ESG: Quantifiable benefits

B Medical Systems emerged as a solution to a healthcare sector bottleneck. The World Health Organization was shipping vaccines to crisis-hit communities from Asia to Africa to South America, but had run into problems around safely transporting and storing its stocks. It approached Electrolux and Vianden was established in 1979. The company subsequently became a division of Dometic Group and was then acquired – and renamed – by Navis Capital Partners in 2015.

As a recognized authority in healthcare cold supply chains and blood safety, B Medical is commercially oriented but also makes an obvious social contribution: without its equipment that keeps vaccines at 2-8 degrees Celsius in remote villages that have no power supply, diseases might go untreated. When Navis wanted to start measuring the social return of its investment, B Medical was quickly identified as an appropriate case study.

“We did a study covering Nigeria, Myanmar, Indonesia and Brazil. On average, having that piece of equipment in the village saves about 10 lives. It averts a lot of health issues within the community as well, and we were able to quantify that and get it validated by the Harvard Health School. Every $1 invested in the cold chain had a $30 payback on society,” says Michael Octoman, a senior partner and COO at Navis.

B Medical has used the study to advocate its product to health ministries in various countries. It also represents a breakthrough in the measurement of certain aspects of environmental, social and governance (ESG) work that are traditionally harder to quantify. For GPs that have implemented ESG policies and now want to apply them consistently, this is crucial to embedding capabilities in an organization so that successes can be replicated systematically in different investment scenarios.

“I think the challenge now for all of us is how do we actually report and manage the metrics we should be getting to demonstrate it is actually creating value,” says James Pearson, CEO of Pacific Risk Advisors. “We all know it is creating value, but how do we demonstrate it?”

Exceeding expectations?

For a private equity firm to reach a position in which it can offer an informed answer to this question, a robust ESG infrastructure must already be in place. It means treating the area as more than just a box-checking exercise used to appease LPs during a fundraising process.

“The biggest improvement is front-ending ESG, especially in relatively higher risk markets. Are there likely to be FCPA [US Foreign Corrupt Practices Act] issues? Are there likely to be health and safety and security issues?” says Patrick Siewert, a managing director with The Carlyle Group. “I think we’ve all been through investment processes where those things come out at the end rather than the beginning, so the bulk of the due diligence time isn’t necessarily spent in the right place.”

This way of working, or even the basic philosophy that sits behind it, has by no means been universally adopted by managers in Asia, many of whom have been accused of using ESG as a means to an end. And in certain situations – particularly when they are worried about securing an allocation to a fund run by an in-demand manager – LPs neglect to push the issue.

Kathleen Bacon, a managing director at HarbourVest Partners, recalls attending the advisory board meeting for a large global private equity firm, and during the in-camera session the chairman asked his fellow LPs what they thought of the GP’s ESG policy. This manager’s reporting method was to produce a selection of case studies and it met with approval from the assembled company.

“I leaned forward and said, ‘Really? You guys are the asset owners, do you really think this is good enough? Shouldn’t we at least ask them to produce risk register to see if there are any looming ESG risks?’” Bacon says. “They nodded their heads, but I got the sense that because this was such a hard-to-access manager, even in the in-camera session LPs didn’t want to put this out there as an issue.”

Christopher Ailman, CIO of California State Teachers’ Retirement System (CalSTRS), adds that he knows of public pension funds in the US that hold back on ESG for fear of souring relations with strong private equity firms. One of the ironies of the situation is that investment professionals working for CalPERS or other institutional players are often trained to prioritize getting access to GPs based on the assumption of persistence of returns.

“They are afraid to ask those questions [about ESG]. But I don’t know if there is persistence of returns anymore,” Ailman notes. He believes CIOs in the US are paying more attention to ESG and asking the right questions, although it is as much of a learning process for LPs as it is for GPs.

With its principles-based approach to ESG compliance a work in progress, CalSTRS has yet to reach the level of its European counterparts. APG, for example, insists on side letters that go beyond normal ESG provisions, and commitments are only signed off at investment committee level once there is satisfaction with requirements pertaining to ESG.

However, the US pension fund has started refusing to back GPs that are seen as merely paying lip service to ESG. “It drives me nuts when people say, ‘We have an ESG team. They aren’t in this building, they are down the block in a small office over there.’ You can tell they aren’t integrated into the process, they are just checking the box,” says Ailman.

In this sense, while ESG competencies are to some extent a function of resources, having full-time staff dedicated to this function is only worthwhile if there is a wider buy-in to their efforts throughout the firm. This includes ensuring investment team members recognize the risks and opportunities presented by ESG, and factor these considerations into each stage of the deal process.

HarbourVest runs an ESG scorecard system, which enables it to engage managers – particularly the venture capital and small to mid-size buyout players that form the bulk of its portfolio – on the importance of compliance and also benchmark performance. The scorecard comprises three main assessment categories: the manager, the investment process, and the quality of reporting.

