Sustainability Boosts Returns for Private Equity Funds, Part IV

Meeting the Expectations of Limited Partners

In late March, I had the opportunity to speak about impact investing at the Information Management Network’s 2012 Spring Investment Series, an event attended by managers of pension funds, endowments, foundations, and a wide array of financial advisers.  While the content of the event covered a wide array of industry topics, from capitalizing on rapidly expanding secondary markets to global economic forecasts intended to guide fixed income asset allocation, the importance of environmental, social, and governance management was raised during several panel discussions.

The emerging commitment of this community to responsible investing has a direct impact on private equity general partners (GPs) as these institutions invest in private equity as limited partners (LPs). As LP expectations continue to rise, GPs will need to increase their management of environmental, social, and governance (ESG) issues in order to raise the capital necessary to acquire companies.

To be fair, many attendees still view responsible investing as a nascent rather than established concept. However, institutions are beginning to take action. For example, Linsey Schoemehl of the Illinois State Board of Investment shared her organization’s experiences as a signatory of the United Nation Principles for Responsible Investment (UN PRI). These principles provide benchmark standards and practices for investors to integrate ESG considerations into their activities.

Although less than a decade old, over 1,000 institutions representing approximately $30 trillion of assets under management have signed the principles – that’s roughly double the annual gross domestic product of the United States committed to responsible investing! Participating organizations include institutional investors such as the New York State Local Retirement System and UAW Retiree Medical Benefits Trust, investment managers such as Goldman Sachs and PIMCO, and private equity general partners such as KKR and Darby Private Equity, among others.

Signatories of the principles make a number of commitments which affect the assets in which they invest. These include, among others:

• Incorporating ESG issues into investment analysis and decision-making;
• Being active owners which incorporate ESG issues into ownership policies; and
• Seeking ESG disclosure from the entities in which they invest.

The rapid adoption of the UN PRI is indicative of a rapidly evolving focus on ESG management by investors in private equity. As part of an ongoing study which the Malk Sustainability Partners team is conducting on this subject, we recently had the opportunity to speak with a number of LPs on their views of ESG issues and their relationship to investment performance.

“We view environmental, social, and governance risks in a private equity general partner’s portfolio as material to our own investment decisions,” said David Russell of the UK’s Universities Superannuation Scheme (USS). “We look for evidence of management processes for these risks, as well as appropriate protocols to communicate about any issues which may arise.” USS invests with general partners which include Oak Tree Capital Management and Silver Lake Partners.

Tim van der Weide of Dutch pension administrator PGGM shared a similar outlook. “As long term investors,” he noted, “management of environmental, social, and governance issues is important to PGGM for both financial and social reasons. Our clients and their beneficiaries ask us about these issues and we want to be at the leading edge of responsible investing.”

As more LPs in the US and abroad increase their focus on responsible investing and adopt protocols such as the UN PRI, GPs will need to pay closer attention to ESG management to satisfy these evolving demands. We suggest that private equity fund managers consider the following actions toward this end:

• Engage your limited partners to discuss their interest in ESG and responsible investing. In speaking with GPs, we consistently hear that LP interest is the single biggest driver of ESG management, and that fund managers expect this interest to increase in the coming years. Rather than waiting for LPs to make requests, it is productive for your investor relations team to proactively engage your LPs on ESG issues.
• Exceed the transparency expectations of your limited partners through ESG communication. We are still in the early innings of efforts within the finance community to enhance ESG management. While they will become standard expectations in the coming years, case studies on ESG management, citizenship reports, and integration of ESG management content into private placement memorandums can be a valuable differentiator in communicating with LPs.

Beyond the expectations of limited partners, we also encourage private equity GPs to consider other stakeholders who may have an interest in ESG performance. For example, acquisition targets may look at such performance as a value-add which your fund provides – a value-add which may persuade executives to do business with your fund rather than a competitor. Similarly, regulators and the public may in some cases be stakeholders; for instance, the private equity sector may receive more attention during this year’s election cycle and GPs which can point to strong ESG and citizenship programs may benefit from a better public image.

Limited partners, particularly in the United States, are not yet demanding exceptional ESG performance from private equity GPs. However, they are already asking about these issues while over 1,000 financial services providers are committing to do even more. In short, ESG management platforms are currently a differentiator for GPs but are fast becoming the new baseline in fund management as LP expectations increase.

Zach Goldman is a Partner with Malk Sustainability Partners (MSP), a specialty management consultancy, which guides businesses in developing profitable corporate environmental sustainability programs.  MSP has particular expertise in engaging private equity funds to unlock value through shifts in thinking about sustainability.  This article was written with MSP Managing Partner Andrew Malk. If you have enjoyed this series so far, we invite you to also download Malk Sustainability Partners’ tear sheet outlining how private equity funds can unlock value through sustainability online here.