PE & PR: Sustainable alpha

The planned $8.9 billion expansion of a petrochemical plant in the eastern Chinese city of Ningbo provoked a wave of protests by residents last month. They were concerned about plans to produce the industrial chemical paraxylene at the facility, which could cause untold damage to the local environment and health. After three days of demonstrations, the local government announced that the project would not go ahead.

This scenario has been repeated time and again in China in recent years. It is symptomatic of a growing awareness of environment and sustainability issues globally, and is reflected by the increasing number of private equity firms putting environmental and social governance (ESG) higher up the agenda. A recent PricewaterhouseCoopers survey into the responsible investment practices of 17 PE houses found that 94% of firms believe that ESG activities can create value at their portfolio companies.

"People nowadays are more aware of bribery and corruption issues, governance problems in companies, worker participation and exploitation issues, and environmental issues such as reduction in carbon footprint and fuel economies," says Claire Wilkinson, general counsel at placement agent MVision and chair of the European Venture Capital Association's Responsible Investment Working Group.

Compliance isn't enough

For those firms investing in China, compliance is a key issue. While many local companies may have undergone environmental impact assessments (EIAs) - to determine the impact a proposed project may have on the environment - and obtained the necessary permits, on numerous occasions permit requirements have not been implemented, meaning investors find themselves liable to pay large sums to bring projects up to the mark.

According to James M. Pearson, CEO of Pacific Risk Advisors, which conducts environmental and social (E&S) due diligence on behalf of investors, firms that are only interested in being compliant - as opposed to wanting to back firms with superior ESG records - are setting their standards too low.

"If you're not in compliance, you're breaking the law, so those people who are really happy because they're compliant are at the bottom of the bottom," he tells AVCJ. "They should be saying they're better than compliance, which would mean they are able to identify a lot of operational improvements staring them in the face. I've never gone to a factory that's been 100% in compliance anyway - I've always found something regulatory-wise, whether it's the environment or health and safety."

Labor issues are also a cause for concern among GPs. The biggest issue - in China, in particular - is that often potential targets have not paid for social insurance for their workers, despite this being required by law. A firm investing into such a company needs to be aware of this, to ensure back-pay is provided and that all future employees have appropriate healthcare and accident coverage. In some cases, a lack of insurance might be cause enough to walk away from a deal.

"If you've got 100 workers and for the last 10 years they've been exposed to some toxic chemical, they may be coming back ill and you're liable to be sued," points out Pacific Risk's Pearson.

Compliance and labor issues are nothing new among Asian companies, though. What's changing is the recognition from investors of the importance of these issues, and risk management is a prime motivator. China Investment Corp-backed China-ASEAN Investment Cooperation Fund (CAF), which invests in infrastructure, energy and natural resources in Southeast Asia and China, views E&S due diligence as just another method for analyzing the capacity of an investee company's management.

"If a potential investee company does not have a sound grasp of ESG management or the willingness to improve, this can be a symptom of greater issues at hand," explains Dean Robinson, an associate at CAF. "By helping an investee company improve its ESG performance, this in turn can help minimize risks and improve value."

It's also not merely the reputation of the individual company that is at stake, either, but the brand of the fund as a whole. No GP wants to have an entity in their portfolio that constitutes an environmental reputational risk. This doesn't mean that an investment won't take place if a negative ESG factor is highlighted in pre-deal screening. It simply means the investment manager will take on that project well-informed of the risks and aware of the value that can be added by instituting new procedures or mitigating downsides.

LP preference

LP expectations constitute another significant driver for PE firms to focus on ESG. According to Coller Capital's latest global private equity barometer, the majority of European (70%) and Asia-Pacific (59%) LPs monitor - or expect to start monitoring - GPs' ESG policies, and most industry participants believe this will grow in coming years. Some investors still pay little attention to ESG issues, however, with Coller's survey noting that only a quarter of North American LPs monitor ESG strategies.

"There are exceptions of course with some notable US public pension plans being very active in this," says MVision's Wilkinson. "I think this is societal. The end investors are expecting good returns from their fiduciaries and maybe in North America, consumers haven't yet moved towards demanding that those returns are also based on sustainable investment criteria."

Other motivations for a robust approach to ESG include the potential cost-savings for the PE firm. KKR and Doughty Hanson are among a handful of investors that have attempted to quantify the financial impact of their environmental activities in monetary terms.

