Emerging markets ESG: Alliances of convenience

For Emerging Markets Investment Advisers (EMIA), the proposal was straightforward. Westline Education Group, a Cambodian private school operator in which the GP had invested in 2011, wanted to create a comprehensive fire safety program for its schools. The company approach EMIA and asked for help in making sure the plan complied with international standards.

On the surface, it was a relatively modest ambition, at least from the viewpoint of investors brought up in developed markets where such procedures are standard for all educational institutions. But clearly marked fire exits, evacuation paths, and regular training for teachers and students are rarities in Cambodia, and Westline wasted no time in making this point to target customers through its advertising.

“The school was able to use that to their advantage from a marketing perspective,” says Joshua Morris, CEO of EMIA. “They were able to highlight to the parents of students and prospective students that they had an internationally-standard compliance with health and safety and fire, when most other schools at that price point in Cambodia didn’t have that type of program at that time.”

EMIA’s experience with Westline demonstrates the opportunity that many private equity investors see for implementing environmental, social, and governance (ESG) protocols in emerging markets. Small investments in comparatively basic improvements can have a big payoff for portfolio companies, and management teams are increasingly aware that addressing ESG issues can lead to significant business benefits.

However, GPs in emerging markets still face challenges justifying the needed investments, particularly in areas where the link between ESG improvements and business growth is not immediately clear and compliance often remains an exercise in box-checking for management, rather than a source of value-add. Achieving progress in these areas is possible, but investors must be selective in identifying companies that will be receptive to their concerns.

“For obvious things it’s not difficult, and for everything else it’s not easy,” says one Southeast Asia-focused investor. “If you tell a founder of a Southeast Asian company that it doesn’t have any independent board members, or it doesn’t have any women on the board or in senior management, management will look at you like they don’t know what you’re talking about.”

Exception to the rule

Making the case for ESG improvements has historically been tricky in emerging markets for a number of reasons. Laws on social and environmental issues in these countries tend to lag those in developed markets. Where tougher regulations do exist it is often an open question whether they will actually be enforced consistently and fairly, and if authorities will be able to keep up with those they are supposed to be controlling.

Consequently, investors in Asia’s developing economies have tended to find that regulatory compliance is the exception rather than the rule. Due diligence committees examining a target company’s books frequently come across income that has gone unreported or labor costs that don’t seem to match up with local minimum wage laws. Such issues serve as a litmus test for whether the GP can expect to find more areas for improvement after its investment.

“Oftentimes, developing countries lack enforceability, and some companies attempt to cut corners by not paying taxes or abiding by minimum wage laws. A company’s non-compliance with local laws gives me a good sense of how they will treat ESG,” says Ralph Keitel, a principal investment officer and regional lead for funds at the International Finance Corporation (IFC).

Tax issues are so widespread in emerging markets that some degree of creative accounting is seen as an almost inevitable cost of doing business for smaller companies. This does not mean ongoing tax evasion is tolerated: fund managers across the board agree that such issues must be cleared up by management as a base condition of their investment. Even with such mandates in place, ensuring that portfolio companies will obey has required some refinement as well.

“Historically we would tolerate some non-compliance, with an agreement that it would be cleaned up in time. But we found that it was quite difficult to get companies to honor their commitments to that stepwise improvement after they had already received our investment,” says Chad Ovel, a partner at Vietnam-focused GP Mekong Capital. “So in our most recent fund we absolutely insist that whatever we identify in the initial assessment be corrected as a condition precedent.”

Though widespread, tax evasion tends to be easily addressed, as even in the most lax regulatory environments getting caught and punished is always a possibility. Settling accounts with the tax authorities and removing this danger has its costs, but the prospect of a fresh capital infusion from private equity investors can be a big incentive for companies to move out of the shadows.

GPs have also found success connecting the tax issue to business opportunities. For example, companies that need to keep more than one set of books find it harder to attract high-level talent than those that are fully compliant. In addition, strategic partners, particularly those from overseas, are more willing to collaborate with companies that conduct their business according to international standards.

Tax compliance is just one area where cooperation is expanding, as companies in Asia’s emerging markets have begun to embrace other aspects of ESG. Navis Capital Partners-backed Saitex and ISA Industrial, for example, have made compliance with international standards in the denim and leather industries, respectively, a centerpiece of their partnerships with leading global clothing manufacturers.

Other companies position themselves as sources of uplift for women and minorities, or like Westline they pursue improvements that can be used in marketing. Upgrades with clear safety or efficiency benefits also tend to be quickly adopted, as with the oil leaks that one GP found at a potential investee’s factory.

“Companies that go with institutional private equity like ourselves are somewhat self-selecting. They’re actively seeking out international best practices and looking for ways to do business better, and that’s why they go through a challenging and detailed due diligence process that has ESG as a component,” says EMIA’s Morris.

On the other hand, ESG measures that are less easily communicated to investors and the public, and those that lack an obvious business impact can be harder to implement. Suggestions to increase the representation of women or minorities in management or on the board tend to be slow-walked by owners who see no benefit for the company in taking such action.

