ESG: Nice guys finish last?

When KKR and Affinity Equity Partners sold Oriental Brewery to Anheuser-Busch InBev for $5.8 billion last month in Asia's largest-ever trade sale, the exit not only proved lucrative - generating a more than 5x money multiple - but it also boosted the investors' green credentials.

KKR claims that during the three-and-a-half-year holding period the business saved $17.7 million in energy costs, reduced water consumption by 19 million cubic meters - saving another $3.7 million - and avoided 85,000 metric tons of greenhouse gas emissions.

The South Korean brewery was part of KKR's Green Portfolio - a cache of companies intended to showcase the PE firm's commitment to environmental, social and governance (ESG) principles. That KKR is now touting the success of investments in terms metrics other than return on equity demonstrates how far ESG has climbed up the private equity agenda.

This is in part a response to pressure from LPs who increasingly require managers to behave as responsible investors. At the same time, many potential buyers of PE-backed assets, notably multinational corporations, recognize the value in - and are therefore willing to pay a premium for - businesses with a good ESG record.

Accordingly, more GPs are looking to establish responsible investment programs, or at the very least review how they how they manage portfolio companies in terms of ESG. Being aware of the importance of ESG is one thing; establishing a successful framework through which initiatives can be executed is quite another, placing demands on time and resources.

"From a fundraising perspective we are seeing a lot more LPs asking about ESG and they are asking in a much more formal way," says Michael Henningsen, managing g director with placement agent Park Hill Group in Hong Kong. "There are now more ESG-related questions within an LP's diligence questionnaire about what sort of processes the GP will put in place and how they are going to articulate their approach."

Priority alert

Demands for better ESG reporting are by no means new to private equity, but in previous years this had largely been limited to development finance institutions (DFIs) that invest in jurisdictions or sectors typically considered to have a high level of ESG risk.

Today, governance issues are becoming mainstream. A greater number and variety of LPs are introducing ESG remits and looking to GPs for action. One of the key developments driving a greater demand for ESG disclosure has been the UN Principles for Responsible Investment (UNPRI), a voluntary set of standards supported by United Nations.

The principles - which to date have attracted around 1,200 signatories, including many European and North American LPs - focus on six broad pledges, covering: the incorporation of ESG principles into investing, decision making and ownership; disclosure on ESG issues; and promotion of ESG.

These form the basis for the global ESG Disclosure Framework published last year in cooperation with 40 LPs, 10 GPs and 20 private equity associations. The framework, which covers disclosures during fundraising and during the life of the fund - is intended to clarify and define what information is needed by LPs to assess how a GP approaches ESG. In addition, it provides a guidance for potential questions an LP can ask of the GP.

Furthermore, LPs have established and strengthened their own protocols with regards responsible investing.

The California Public Employees' Retirement System (CalPERS), for example, pledged to integrate ESG across all it investments as early as 2011 and has a global governance team to oversee this area. The pension system uses ESG questionnaire across all its investments. It is also pushing for more standardized information from GPs in areas such as climate risk exposure and has formed the Global Peer ESG Exchange to benchmark sustainable investment efforts.

The private equity community has responded with varying degrees of enthusiasm. According to a report on attitudes to ESG in private equity put out by PricewaterhouseCoopers (PwC) last year, 57% of GPs surveyed have a formalized public commitment on ESG management and around 55% actually having relevant policies in place.

Looking at Asia Pacific in isolation, it is perhaps unsurprising that the region trails its global peers. Just 15% of GPs currently disclosing ESG activities in their portfolio to investors, compared to 61% in Europe, 100% in North America and 43% in South America. The global average is 56%.

"The PE landscape in Asia has a large of number of small funds that have traditionally focused on maximizing returns and therefore have limited focus on sustainability and, accordingly, limited focus on ESG issues," says Monica Hira, risk assurance partner at PwC Singapore. "You do see larger PE houses with an established approach to ESG assessment of target companies but the smaller houses are still behind."

Big and bold

The large global firms, by virtue of their networks, resources and LP bases, have not only been the earliest adopters of ESG policies, but have also helped drive a standardized approach to ESG reporting.

The Carlyle Group, for example, established its own set of responsible investment guidelines in 2010, using UNPRI and UN Global Compact - a policy initiative aimed at getting businesses to align operations with broad human rights, labor, environmental and anti-corruption principles -as a starting point. These in turn helped form the basis of responsible investment guidelines adopted by the Private Equity Growth Capital Council (PEGCC) under the umbrella of UNPRI.

While many GPs are aware of what is required, the issue is how to demonstrate to LPs that they are making the necessary change to their portfolios. Several sets of sweeping guidelines have been published but there is no one-size-fits-all model that can easily be applied across a portfolio. A fund can have a core set of principles, but approaches differ from business to business.

From a GP perspective, ESG is addressed in two ways, depending on the stage of the investment cycle being targeted. There is ESG risk management during due diligence and then ESG in the context of post-investment value-add. Typically, GPs and LPs have focused on the former. However, private equity firms are increasingly looking at how ESG can contribute to the development of portfolio companies.

Carlyle cites its investment in Yashili, a Chinese infant formula manufacturer exited to China Mengniu Dairy last June for HK$3 billion ($387 million), as an example of how ESG improvements can lead to value-add.

When the private equity firm bought a 17.3% stake in the company for $95.2 million in 2009, China's dairy industry was still reeling from the a tainted milk scandal that saw infant formula contaminated with the chemical melamine, resulting in the death of six infants, while hundreds more were hospitalized.