According to Bacon, reporting is where private equity firms tend to score lowest. There is a size bias – larger players have more institutionalized processes, a consequence of their greater financial resources and the demands imposed by broader LP bases – but a regional bias as well. Europe tends to score higher than the US, with Asia trailing.

Effective tracking

FountainVest Partners is one of numerous firms in the region seeking to improve in this area. The China-focused GP drew up an ESG policy in consultation with LPs not long after it was founded in 2007. The initial focus was on implementation: establishing ESG within its culture so that investment professionals do not view it as a hindrance; and not only including compliance considerations in due diligence but also writing it into shareholder agreements with portfolio companies.

The priority for the next 12 months is strengthening reporting capabilities, a process that is likely to involve an outside consultant reviewing current approaches and recommending improvements.

“Secondly, we want to go to portfolio companies and see how they can work within our template to provide ESG reports themselves, so they are not only covered by our due diligence and committed to complying with our policies, but we can also track how they are doing,” sats Frank Tang, CEO and managing partner at FountainVest. “We have yet to do this tracking at the portfolio level.”

When properly implemented, this has proved effective, but even some of the larger private equity firms in the region are still putting plans in place. CVC Capital Partners, for example, started looking at ESG initiatives in Asia a decade ago, but it is only in the last three or four years that efforts have accelerated with compliance becoming a significant and consistent part of the due diligence process, investment committee discussions, and 100-day plans.

Last year, the GP introduced a pilot program for tracking ESG key performance indicators at Softex Indonesia, a diaper and sanitary napkins manufacturer in which it holds a minority stake. The question was whether management could use data produced on energy and water consumption to achieve ESG goals. Alvin Lam, a senior managing director with CVC, describes the process as painful, but the firm now believes it can expand the program to include other portfolio companies in Asia.

“We have portfolio companies that are very good and others where we have identified areas for improvement,” Lam adds. “We also need to recognize we are starting from a lower base. We invest a lot more in family businesses, whereas in Europe it is more corporate spin-offs that come with systems and processes that were put in place when they were part of larger, more established groups. The starting point is different, but I do think Asia is catching up quickly.”

Securing management buy-in on ESG initiatives is cited by numerous industry participants as a bottleneck. It’s not that founder-entrepreneurs are inherently opposed to what private equity investors are trying to achieve, they just haven’t considered it before. And once the importance of compliance has been explained it must be reinforced. CVC did this at a manufacturing business by making health and safety the first slide in every presentation at board meetings.

“Ten years ago, it was the basics – cost savings and ESG making good business sense,” says Octoman of Navis. “Then you get into the softer aspects, which are harder to measure, around people and so forth. It is a journey. Change cannot happen overnight, but it is all about getting that alignment.”

Improvement by numbers

There are various ways to bring about that alignment, including the fact that a growing number of stock exchanges in Asia require listing candidates to fulfill certain ESG criteria. And when making the case from a pure business improvement perspective, investors have more data at their fingertips than ever before.

Carlyle used analytic models to improve driver routing efficiency in security services business ADT, leading to a reduction in fuel consumption and road accidents. It is now working with McDonald’s in China – having participated in a buyout of the business earlier this year – on supply chain modeling intended to bring the ingredients of a Big Mac closer to the consumer that eats it. “That used to be herculean,” says Siewert. “Now it’s table stakes for being able to set up a profitable business.”

Similar profit-driven initiatives that deliver environmental benefits are visible in almost every traditional industry that is being disrupted by technology, from long-haul trucking to retail. Jie Gong, a partner at Pantheon Ventures, observes that supply chain automation is the most value-added component for environmental causes from an IT-enabling perspective. “It allows for much greater reduction of redundancy,” she adds.

Asia’s progress can also be seen in private equity firms making investments in businesses because of their ESG credentials. This was the case with Navis’ acquisition of ISA Industrial, a Macau-based leather goods producer with a sizeable manufacturing presence in Vietnam. According to Octoman, the company’s carbon footprint is 50% smaller than that of its industry peers in Europe due to the introduction of recycling and renewable energy programs.

Navis concluded that being able to showcase ISA’s sustainability initiatives would play well in a leather tanning industry that has been blighted by employee health concerns globally, prompting leading leather goods retailers to look for suppliers that reflect best practices.

“The more we can measure, the more we can quantify, and the more we can justify ESG,” Octoman says. “We are not there yet across our whole portfolio, but in a few cases, yes we are.”

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• Topics
• Greater China
• Southeast Asia
• Regulation
• Performance
• GPs
• LPs
• ESG
• Fountainvest Partners
• California State Teachers’ Retirement System (CalSTRS)
• HarbourVest Partners
• CVC Capital Partners
• Navis Management
• The Carlyle Group