impact Finance Bonds.
[6] Bridges Ventures. (2015). Bridges-backed Career Connect delivers key SIB milestone.
Bibliography:
- http://www.un.org/sustainabledevelopment/sustainable-development-goals/
- https://thegiin.org/assets/GIIN_Impact%20InvestingSDGs_Finalprofiles_webfile.pdf
- https://sustainabledevelopment.un.org/content/documents/7969EconSDPartnerships.pdf
- http://www.consultancy.uk/news/12839/private-equity-increasingly-focused-on-meeting-esg-and-sdg-goals
- http://www.pwc.com/gx/en/services/advisory/consulting/risk/resilience/publications/pe-value-in-investment.html
- https://www.pwc.com/gx/en/sustainability/publications/assets/pwc-the-integration-of-environmental-social-and-governance-issues-in-mergers-and-acquisitions-transactions.pdf
- https://www.pwc.com/gx/en/sustainability/publications/assets/pe-survey-report.pdf
- https://www.icmagroup.org/Regulatory-Policy-and-Market-Practice/green-social-and-sustainability-bonds/
- http://www.hsbc.com/news-and-insight/insight-archive/2015/social-and-sustainability-bonds
- “Sustainable Development Bonds” – European Impact Investing