16. Sustainable Private Equity Investments

Adam Heltzer Responsible Investment, Partners Group

Development of Sustainable Investment in Private Equity

Most investors wanting to take account of environmental, social, and governance (ESG) factors focused initially on listed equities investments. However, when it comes to managing ESG factors effectively, private equity investors have inherent corporate governance advantages compared to their public market peers. These provide opportunities to implement superior sustainable investment strategies and to enhance investment returns (see Figure 20). 1

Private equity investors are increasingly recognising the expectation and opportunity for them to invest sustainably and are leveraging these inherent advantages. Currently, nearly 300 signatories to the UN-supported Principles for Responsible Investment (PRI) invest in private equity.

Implementation

In private equity, there are three different types of investments:

Figure 20. Comparison of Corporate Governance of Private Equity and Public Market Investors

Private investors Public investors

Information

Influence

Time horizon Detailed: full access to information on firms during due diligence andownership

Large, concentrated shareholdings: more control and better alignment of incentives

Long-term ownership: enables long-term approach to value creation. Value creation focus Limited: Limited due diligence possible, only public information available to investors

Limited: all UK FTSE 350 board director candidates proposed from 2006 to 2010 were appr oved byshareholders*

Short: average duration of US & UK public investors’ holdings has fallen to 7 months.** Quarterly reporting focus.

Sources: *Cevian’s submission to Kay Review (2011); **“Patience and Finance,” speech by Andrew Haldane, Partners Group (2010).

1. Direct: an investment made directly by a private equity investor in a privately held company. 2. Primary: an investment made by an investor into a private equity fund (sometimes known as a “fund of funds”). 3. Secondary: an investment made by one investor selling to another investor his holding in an asset or portfolio of assets part of the way through the term of the private equity fund.

The implementation of sustainable investment strategies varies between the different types of private equity investments, as illustrated in the “toolkit” below.

Direct investments. Direct investments offer investors greater control over their private equity portfolio companies. • Sourcing: Environmental and social trends are powerful drivers of change and are thus linked to business opportunity. Private equity investors can, therefore, use such trends proactively to identify companies with promising growth prospects. • Due diligence: During due diligence, direct private equity investors obtain full access to information on a company. They can use this to assess how the company is managing ESG factors and thereby identify: i. potential reputational or investment risks that could affect the attractiveness or valuation of the company, and ii. areas in which the company’s management of ESG factors needs to be improved during the ownership period. • Acquisition: Before investing, private equity investors can obtain warranties that a company is following relevant laws and standards. Governance arrangements, such as the composition of the board and management compensation, are also agreed at this stage. • Ownership: Private equity investors are often represented on the boards of their portfolio companies. This enables them to actively initiate and complete projects, together with management teams, designed to improve how ESG factors are managed. Typically, the active investment manager will work closely with management teams to develop a company and increase its value throughout the life of the investment. • Exit: Well-implemented projects that improve a company’s management of ESG factors may facilitate a sales process and can even drive valuation.

Primary and secondary investments. The implementation of sustainable investment practices in primary and secondary investments requires investors to ensure investment managers are effectively integrating ESG factors. 2

Primaries: Prior to making a commitment, investors should perform thorough due diligence to ensure an investment manager has integrated ESG factors into the management of a private equity fund. 3 In addition, potential investors in a private equity fund often seek to negotiate ESGrelated terms into the documentation that governs how the fund will be managed. In practice, this is generally achieved by including specific additional arrangements in the limited partnership agreement (the document that governs how the private equity fund will be managed). Finally, during the life of a private equity fund, investors can influence the investment manager via the fund’s advisory board to ensure the portfolio companies manage ESG factors effectively. Secondaries: Private equity investors have good visibility on the assets in a portfolio when it comes to secondary investments and during due diligence and can, therefore, assess the underlying portfolios to identify companies that pose ethical or reputational risks. They can interact with the investment managers during ownership in the same way primary investors can, but they do not have the same ability to influence the initial terms that govern how a fund will operate.

Performance Impact and Societal Benefits

Leading investors, particularly in the US, have developed advanced metrics to measure the societal benefits of their private equity investments. Metrics can cover a range of environmental and social benefits. For example, the direct private equity investments led and jointly led by Partners Group had a net job creation rate of 3.6% during 2016, which was 2.6× greater than that achieved by the US economy in 2015. 4 Therefore, by providing an attractive risk–return profile and proven societal benefits, sustainable private equity investments could be preferred to other investments that do not integrate ESG factors as effectively.

Further Reading

• Principles for Responsible Investment. (2016). Report on progress: Private equity. • Principles for Responsible Investment & Institutional Investors Group on

Climate Change. (2016). A guide on climate change for private equity investors.

Endnotes

1 Harris, R. S., Jenkinson, T., & Kaplan, S. N. (2014). Private equity performance: What do we know? Journal of Finance, 69(5), 1851–1882. 2 In primary investments, the asset owners are known as Limited Partners (LPs) and the investment manager is known as the General Partner (GP). 3 To enable more efficient and effective due diligence on primary investments, the United Nations-supported Principles for Responsible Investment published in December 2015 a “Limited Partner Due Diligence Questionnaire”: https://www.unpri.org/news/ pri-launches-private-equity-due-diligence-question. 4 Furthermore, in the 12 months up to June 2016, Partners Group’s direct infrastructure investments avoided 1,100,000 metric tons of carbon dioxide, enabled 2.7 million people to travel safely, and supplied 3.6 million people with water.