Social and governance: A good neighbor

"You're looking for evidence of poor governance from the board side, through what's happening on the factory floor or wherever it is," says James Pearson, CEO of consultancy firm Pacific Risk Advisors. "If you've got people who are working 15 hours a day, the board knows they're happy to make the money doing it, but they also know that 15 hours a day is actually breaking the rules."

With all of the current public attention on environmental issues, the social and governance sides of the ESG equation may seem to get short shrift. But investment professionals caution that they still deserve careful consideration. After all, a GP that gets it right can ultimately secure a better deal - or perhaps avoid a bad one.

The real challenge for private equity firms - and one they must be prepared to face - is that addressing each social and governance issue individually is only part of the solution. They must also be integrated into a long-term plan for a portfolio company, a process that often involves expending a great deal of time and energy.

The first thing is to have an internal system. If they don't have a system that they're following themselves, then we know there are going to be lots of issues, because people aren't doing things consistently - James Pearson

Pearson continues: "When we do E&S, yes, we have 20 different topics for environmental, 15 for health and safety, and 20 for social labor. But we need to pull all that together to work out how this relates to the deal, what are the big red flags, what are the little red flags, and what are the things they need to do over the next two to three years."

One of the trials of dealing with the social and governance sides is the difficulty of assigning a value to these variables. With social issues in particular, it may be hard to quantify the benefit they bring in the long term - and therefore it becomes much harder for a GP's ESG team to impress upon company management the importance of providing proper social support.

In some cases, the nature of a business can provide focus for reviewers. Chris Chia, managing partner at Kendall Court Capital Partners, notes that for a healthcare provider, there is little in the way of environmental impact. However, given the large, well-educated workforce, employees must be made to feel essential.

"The employees start to become a very key part of it, because they've got a lot of nurses, a lot of doctors," says Chia. "So you want to make sure that there is training as well as policies and procedures for people to vent their frustrations - a whistle blowing policy, for example. Governance is a key issue as well when you don't have just one locality of operations but across different parts of the world."

Getting companies to take proactive steps for social responsibility, rather than simply adhering to the legal minimum, can be even more of a challenge. Management may take convincing to spend money on socially beneficial actions that do not have an obvious monetary payoff.

Companies that do set up social responsibility programs often do so in ways that fit their business model, though this is not always the case. At one end of the spectrum, Pacific Risk Advisors' Pearson recalls that a toy maker's corporate social responsibility program consisted of giving away its products to an orphanage; at the other end are technology companies that meet their social goals by planting trees, an endeavor that has little to do with their business.

Good governance?

The governance side is of considerable importance; in fact, some consider it the most important of the three, because it is the mechanism by which policies affecting the other two issues are formulated and implemented.

"The first thing is to have an internal system. If they don't have a system that they're following themselves, then we know there are going to be lots of issues, because people aren't doing things consistently," says Pearson. "Whoever's responsible for these matters, where does that person fit in the hierarchy of the company? Are they low to middle, are they middle to high, or are they on the board?"

One issue with governance is that it can represent what one GP calls a "negative hypothesis": it is defined by undesired consequences, rather than positive steps. With environmental and social factors, one can set clear goals; but with governance, GPs are much more reliant on management to acknowledge that there is a need for improvement - and the prospect of lack of cooperation can be enough to scuttle an otherwise promising deal.

"Usually we find with the environmental side there are shortcomings, but with a small amount of investment they can be remedied quite quickly," says Michael Octoman, partner with Navis Capital Partners. "With the social element, we usually find it's an enhancement that's needed to the healthcare policies, or the health and safety standards on the factory floor, and it's easily remedied. But the deal breakers are usually somewhat in and around the governance area."

Many GPs have incorporated social and governance issues into due diligence processes at a senior level. In the case of Navis, social issues are handled by a dedicated compliance director who investigates a potential investee using a standard questionnaire, looking for such common problems as minimum wage compliance and working hours. Third-party investigators may also be brought in to provide expertise in local matters.

Social and governance issues play a role post investment as well, with the issues identified during due diligence forming part of the GP's 90-day plan. The firm also checks on the ESG factors on a yearly basis as part of its standard review.

Based on a GP survey conducted by PwC, Navis' practices appear to stand out somewhat from its industry peers. The survey showed that PE firms worldwide reported highest interest in ESG management issues at the acquisition stage, with interest declining throughout the holding period. On average, 71% of investors claimed to screen for ESG risks "always" or "frequently" at acquisition, while 50% did so at the 100-180 day stage, and 36% did so at exit.

Breaking down the firms by size is more revealing: large cap GPs showed the highest interest in ESG issues at acquisition, but also the greatest decline at exit stage, from 94% to 38%. Small cap GPs exhibited a smaller decline, from 47% to 31%, but lower numbers overall. This could reflect their relative lack of resources.

Hannah Routh, director of sustainability and climate change at PwC, cautions that investor interest in ESG issues does not always reflect real actions. "What we advise our clients against is having a fully functioning sustainability function that has no impact on the business," she says. "You do see this a lot, particularly within corporates. They do a great job in terms of reporting, but they're not influencing the business at all."

Exerting leverage

While not all GPs value ESG factors equally, they can prove to be an effective means of leverage in negotiations. Even when an issue is not serious enough to back off of the investment entirely, it can still be used to demand concessions that might not otherwise be available.

For other GPs, ESG issues can provide an effective preview of management's willingness to comply with outside direction. A team that is reluctant to update its social policies may have little interest in listening to the advice of an investor. In this way, ESG can be seen as a canary in the coal mine, signaling a bad environment before the due diligence process takes up too much of a firm's resources.

A company's response to governance issues can indicate needed reforms as well. If management tolerates laxity on the lower levels, their own attitudes may need adjustment as well.

Industry players say that despite the difficulty of imposing one's will on a recalcitrant management team, GPs need to be firm on their priorities. Since they are capable of denying needed funding, they may be the only ones with the authority to push necessary changes.

"I think actually the appreciation is still very nascent, it's still very early stage," says Kendall Court's Chia. "And the fact that we're actually having a conference about this only goes to show that we still need to do a lot of education. Because we're in the position of capital providers, I always believe that this is a top down approach."

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• Topics
• Portfolio management
• GPs
• Investments
• Regulation
• GPs
• regulation
• ESG
• Kendall Court Capital Partners
• Navis Management