"Sometimes it takes a bad situation to give people the conviction that ESG is both a risk and an opportunity," say Patrick Siewert, managing director with Carlyle in Hong Kong. "In this particular case the management had a strong conviction around quality and doing the right thing."

The private equity firm's first move was to bring in Robert Brackett, former director of the US Food and Drug administration's Center for Food Safety and Applied Nutrition, to head Yashili's food safety and quality assurance committee (FQSAC). In addition, the firm was forced to think more strategically about quality while reorienting its supply chains to source raw milk from New Zealand. Better production processes were also introduced alongside a strong compliance framework that suited the company and industry well.

"Those that talk about ESG as risk management are reacting to pressure rather than trying to get out in front and recognizing that ESG is not only the right thing but that it can also a competitive advantage," says Siewert.

This view is echoed by Steve Okun, director of public affairs with KKR, who reflects that it is not only possible for ESG to play a role in the value-add process but essential if investments are to be sustainable.

"If you change the way a company operates and it is profitable, that change is going to last," he says. "If you do something that is ‘nice to do' but does not add to the bottom line, the minute the operating environment changes, such as during a financial crisis, you are likely to drop it."

KKR also invested in China's dairy sector in the wake of the melamine crisis. Acting in tandem with CDH Investments, it backed China Modern Dairy and helped the company establish itself as a high-end milk producer. The PE firms made a partial exit last year, also to Mengniu.

Tight resources

At the other end of the spectrum, small players often struggle to satisfy LPs' ESG requirements because they lack the financial and human resources of their larger counterparts. Indeed, many managers that are scaling up for Fund II or III and want to deepen their LP bases with the addition of European and North American institutional investors, find themselves unprepared.

"Over the last couple of years there are mid-market GPs that have started to receive requests from pension funds and other new LPs on their ESG programs, and in many cases it takes them by surprise," says Javad Movsoumov, executive director in the private funds group at UBS.

"They operate with ESG principles in mind but very often that part of the investment process is not well documented. In many cases there will not be a separate ESG part of the process simply because no one has asked for it before."

Not only do these GPs have little experience with ESG mandate-wielding LPs, but those operating in Asia's emerging economies are often making growth, not buyout, investments.

With limited influence at board level, they might struggle to implement ESG policies even if they had them. And their typical mode of exit is an IPO - the founder and majority shareholder wants to maintain control of the company - so these GPs are not necessarily incentivized to improve ESG credentials to meet the requirements of acquisitive multinationals.

However, UBS's Movsoumov notes that while few GPs raising funds with less than $1 billion in commitments are likely to have a dedicated in-house ESG team, there are exceptions.

Indonesia-based GP Saratoga Capital, for example, has its own ESG director to oversee investments, despite raising about $750 million across its two institutional funds. This is chiefly because DFIs such as International Finance Corporation and CDC Group feature prominently in the first of these funds and because Indonesia is perceived to have higher levels of ESG risk.

Less is more?

As such, some are skeptical as to whether a lack of resources is sufficient reason for a GP not to have a proper ESG policy in place. "There is no reason why proper ESG due diligence cannot happen," says James Pearson, CEO of Pacific Risk Advisors."If a GP starts saying ‘we cannot afford it, we will go bust if we do this' then they really do not understand what it is all about."

Similarly, taking minority stakes does not preclude a private equity firm from generating successful ESG outcomes from an investment. KKR took a minority interest in India's Dalmia Bharat Cement in 2010, added the company to its Green Portfolio two years later, and so far claims to have saved 141,000 metric tons in greenhouse gas emissions.

"When you do a minority investment, you have to aim for a partnership approach, and it can be a little bit different in terms of convincing people to make changes," says KKR's Okun." One of the key things for us is that the portfolio companies need to agree to do it and they need to want to do it, because if they don't it is not going to be effective."

In either case - whether you are a mid-market country fund or global buyout shop - the issue is remains how to record and measure ESG improvements in a meaningful way. While some initiatives, such as saving water and reducing greenhouse emissions, can be quantified, other elements like social and governance impact are harder to quantify.

"The Holy Grail is to truly quantify how much of an IRR comes from the ESG element," says Mark Goldsmith, head of responsible investment as Actis. "Improvement on the governance side, which is often the biggest driver of value, is hard to separate out from what you would have done anyway as part of being a good private equity investor versus it being part of your ESG."

 

SIDEBAR - ESG: Disclosure guidelines

The global ESG Disclosure Framework was published last year with the cooperation of 40 LPs, 10 GPs and 20 private equity associations under the umbrella of the UN Principle of Responsible Investment.

Disclosures during fund-raising

A GP should disclose information sufficient to enable an LP to:

• Assess if the GP is aligned with the LP's ESG-related policy and investment beliefs

• Assess the GP's policies, processes, and systems for identifying ESG-related value drivers and managing material ESG-related risks; and to identify possible areas for future development

• Understand if and how the GP influences and supports its portfolio companies' management of ESG related risks and pursuit of ESG-related opportunities

• Assess how the GP will help the LP to monitor and, where necessary, ensure that the GP is acting consistent with the agreed-upon ESG-related policies and practices as set forth at fund formation

• Assess the GP's approach to managing and disclosing material incidents at the GP and portfolio companies

Disclosures during the life of a fund

A GP should seek to disclose information sufficient to enable an LP to:

• Establish if a GP is acting in a manner consistent with the GP's investment policies, processes, and agreed-upon fund terms regarding ESG management

• Understand positive and negative ESG-related developments that may impact portfolio companies in the fund

• Determine if responses to GP and portfolio company incidents and incident reporting are consistent with relevant investment terms, the fund's policies, and the LP-stated objectives regarding incident disclosure

 

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• Topics
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