Private equity as an investor category is fairly new, growing rapidly from the leveraged buyout firms formed in the 1980s. Today these investment organizations, which amass capital to buy large interests in corporations, own the companies that employ roughly 1 in 10 Americans. Private equity fund managers, referred to as general partners or ‘GPs’, have at times been surrounded by controversy with a reputation for being highly pragmatic in buying companies and realizing big returns through financial engineering or operational restructuring.
It is easy to assume that management of triple bottom line issues, often described in finance as environmental, social, and governance (‘ESG’) matters would be of little interest to such financiers. However, GPs around the world are beginning to adopt ESG in a context they are familiar with: value creation.
Active value creation is now fundamental to providers of private capital. A recent survey by tax and assurance consultancy McGladrey, for example, found that 70% of firms now implement a ‘100 day plan’ to realize operational cost savings and other strategic benefits shortly after acquiring a company. Once the domain of only the most active funds, 100 day plans and other approaches to operational improvement are now commonplace.
An increasing number of funds now see ESG management and environmental management in particular as a means of creating value. In a recent study our group conducted in collaboration with the Environmental Defense Fund (‘EDF’), 69% of responding GPs noted that environmental issues are material to investments from a cost savings perspective and 77% cited materiality from a risk management perspective. In short, funds are increasingly confirming the perception that they can profit by focusing on sustainability.
How can funds profit from ESG management? In our experience, GPs are doing so by:
- Leveraging eco-efficiency efforts as a method of driving operational ‘cost-outs’
Funds are engaging management of their portfolio companies to focus on savings which can be realized by increasing the energy efficiency of operating areas such as facilities, manufacturing processes and logistics while identifying other cost saving opportunities in areas such as packaging or waste management. For instance, private equity fund TPG collaborated with portfolio company Caesars Entertainment on energy and waste management initiatives which resulted in $17 million in annual run-rate savings across 110 projects and a 33% reduction in trash at 2 properties.Another interesting example of eco-efficiency is KKR’s Green Portfolio Program. This initiative, which began within a small subset of the fund’s portfolio as a collaborative effort with EDF, has expanded across 13 companies between 2008 and 2011 and resulted in $365 million of avoided costs. At the same time, Green Portfolio initiatives have avoided over 800,000 metric tons of greenhouse gas emissions, 2 million tons of solid waste, and 300 million liters of water use.Such efficiency initiatives are an extension of the private equity sector’s focus on reducing operating costs within portfolio companies and can often generate attractive returns. In our experience, GPs typically expect green cost-out initiatives to have a simple payback of less than three years and a meaningful impact on a company’s EBITDA.
- Integrating ESG considerations into portfolio management & investor relations
While reducing portfolio company operating expenses through eco-efficiency initiatives is the primary focus of ESG initiatives at many funds, particularly in the United States, GPs are also striving to integrate these considerations throughout the investment cycle and into relations with the institutional investors which are limited partners (LPs) in private equity funds.These efforts are driven, in large part, by the increasing expectations of LPs that GPs more proactively manage ESG issues. A representative of one major UK-based institutional investor recently shared four overarching questions which he asks when evaluating a private equity fund manager:
- How do you as a GP look at ESG issues in your own due diligence?
- How do you look at these issues when you’re managing an asset?
- How do you communicate to LPs and other stakeholders?
- What are your views on ESG-related protocols including the United Nations Principles for Responsible Investment?
These inquiries, and similar questions which large LPs are increasingly asking fund managers, are driving GPs to look more closely at environmental, social, and governance issues throughout the investment cycle. Amongst other benefits, doing so helps them to please their investors and supports fundraising efforts.
The Economist recently argued that the public company is in danger of extinction (the number of public companies in the U.S. has fallen by 38% since 1997) and it is expected that private capital will play an expanding role in the global economy. Private equity funds could therefore play a prominent and expanding role in the business world. At the same time, commodity-related risks (such as price volatility) are making the mandate for efficiency in business stronger than ever.
Given this growing role, increasing visibility, and the business case for smarter resource use, many private equity fund managers are beginning to manage environmental, social, and governance matters in a more systematic, value-oriented way. At Malk Partners we look forward to seeing this trend continue, and to accelerating it wherever we can.