KKR, for example, claims that thanks to being part of its Green Portfolio Program, investee company Oriental Brewery has saved $5.3 million and avoided generating 40,000 metric tons of greenhouse gas (GHG) emissions. Collectively, the 23 portfolio companies that have taken part in the scheme have achieved more than $365 million in financial impact and avoided 810,000 metric tons of GHG emissions, 2.2 million tons of waste, and 300 million liters of water.

"Cost-savings are what makes the program sustainable over a long period of time. If it's done the right way, this program should go on forever," says Steve Okun, director of Asia-Pacific public affairs. "If it makes business sense to do something - and you can have an environmental impact - why wouldn't you do it?"

Exit gains

A related advantage is the benefit the GP sees on exit. The notion of "sustainable alpha" - creating a difference in value at the exit point through focusing on sustainability risk - is one that is gaining traction. Not only it is advisable to have reputable E&S procedures in case the company decides the pursue a listing - the Hong Kong Stock Exchange has just introduced new ESG reporting requirements and other exchanges have their own stipulations - but firms going down the secondary or trade sale route should also be considering the impact ESG can have.

"You can harp on about how compliance is expensive and takes time but the smart GPs get it," says VikramRaju, senior global funds specialist for the International Finance Corporation (IFC). "If you have two equal companies - one with ESG standards and the other without - the company with ESG standards can command a better multiple. If you don't have this, it definitely dents your valuations."

The potential magnitude of E&S disasters and pressure from investors, particularly IFC and Asian Development Bank, mean it's a foregone conclusion that the PE industry's response to ESG will evolve rapidly. What form this evolution will - and should - take is a matter for debate.

"At the operational level, PE investor leaders in ESG integration like Robeco Private Equity will help push the industry to move past a tendency to focus on one or two ESG issues (such as corruption or water) and take a more holistic, engaging approach with the GP," says David Doré, research manager at ASrIA, an organization that promotes sustainable finance and responsible investment in Asia.

"We would expect an even greater awareness that ESG integration, such as focusing on employee satisfaction thereby lowering sick leaves and increasing productivity, is not in conflict with value creation and operational efficiency."

As demands from society and LPs rise, those firms that develop in-house capabilities to tackle ESG may be in a much stronger position than those that do not. The more forward-looking firms will see this as an opportunity rather than a challenge.

SIDEBAR: Global PE firms' ESG policies for Asia

CVC Capital Partners

"Our ESG policy in Asia is consistent with our global policy. As a responsible investor, CVC is committed to the effective management of ESG issues, which it believes should be an integral part of the overall investment process. All deal teams are therefore required to consider the sustainability implications (both risks and opportunities) of acquiring a target, and to formally document their evaluation in the teams' investment papers. In order to assist the team, a comprehensive online ‘Sustainability Toolkit' covering 11 industry sectors is available to provide guidance and help teams identify relevant ESG issues on each deal."

TPG Capital

"TPG's commitment to sustainability in Asia supports the firm's long-standing consideration of environmental, health and safety practices in due diligence, investment decisions and operations. Our focus on sustainability enables us to make better investment decisions and achieve greater results for investors, portfolio companies and stakeholders. TPG's sustainability commitment ensures that sustainability practices are implemented and that measurable results are achieved in our companies and our operations. We incorporate sustainability considerations into our investment diligence and decisions and strive for greater transparency and governance from our companies."

KKR

"In 2009, we became signatories of the United Nations-backed Principles for Responsible Investment, in part to give us a platform to engage with our investors and peers on managing ESG issues. In addition, we partner directly with a number of LPs to help define and prioritize our ESG-related efforts as well as to learn from their experiences, including through our ‘ESG round tables,' which we started holding in some cities in 2010."

Bain Capital

"ESG principles are at the core of Bain Capital's value-added investment approach. We encourage our employees, worldwide, to give back to the communities in which they live and work, to help the businesses that we collaborate with to be environmentally efficient and to help ensure that the management teams with which we partner operate with the highest standards of integrity."

The Carlyle Group

"Carlyle employs ESG principles to create long-term value for our investors. We are integrating responsible investment guidelines into our investment decision-making process for controlling, corporate buyouts across our portfolios. We can work with our portfolio companies to facilitate their evaluation of the ESG issues associated with their businesses. As a result of our encouragement, more than 60 Carlyle portfolio companies - representing more than 90% of Carlyle-controlled companies - reviewed their operations in accordance with the Private Equity Growth Capital Council guidelines corporate social responsibility in 2011."

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