The hesitation can be even worse in areas where the management team feels it has already done enough – for example, by meeting Indonesia’s national certification for responsible palm oil rather than the more stringent global standard. The company is already compliant, likely at considerable cost, so why spend more to get an additional certificate?

Though the difficulty of implementing ESG policies with these management teams frustrates GPs, the same investors admit there is a logic to the reluctance. Compliance demands can seem arbitrary and unfair when most of a company’s peers face no such requirements.

“Their concern is that if they spend the time and money developing this program or following these policies, it’s going to increase their cost base. That will hurt profitability, and if the consumer doesn’t know about it, then what benefit does it give them?” Morris says. “A key component to ESG in frontier and emerging markets is to ensure that entrepreneurs can turn it into something that differentiates themselves to their stakeholder base or customer base.”

LP pushback

Most GPs in the region have a number of case studies on the benefits of ESG that they use to address portfolio companies’ concerns. However, achieving alignment with management teams requires commitment that is not always present, even on the investor level. Some firms admit they prefer to focus on improvements in areas where they know they can make a convincing business case, leaving efforts for gender inclusion, environmental improvements, and other measures for later – if ever.

Institutional investors have helped to push back against this reluctance, with a growing number of LPs insisting that their GPs develop real commitments to ESG. One fund manager found during its last fundraise in 2013, the few LPs that asked about its ESG policy were satisfied when told that the firm was working on it. For its current fund, nearly every LP has raised the topic, with most of them requesting detailed information about reporting standards.

Development finance institutions (DFIs) have played a major role in encouraging GPs to assess the impact of their investments, with IFC prominent among them – indeed, most investors refer to IFC’s ESG policies as the standard for their investing. However, Keitel has found that commitment to the guidelines is not always reflected by an investor’s internal culture.

“Does the GP have an ethics code or code of conduct? What’s the gender ratio within the firm?” he says. “When I walk through a fund manager’s office and I see 20 people, 19 of whom are male, and the one female is the secretary, I will point it out. When we have those conversations and introduce IFC’s ESG policies, you quickly get a sense of whether there’s real buy-in or if the GP is just keen to appear cooperative because it needs the money.”

IFC and other DFIs may be strict in their standards, but it can also be helpful to have investors in a fund that are aware of the challenges of frontier and emerging markets and insist on the best governance standards.

For example, one of EMIA’s portfolio companies had a shipment held up in port due to a dispute over tariff payments. Such issues are often settled with a bribe, but this was not permitted by EMIA’s zero tolerance policy on corruption. As a consequence, the shipment was delayed by six months and the portfolio company lost half a year’s worth of business. EMIA’s LPs – all DFIs – supported its decision even though their investment suffered.

Adherence to a strong ESG policy can be reflected in the deals a firm walks away from, just as much as those that it completes. Mekong regularly turns down investments in companies that it determines would no longer be viable if they were made tax-compliant. Other GPs report that they are rejecting a growing number of deals for similar reasons.

“Often we’re turning down transactions because of ESG issues that we see are so fundamental, and either they’re broken beyond repair or we can’t get to a meeting of minds on what changes are needed,” says Michael Octoman, a senior partner and COO at Navis. “There’s at least one company every quarter where we’ll decide not to proceed because of governance or integrity questions.”

Incremental change

Although ESG compliance is still a challenge in emerging markets, participants say the growing sophistication of stakeholders across the ecosystem – including GPs, LPs, regulators, and consumers – is having a noticeable effect on portfolio companies. Mekong has seen the incidence of tax non-compliance decline significantly over the last few years as Vietnam’s government steps up enforcement efforts and investors insist on transparent accounting practices. Ovel expects the issue to be almost completely resolved by 2025.

The growing track record of PE firms in Asia for delivering positive transformation to portfolio companies is also providing a strong impetus for management teams to work with investors on ESG. Private equity involvement is increasingly seen as a guarantee that a company can operate on the same level as its world-class peers.

“We introduce world-class governance processes, we establish a board with independent directors, we professionalize the company,” says James Magor, a responsible investment manager at UK-based emerging markets investor Actis. “And when we do exit through a trade sale to a multinational, it’s very easy for them. We’ve heard feedback from buyers that they recognize they paid a premium, but they know they’re buying an Actis company, and they’re prepared to pay because of the ESG standards they will inherit.”

For IFC, the growing enthusiasm for ESG principles is a welcome sign that its industry leadership is paying off. The DFI believes that as more LPs follow its example and demand greater social and environmental impact from their GPs, the increased focus on compliance will continue to trickle down through the fund managers and into the portfolio companies.

“It’s always a delight to meet a new GP at a conference, and one of the first things they say is that they’re already compliant with IFC’s ESG policies,” says Keitel. “When you’ve been doing this long enough, people understand that following the highest ESG standards is a little more work, but it helps to differentiate a fund manager when it is time to fundraise.”

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• Topics
• Southeast Asia
• South Asia
• GPs
• LPs
• Performance
• Regulation
• ESG
• IFC
• Navis Management
• Mekong Capital
• Actis Capital